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Cephalon 10-K 2007

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


FORM 10-K

    (Mark One)

x                               ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

or

o                                  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from               to                

Commission file number 000-19119

Cephalon, Inc.

(Exact Name of Registrant as Specified in Its Charter)

Delaware

 

23-2484489

(State or Other Jurisdiction of
Incorporation or Organization)

 

(I.R.S. Employer
Identification No.)

41 Moores Road

 

19355

P.O. Box 4011

 

(Zip Code)

Frazer, Pennsylvania

 

 

(Address of Principal Executive Offices)

 

 

 

Registrant’s telephone number, including area code: (610) 344-0200

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

 

 

 

Name of each exchange on which registered

 

Common Stock, par value $.01 per share

 

Nasdaq

 

Securities registered pursuant to Section 12(g) of the Act:

None

(Title of Class)


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x  No o.

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o  No x.

Indicate by check mark whether the registrant (1) has filed all reports 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. Yes x  No o.

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

Large accelerated filer x  Accelerated filer o  Non-accelerated filer o.

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

The aggregate market value of the voting stock held by non-affiliates of the registrant, as of June 30, 2006, was approximately $1.6 billion. Such aggregate market value was computed by reference to the closing price of the Common Stock as reported on the Nasdaq Stock Market on June 30, 2006. For purposes of making this calculation only, the registrant has defined affiliates as including only directors and executive officers and shareholders holding greater than 10% of the voting stock of the registrant as of June 30, 2006.

The number of shares of the registrant’s Common Stock outstanding as of February 15, 2007 was 65,691,380.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive proxy statement for its 2007 annual meeting of stockholders are incorporated by reference into Items 10, 11, 12, 13, and 14 of Part III of this Form 10-K.

 




TABLE OF CONTENTS

 

 

 

Page

Cautionary Note Regarding Forward-Looking Statements

 

ii

 

 

PART I

 

 

Item 1.

 

Business

 

1

Item 1A.

 

Risk Factors

 

24

Item 1B.

 

Unresolved Staff Comments

 

37

Item 2.

 

Properties

 

37

Item 3.

 

Legal Proceedings

 

38

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

38

 

 

PART II

 

 

Item 5.

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

40

Item 6.

 

Selected Financial Data

 

43

Item 7.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations      

 

44

Item 7A.

 

Quantitative and Qualitative Disclosures About Market Risk

 

71

Item 8.

 

Financial Statements and Supplementary Data

 

72

Item 9.

 

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure     

 

125

Item 9A.

 

Controls and Procedures

 

125

Item 9B.

 

Other Information

 

125

 

 

PART III

 

 

Item 10.

 

Directors, Executive Officers and Corporate Governance

 

126

Item 11.

 

Executive Compensation

 

126

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   

 

126

Item 13.

 

Certain Relationships and Related Transactions, and Director Independence

 

126

Item 14.

 

Principal Accounting Fees and Services

 

126

 

 

PART IV

 

 

Item 15.

 

Exhibits and Financial Statement Schedules

 

127

SIGNATURES

 

137

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

In addition to historical facts or statements of current condition, this report and the documents into which this report is and will be incorporated contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements contained in this report or incorporated herein by reference constitute our expectations or forecasts of future events as of the date this report was filed with the Securities and Exchange Commission (the “SEC”) and are not statements of historical fact. You can identify these statements by the fact that they do not relate strictly to historical or current facts. Such statements may include words such as “anticipate,” “will,” “estimate,” “expect,” “project,” “intend,” “should,” “plan,” “believe,” “hope,” and other words and terms of similar meaning in connection with any discussion of, among other things, future operating or financial performance, strategic initiatives and business strategies, regulatory or competitive environments, our intellectual property and product development. In particular, these forward-looking statements include, among others, statements about:

·       our dependence on sales of PROVIGIL® (modafinil) [C-IV] in the United States and the market prospects and future marketing efforts for PROVIGIL, FENTORA™ (fentanyl buccal tablet) [C-II] and VIVITROL® (naltrexone for extended-release injectable suspension);

·       any potential approval of our product candidates, including NUVIGILÔ (armodafinil);

·       our anticipated scientific progress in our research programs and our development of potential pharmaceutical products including our ongoing or planned clinical trials, the timing and costs of such trials and the likelihood or timing of revenues from these products, if any;

·       the timing and unpredictability of regulatory approvals;

·       our ability to adequately protect our technology and enforce our intellectual property rights and the future expiration of patent and/or regulatory exclusivity on certain of our products;

·       our future cash flow, our ability to service or repay our existing debt and our ability to raise additional funds, if needed, in light of our current and projected level of operations; and

·       other statements regarding matters that are not historical facts or statements of current condition.

Any or all of our forward-looking statements in this report and in the documents we have referred you to may turn out to be wrong. They can be affected by inaccurate assumptions we might make or by known or unknown risks and uncertainties. Therefore, you should not place undue reliance on any such forward-looking statements. The factors that could cause actual results to differ from those expressed or implied by our forward-looking statements include, among others:

·       the acceptance of our products by physicians and patients in the marketplace, particularly with respect to our recently launched products;

·       our ability to obtain regulatory approvals to sell our product candidates, particularly with respect to NUVIGIL, and to launch such products successfully;

·       scientific or regulatory setbacks with respect to research programs, clinical trials, manufacturing activities and/or our existing products;

·       unanticipated cash requirements to support current operations, expand our business or incur capital expenditures;

·       the inability to adequately protect our key intellectual property rights;

·       the loss of key management or scientific personnel;

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·       the activities of our competitors in the industry, including the continued erosion of ACTIQ (oral transmucosal fentanyl citrate) [C-II] sales to generic competitors;

·       regulatory or other setbacks with respect to our settlements of the PROVIGIL and ACTIQ patent litigations;

·       unanticipated conversion of our convertible notes by our note holders;

·       market conditions in the biopharmaceutical industry that make raising capital or consummating acquisitions difficult, expensive or both; and

·       enactment of new government laws, regulations, court decisions, regulatory interpretations or other initiatives that are adverse to us or our interests.

We do not intend to update publicly any forward-looking statement, whether as a result of new information, future events or otherwise, except as required by law. We discuss in more detail the risks that we anticipate in Part I, Item 1A of this report. This discussion is permitted by the Private Securities Litigation Reform Act of 1995.

iii




PART I

ITEM 1.                BUSINESS

Overview

Cephalon, Inc. is an international biopharmaceutical company dedicated to the discovery, development and marketing of innovative products to treat human diseases. We currently focus our efforts in four core therapeutic areas: central nervous system (“CNS”) disorders, pain, cancer and addiction. In addition to conducting an active research and development program, we market six products in the United States and numerous products in various countries throughout Europe. Consistent with our core therapeutic areas, we have aligned our 829-person U.S. field sales and sales management teams by area. In Europe, we have a sales and marketing organization numbering approximately 412 persons that supports our presence in nearly 20 European countries, including France, the United Kingdom, Germany, Italy and Spain.

Our most significant product is PROVIGIL® (modafinil) Tablets [C-IV], which comprised approximately 43% of our total consolidated net sales for the year ended December 31, 2006, of which approximately 94% was in the U.S. market. For the year ended December 31, 2006, consolidated net sales of PROVIGIL increased 43% over the year ended December 31, 2005. Under our co-promotion agreement with Takeda Pharmaceuticals North America, Inc., 500 Takeda sales representatives began promoting PROVIGIL in the second position to primary care physicians and other appropriate health care professionals in the United States beginning July 1, 2006. Effective January 1, 2007, an additional 250 Takeda sales representatives were added, all of whom are detailing PROVIGIL in the first position. Together with our CNS field sales and sales management teams, we now have nearly 1,200 persons focused on detailing PROVIGIL in the United States.

Our second most significant product in 2006 was ACTIQ® (oral transmucosal fentanyl citrate) [C-II], which comprised approximately 34% of our total consolidated net sales for the year ended December 31, 2006, of which approximately 95% was in the U.S. market. In late September 2006, Barr Laboratories, Inc. entered the U.S. market with a generic version of ACTIQ (“generic OTFC”) pursuant to our license and supply agreement. As a result, ACTIQ sales have been meaningfully eroded by generic OTFC products sold by Barr and by us through our sales agent, Watson Pharmaceuticals, Inc., and we expect this erosion will continue during 2007.

During 2006, two of our products were approved by the U.S. Food and Drug Administration (the “FDA”). In late September 2006, we received FDA approval of our next-generation proprietary pain product, FENTORA™ (fentanyl buccal tablet) [C-II], and launched the product in the United States in early October. FENTORA is indicated for the management of breakthrough pain in patients with cancer who are already receiving and are tolerant to opioid therapy for their underlying persistent cancer pain. We are focusing our longer-term clinical strategy on developing FENTORA for patients with breakthrough pain associated with other conditions, including neuropathic pain and back pain. In October 2006 and January 2007, we announced that data from Phase 3 clinical trials of FENTORA demonstrated efficacy in the management of breakthrough pain in opioid-tolerant patients with chronic low back pain and chronic neuropathic pain, respectively. Pending positive data from an ongoing study in patients with non-cancer breakthrough pain, our goal is to submit a supplemental new drug application (“sNDA”) to the FDA in late 2007. This sNDA would seek to expand the labeled indications for FENTORA beyond breakthrough pain in patients with cancer.

In April 2006, the FDA approved VIVITROL™ (naltrexone for extended-release injectable suspension), and we launched the product in June. VIVITROL is indicated for the treatment of alcohol dependent patients who are able to abstain from alcohol in an outpatient setting and are not actively drinking when initiating treatment. Treatment with VIVITROL should be used in combination with psychosocial support, such as counseling or group therapy. Under the license and collaboration agreement

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we signed with Alkermes, Inc. in June 2005, Alkermes is responsible for manufacturing commercial supplies of VIVITROL and we have primary responsibility for the marketing and sale of the product.

We also made progress in 2006 toward the approval of NUVIGIL™ (armodafinil) with an anticipated indication for excessive sleepiness. NUVIGIL is a single-isomer version of modafinil, the active ingredient in PROVIGIL. In May 2006, we received an approvable letter from the FDA; we currently expect a final approval decision from the FDA on or before March 31, 2007. The FDA is continuing to evaluate the single case of serious rash reported in a SPARLON™ (modafinil) Tablets [C-IV] clinical study discussed below. We have provided additional information to the FDA to help the agency place this isolated case in the context of the safety profile for modafinil that has been established over more than a decade of commercial use. The reviewing division has not requested any additional information related to NUVIGIL and is working with us to finalize the product’s label. Since NUVIGIL is derived from the active ingredient in PROVIGIL, we expect that the safety information in the PROVIGIL label will be appropriately modified to reflect the safety information in the final NUVIGIL label. NUVIGIL is protected by a composition of matter patent that will expire on December 18, 2023 and covers a novel polymorphic form of armodafinil, the active pharmaceutical ingredient in NUVIGIL.

In March 2006, we announced that the FDA’s Psychopharmacologic Drugs Advisory Committee voted not to recommend approval of SPARLON for the treatment of attention deficit/hyperactivity disorder (“ADHD”) in children and adolescents. This recommendation was the result of concerns expressed by the advisory committee regarding a possible case of Stevens-Johnson syndrome (“SJS”), a rare but serious skin rash condition, in a child who participated in one of the Phase 3 clinical trials. In August 2006, we announced that the FDA had issued a letter indicating that the SPARLON sNDA was “not approvable.” In light of the FDA’s decision, we currently are not pursuing development of SPARLON.

We also have significant discovery research programs focused on developing therapeutics to treat neurological disorders and cancers. Our technology principally focuses on an understanding of kinases and the role they play in cellular survival and proliferation. We have coupled this knowledge with a library of novel, small, synthetic molecules that are orally active and inhibit the activities of specific kinases. We also work with our collaborative partners to provide a more diverse therapeutic breadth and depth to our research efforts.

As a biopharmaceutical company, our future success is highly dependent on obtaining and maintaining patent protection for our products and technology. We intend to vigorously defend the validity, and prevent infringement, of our patents. The loss of patent protection on any of our existing products, whether by third-party challenge, invalidation, circumvention, license or patent expiration, could materially impact our results of operations. In late 2005 and early 2006, we entered into settlement agreements with each of Teva Pharmaceuticals USA, Inc., Mylan Pharmaceuticals Inc., Ranbaxy Laboratories Limited and Barr. As part of these separate settlements, we agreed to grant to each of these parties a non-exclusive royalty-bearing right to market and sell a generic version of PROVIGIL in the United States. These licenses generally will become effective in April 2012. For more information concerning these settlements, please see “Central Nervous System Disorders—Modafinil Products and Product Candidates—Intellectual Property Position” below.

Our activities and operations are subject to significant government regulations and oversight. In September 2004, we announced that we had received subpoenas from the U.S. Attorney’s Office in Philadelphia. That same month, we received a voluntary request for information from the Office of the Connecticut Attorney General. Both the subpoenas and the voluntary request for information appear to be focused on our sales and promotional practices with respect to ACTIQ, GABITRIL® (tiagabine hydrochloride) and PROVIGIL, including the extent of off-label prescribing of our products by physicians. We are cooperating with the U.S. Attorney’s Office and the Office of the Connecticut Attorney General, are providing documents and other information to both offices in response to these and additional requests and are engaged in ongoing discussions with both parties. These matters may involve the bringing of

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criminal charges and fines, and/or civil penalties. We cannot predict or determine the outcome of these matters or reasonably estimate the amount or range of amounts of any fines or penalties that might result from a settlement or an adverse outcome. However, a settlement or an adverse outcome could have a material adverse effect on our financial position, liquidity and results of operations.

For the year ended December 31, 2006, our total revenues and net income were $1.8 billion and $144.8 million, respectively. Our revenues from U.S. and European operations are detailed in Note 16 to our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. While we seek to increase profitability and cash flow from operations, we will need to continue to achieve growth of product sales and other revenues sufficient for us to attain these objectives. The rate of our future growth will depend, in part, upon our ability to obtain and maintain adequate intellectual property protection for our currently marketed products, and to successfully develop or acquire and commercialize new product candidates.


We are a Delaware corporation with our principal executive offices located at 41 Moores Road, P.O. Box 4011, Frazer, Pennsylvania, 19355. Our telephone number is (610) 344-0200 and our web site address is http://www.cephalon.com. Our research and development headquarters are in West Chester, Pennsylvania and we also have offices in Salt Lake City, Utah, suburban Minneapolis-St. Paul, Minnesota, France, the United Kingdom, Denmark, Germany, Italy, the Netherlands, Poland, Spain and Switzerland. We operate manufacturing facilities in France for the production of modafinil, which is used in the production of in PROVIGIL and NUVIGIL. We also have manufacturing facilities in Salt Lake City, Utah, for the production of FENTORA, ACTIQ and generic OTFC for worldwide distribution and sale, and Eden Prairie and Brooklyn Park, Minnesota, for the production of orally disintegrating versions of drugs for pharmaceutical company partners.

Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports are available free of charge through the Investor Information section of our web site as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission. We include our web site address in this Annual Report on Form 10-K only as an inactive textual reference and do not intend it to be an active link to our web site.


CENTRAL NERVOUS SYSTEM DISORDERS

Our CNS disorders portfolio includes two marketed products: PROVIGIL, for improving wakefulness in patients with excessive daytime sleepiness associated with narcolepsy, obstructive sleep apnea/hypopnea syndrome (“OSA/HS”) and shift work sleep disorder (“SWSD”), and GABITRIL, for use as adjunctive therapy in the treatment of partial seizures in epileptic patients. We also are seeking final approval from the FDA to market NUVIGIL for improving wakefulness in patients with excessive daytime sleepiness associated with narcolepsy, OSA/HS and SWSD; we anticipate final FDA approval by March 31, 2007.

Modafinil Products and Product Candidates

PROVIGIL

Modafinil, the active ingredient in PROVIGIL, is the first in a new class of wakefulness-promoting agents. While its exact mechanism of action remains to be fully elucidated, modafinil appears to act selectively in regions of the brain believed to regulate normal sleep and wakefulness. The FDA approved PROVIGIL to improve wakefulness in patients with excessive daytime sleepiness associated with narcolepsy, and we launched the product in the United States in February 1999. In January 2004, we received FDA approval to expand the label for PROVIGIL to include improving wakefulness in patients with excessive sleepiness associated with OSA/HS and SWSD. In clinical studies, PROVIGIL was found to

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be generally well-tolerated, with a low incidence of adverse events relative to placebo. The most commonly observed adverse events were headache, infection, nausea, nervousness, anxiety and insomnia.

Outside of the U.S., modafinil currently is approved in more than 30 countries, including France, the United Kingdom, Ireland, Italy and Germany, for the treatment of excessive daytime sleepiness associated with narcolepsy. In certain of these countries, we also have approval to market modafinil to treat excessive daytime sleepiness in patients with OSA/HS and/or SWSD.

NUVIGIL

An important focus of our modafinil strategy has been the development of next-generation compounds, including NUVIGIL, a single-isomer formulation of modafinil. In March 2005, we filed a new drug application (“NDA”) with the FDA seeking approval to market NUVIGIL with the same labeled indications as PROVIGIL. In May 2006, we received an approvable letter from the FDA; we currently expect a final approval decision from the FDA on or before March 31, 2007. We are planning to transition our wakefulness franchise to NUVIGIL around 2010, prior to the April 2012 license effectiveness dates under the generic settlement agreements related to PROVIGIL. The FDA is continuing to evaluate the single case of serious rash reported in a SPARLON (modafinil) clinical study. We have provided additional information to the FDA to help the agency place this isolated case in the context of the safety profile for modafinil that has been established over more than a decade of commercial use. The reviewing division has not requested any additional information related to NUVIGIL and is working with us to finalize the product’s label. Since NUVIGIL is derived from the active ingredient in PROVIGIL, we expect that the safety information in the PROVIGIL label will be appropriately modified to reflect the safety information in the final NUVIGIL label.

In Phase 3 clinical trials of 150- and 250-milligram daily doses of NUVIGIL in patients suffering from excessive sleepiness associated with narcolepsy, SWSD or OSA/HS, results indicate that NUVIGIL significantly improves wakefulness and the overall clinical condition of patients as compared to placebo. The 12-week, double-blind, randomized, placebo-controlled Phase 3 studies of approximately 1,000 patients included one study of excessive sleepiness in narcolepsy, one study in SWSD and two studies in OSA/HS. The primary endpoints in each Phase 3 study were measures of objective sleep latency (Maintenance of Wakefulness Test or Multiple Sleep Latency Test) and the physician rating of Clinical Global Impression-Change. These primary endpoints are identical to those studied for the currently approved indications for PROVIGIL. In each Phase 3 study, patients treated with NUVIGIL showed a highly statistically significant improvement on both primary endpoints compared to placebo. In these studies, NUVIGIL was generally well-tolerated. The most commonly observed adverse effects included headache, nausea, dizziness, insomnia and anxiety.

In 2007, we expect to initiate clinical studies of NUVIGIL in bi-polar depression, cognition in schizophrenia and excessive sleepiness and fatigue in conditions such as Parkinson’s Disease and cancer. If the results of any of these studies are positive, we plan to seek an expansion of the labeled indications for NUVIGIL.

Co-Promotion Agreement with Takeda

On June 12, 2006, we entered into a co-promotion agreement with Takeda with respect to PROVIGIL in the United States. Under the co-promotion agreement, 500 Takeda sales representatives began promoting PROVIGIL in the second position to primary care physicians and other appropriate health care professionals in the United States beginning July 1, 2006. Effective January 1, 2007, an additional 250 Takeda sales representatives were added, all of whom are detailing PROVIGIL in the first position. Together with our CNS field sales and sales management teams, we now have nearly 1,200 persons focused on detailing PROVIGIL in the United States. We also have an option to utilize the Takeda sales force for the promotion of NUVIGIL, assuming FDA approval of this product candidate.

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The parties have formed a joint commercialization committee to manage the promotion of PROVIGIL. We have retained all responsibility for the development, manufacture, distribution and sale of the product.

The co-promotion agreement has a three-year term. If we undergo a change of control during the three-year term, we have the option to terminate the co-promotion agreement, subject to our obligation to make certain specified payments to Takeda. We pay Takeda a royalty based on certain sales criteria for PROVIGIL and NUVIGIL during the three-year term and, if specified sales levels are reached, during the three calendar years following the expiration of the co-promotion agreement.

Targeted Diseases/Disorders

Narcolepsy:   Narcolepsy is a debilitating, lifelong sleep disorder whose symptoms often first arise in late childhood. Its most common symptom is an uncontrollable propensity to fall asleep during the day. PROVIGIL has been recognized by the American Academy of Sleep Medicine as a standard of therapy for the treatment of excessive daytime sleepiness associated with narcolepsy.

OSA/HS:   Individuals with OSA/HS experience frequent awakenings, sometimes occurring hundreds of times during the night as a result of blockage of the airway passage, usually caused by the relaxation and collapse of the soft tissue in the back of the throat during sleep. Continuous positive airway pressure (“CPAP”), a medical device that blows air through the nasal passage, is the primary treatment for OSA/HS. However, approximately 30 percent of patients that use CPAP continue to experience excessive sleepiness, for which PROVIGIL may be an appropriate adjunctive treatment.

SWSD:   SWSD is defined as a persistent or recurrent pattern of sleep disruption that leads to excessive sleepiness or insomnia due to a mismatch between the natural circadian sleep-wake pattern and the sleep-wake schedule required by a person’s environment. SWSD particularly affects those who frequently rotate shifts or work at night, which is contrary to the body’s natural circadian rhythms.

Intellectual Property Position

We own various U.S. and foreign patent rights that expire between 2014 and 2015 and cover pharmaceutical compositions and uses of modafinil, specifically, certain particle sizes of modafinil contained in the pharmaceutical composition of PROVIGIL. We also hold rights to other patents and patent applications directed to polymorphs, manufacturing processes, formulations, and uses of modafinil and to next-generation modafinil products. We also own rights to PROVIGIL and other various trademarks for our pharmaceutical products containing the active drug substance modafinil. Ultimately, these patents and patents related to our other products and products candidates might be found invalid if challenged by a third party, or a potential competitor could develop a competing product or product formulation that avoids infringement of these patents.

In late 2005 and early 2006, we entered into settlement agreements with each of Teva, Mylan, Ranbaxy and Barr. As part of these separate settlements, we agreed to grant to each of these parties a non-exclusive royalty-bearing right to market and sell a generic version of PROVIGIL in the United States. These licenses will become effective in April 2012. An earlier entry may occur based upon the entry of another generic version of PROVIGIL. Each of these settlements has been filed with both the United States Federal Trade Commission (the “FTC”) and the Antitrust Division of the Department of Justice (the “DOJ”) as required by the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Medicare Modernization Act”). The FTC has requested from us, and we have provided, certain information in connection with its review of the PROVIGIL settlements. In July 2006, the FTC requested that we voluntarily submit additional information and documents in connection with its investigation of this matter. We are cooperating fully with this request. The FTC could challenge in an administrative or judicial proceeding any or all of the settlements if they believe that the agreements violate the antitrust laws, although we believe that such a challenge would take years to resolve.

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We also are aware of a number of civil antitrust complaints, purportedly filed as class actions, filed by private parties in U.S. District Court for the Eastern District of Pennsylvania, each naming Cephalon, Barr, Mylan, Teva and Ranbaxy as co-defendants and claiming, among other things, that the patent litigation settlements concerning PROVIGIL violate the antitrust laws of the United States and certain state laws. The proposed consolidated class action complaints have been designated by plaintiffs, each of which seeks to certify separate, purported classes of plaintiffs: direct purchasers of PROVIGIL, and consumers and other indirect purchasers of PROVIGIL. The plaintiffs in both cases are seeking monetary damages and/or equitable relief. Separately, in June 2006, Apotex, Inc., a subsequent abbreviated new drug application (“ANDA”) filer seeking FDA approval of a generic form of modafinil, filed suit against us also in the U.S. District Court for the Eastern District of Pennsylvania alleging similar violations of antitrust laws and state law. Apotex asserts that the PROVIGIL settlement agreements improperly prevent it from obtaining FDA approval of its ANDA, and seeks monetary and equitable remedies, including a declaratory judgment that our U.S. Patent No. RE37,516 (the “‘516 Patent”) is invalid and unenforceable. We filed a motion to dismiss the Apotex case in late September 2006. We believe that both the purported class action cases and the Apotex case are without merit. While we intend to vigorously defend ourselves and the propriety of the settlement agreements, these efforts will be both expensive and time consuming and, ultimately, due to the nature of litigation, there can be no assurance that these efforts will be successful.

In early August 2006, we entered into a settlement agreement with Carlsbad Technology, Inc. and its development partner, Watson, which we understand has the right to commercialize the Carlsbad modafinil product if approved by FDA. As part of this settlement, we agreed to grant to Watson a non-exclusive royalty-bearing right to market and sell a generic version of PROVIGIL in the United States. This license will become effective on or after April 6, 2012, subject to applicable regulatory considerations. An earlier entry may occur based upon the entry of another generic version of PROVIGIL. This agreement has been filed with both the FTC and the DOJ, as required by the Medicare Modernization Act.

In late November 2005 and March 2006, we received notice that Caraco Pharmaceutical Laboratories, Ltd. and Apotex, respectively, also filed Paragraph IV ANDAs with the FDA in which each firm is seeking to market a generic form of PROVIGIL. We have not filed a patent infringement lawsuit against either Caraco or Apotex as of the filing date of this report, although Apotex has filed suit against us, as described above.

With respect to NUVIGIL, we successfully obtained issuance of a U.S. patent in November 2006 claiming the Form I polymorph of armodafinil, the active drug substance in NUVIGIL. This patent is currently set to expire in 2023. Foreign patent applications directed to the use of the Form I polymorph of armodafinil in treating sleep disorders are pending in Europe and elsewhere. We also own composition of matter patents covering armodafinil that are set to expire in May 2007 in the United States and that expired in January 2007 outside the United States. In addition, the particle size patent described above for PROVIGIL also covers NUVIGIL. Assuming success in attaining FDA approval for this compound in March 2007, we would expect to receive a three year period of marketing exclusivity (until early 2010). In addition, assuming this same timetable for approval, we would anticipate that the term of this patent would be extended under the Hatch-Waxman Act until approximately early 2010. If we perform an additional clinical study of this product in pediatric patients, the FDA could grant us six months of exclusivity beyond the expiration of the patent and the three-year period of marketing exclusivity (until early 2010). We intend to perform such a study once a mutually agreed upon clinical protocol is reached with the FDA. We also hold rights to other patent applications directed to other polymorphic forms of armodafinil and to the manufacturing process related to armodafinil. We also hold rights to the NUVIGIL trademark.

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Manufacturing and Product Supply

At our manufacturing facility in Mitry-Mory, France, we produce modafinil for use in the production of PROVIGIL and NUVIGIL. We also have third party agreements with four companies to supply us with modafinil (which requirements include certain minimum purchase requirements) and two companies to supply us with finished commercial supplies of PROVIGIL. With respect to NUVIGIL, we have two third parties who will manufacture the active drug substance armodafinil and one qualified manufacturer of finished supplies of NUVIGIL tablets. We also are preparing to qualify an additional manufacturer to provide active drug substance and finished product following FDA approval of NUVIGIL. We seek to maintain inventories of active drug substance and finished products to protect against supply disruptions. Any future change in manufacturers or manufacturing processes requires regulatory approval.

Competition

With respect to PROVIGIL, and, if approved, NUVIGIL, there are several other products used for the treatment of excessive sleepiness or narcolepsy in the United States. Many of these products, including methylphenidate products such as RITALIN® by Novartis Pharma AG, have been available for a number of years and are available in inexpensive generic forms. We also are aware of numerous companies seeking to develop products to treat excessive sleepiness.

GABITRIL

GABITRIL is a selective GABA (gamma-aminobutyric acid) reuptake inhibitor approved for use as adjunctive therapy in the treatment of partial seizures in epileptic patients. Epilepsy is a chronic disorder characterized by seizures that cause sudden, involuntary, time-limited alteration in behavior, including changes in motor activities, autonomic functions, consciousness or sensations, and accompanied by an abnormal electrical discharge in the brain. We currently have worldwide product rights to GABITRIL, excluding Canada and Latin America, and we market GABITRIL in the United States, France, the United Kingdom and Germany, among other countries. We have one third-party manufacturer of the active drug substance in GABITRIL and finished commercial supplies of the product in the United States and one third-party manufacturer of the active drug substance and finished commercial supplies outside the United States.

While applicable laws and regulations prevent us from promoting our products for uses beyond those contained in the approved label, our analysis of prescription data in the United States for GABITRIL indicates that many physicians have elected to prescribe the product to treat conditions outside of its currently labeled indication. In February 2005, working with the FDA, we updated our prescribing information for GABITRIL to include a bolded warning describing the risk of new onset seizures in non-induced patients without epilepsy. Following this update, we actively communicated this risk to physicians and otherwise limited our sales and marketing efforts for GABITRIL. These actions have led to a decrease in prescriptions and sales of GABITRIL.

In June 2006, we announced that data from our Phase 3 clinical program evaluating GABITRIL for the treatment of generalized anxiety disorder (“GAD”) did not reach statistical significance on the primary study endpoints. We have no plans to continue further study of GABITRIL for the treatment of GAD or any other disease or disorder.

Intellectual Property Position

GABITRIL is our trademark that is used in connection with pharmaceuticals containing tiagabine as the active drug substance. This product is covered by U.S. and foreign patents that are held by Novo-Nordisk A/S. The U.S. patents have been licensed in the United States exclusively to Abbott Laboratories.

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We have an exclusive sublicense from Abbott to these patents in the United States and exclusive licenses from Novo-Nordisk to corresponding foreign patents.

There are four U.S. composition-of-matter patents covering the currently approved product: a patent claiming tiagabine, the active drug substance in GABITRIL; a patent claiming crystalline tiagabine hydrochloride monohydrate and its use as an anti-epileptic agent; a patent claiming the pharmaceutical formulation and a patent claiming anhydrous crystalline tiagabine hydrochloride and processes for its preparation. These patents currently are set to expire in 2011, 2012, 2016 and 2017, respectively. Supplemental Protection Certificates based upon corresponding foreign patents covering this product are set to expire in 2011. We also hold rights to the GABITRIL trademark.

PAIN

Our pain therapeutics portfolio currently includes three marketed products, FENTORA, ACTIQ and generic OTFC, focused on treating breakthrough cancer pain. One of the most challenging components of cancer pain is breakthrough pain. Breakthrough pain is a transitory flare of moderate to severe pain that “breaks through” the medication patients use to control their persistent pain. Breakthrough cancer pain typically develops rapidly, can reach maximum intensity in three to five minutes and typically lasts for 30 to 60 minutes. Breakthrough pain may be related to a specific activity, or may occur spontaneously and unpredictably. Cancer patients who suffer from breakthrough pain may suffer a number of episodes every day. Breakthrough pain can have a profound impact on an individual’s physical and psychological well-being and is often associated with a more severe and difficult to treat pain condition.

While applicable laws and regulations prevent us from promoting our product for uses beyond those contained in the approved label, our analysis of prescription data for FENTORA and ACTIQ in the United States indicated that many physicians have elected to prescribe these products to treat conditions outside their respective labeled indications.

FENTORA

We received FDA approval of FENTORA in late September 2006 and launched the product in the United States in early October. FENTORA is indicated for the management of breakthrough pain in patients with cancer who are already receiving and are tolerant to opioid therapy for their underlying persistent cancer pain. FENTORA is the first and only buccal tablet approved for this indication.

FENTORA delivers fentanyl, a powerful, Schedule II opioid analgesic, through the oral mucosa (the lining of the mouth) utilizing our proprietary, enhanced absorption technology, ORAVESCENT®. The sugar-free FENTORA tablet is placed between the upper cheek and gum above a rear molar tooth. When it comes into contact with saliva, FENTORA’s delivery system generates a reaction leading to the release of carbon dioxide. It is believed that transient pH changes accompanying this reaction may optimize how well the tablet dissolves and how quickly the medicine passes across the buccal mucosa.

In clinical trials, FENTORA was generally well tolerated. Most adverse events occurring with FENTORA are typical opioid side effects. The most serious adverse events associated with all opioids are respiratory depression (potentially leading to apnea or respiratory arrest), circulatory depression, hypotension, and shock. The most common (greater than or equal to 10 percent) adverse events observed in clinical trials of FENTORA were nausea, vomiting, application site abnormalities, fatigue, anemia, dizziness, constipation, edema, asthenia, dehydration and headache. Most side effects were mild to moderate in severity.

We are focusing our longer-term clinical strategy on developing FENTORA for patients with breakthrough pain associated with other conditions, including neuropathic pain and back pain. In October 2006 and January 2007, we announced that data from Phase 3 clinical trials of FENTORA demonstrated efficacy in the management of breakthrough pain in opioid-tolerant patients with chronic

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low back pain and chronic neuropathic pain, respectively. Pending positive data from an ongoing study in patients with non-cancer breakthrough pain, our goal is to submit a sNDA to the FDA in late 2007. This sNDA would seek to expand the labeled indications for FENTORA beyond breakthrough pain in patients with cancer.

ACTIQ/Generic OTFC

ACTIQ is approved in the United States for the management of breakthrough cancer pain in opioid tolerant patients. It was approved by the FDA in November 1998 and was launched in the United States in March 1999. Following our acquisition of Anesta Corp. in October 2000, we relaunched ACTIQ in February 2001. In October 2002, we reacquired rights to ACTIQ in 12 countries, principally in Europe, from Elan Pharma International Limited.

ACTIQ uses an oral transmucosal delivery system (“OTS®”) to deliver fentanyl citrate, a powerful, Schedule II opioid analgesic. The OTS delivery system consists of a drug matrix that is mounted on a handle. It is designed to achieve rapid absorption of fentanyl through the oral mucosa and into the bloodstream, with pain relief that may begin within 15 minutes. ACTIQ is available in six dosage strengths to allow individualization of dosing. Side effects of ACTIQ are typical of opioid products and include somnolence, nausea, vomiting and dizziness. The greatest risk from improper use of ACTIQ, as with all opioid-based products, is the potential for respiratory depression, which can be life-threatening. We market ACTIQ under a comprehensive risk management program of educational and safe use messages that inform health care professionals, patients and their families of proper use, storage, handling and disposal of the product.

To secure FTC clearance of our acquisition of CIMA LABS INC., we agreed to license to Barr our U.S. rights to intellectual property necessary to manufacture and market a generic OTFC. The rights we granted to Barr became effective on September 5, 2006 and Barr entered the United States market with generic OTFC on September 27, 2006. On this same date, we also entered the market with a generic OTFC. We are utilizing Watson as our sales agent in this effort. As a result, ACTIQ sales have been meaningfully eroded by generic OTFC products sold by Barr and by us through Watson and we expect this erosion will continue during 2007.

Under our agreement with Barr, we also agreed to sell to Barr generic OTFC for resale in the United States until the earlier of such time that Barr is able to gain FDA approval of its ANDA or September 2009. Barr has invoked this supply option and we have been manufacturing generic OTFC for Barr since the launch of the product in September 2006. Under the agreement, we are responsible for delivering bulk units to Barr and Barr is responsible for all packaging and labeling of the product. In addition, we have agreed to forbear from asserting any remaining patent rights in ACTIQ against other parties beginning on March 5, 2007.

Intellectual Property Position

FENTORA:   We own patents and/or patent applications covering formulation, method of treatment and manufacturing for FENTORA expiring between 2019 and 2024. Upon FDA approval for this product, we also received a three-year period of marketing exclusivity that extends until September 2009. We also hold rights to the FENTORA trademark.

ACTIQ:   The U.S. patents covering the currently approved compressed powder pharmaceutical composition and the method for administering fentanyl via this composition expired in September 2006. As described above, we have licensed to Barr our U.S. rights to intellectual property necessary to manufacture and market a generic OTFC. Corresponding patents covering the current formulation of ACTIQ in foreign countries generally expire between 2009 and 2010. Our patent protection with respect to the ACTIQ formulation we sold in the United States prior to June 2003 expired in May 2005.

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Other issued patents and pending patent applications in the United States and foreign countries that are owned or licensed by us are directed to various formulations (including a sugar-free formulation), processes for manufacturing the product, methods of using the product and disposable containers required by the FDA to be provided as part of the product. We also hold the rights to the ACTIQ trademark.

Manufacturing and Product Supply

At our facility in Salt Lake City, Utah, we manufacture FENTORA, ACTIQ and generic OTFC for our sale in the United States and international markets. We also currently are manufacturing generic OTFC bulk units for Barr. In August 2006, we completed a nearly $70 million, two-year capital expansion project at our Salt Lake City facility to increase our manufacturing and packaging capacity with respect to FENTORA, ACTIQ and generic OTFC.

Fentanyl, the active ingredient in FENTORA, ACTIQ and generic OTFC, is a Schedule II controlled substance under the Controlled Substances Act. Our purchases of fentanyl for use in the production of FENTORA, ACTIQ and generic OTFC are subject to quota that is approved by the U.S. Drug Enforcement Administration (“DEA”). Supply disruption could result from delays in obtaining DEA approvals or the receipt of approvals for quantities of fentanyl that are insufficient to meet current or projected product demand. The quota system also limits our ability to build inventories as a method of insuring against possible supply disruptions. While we currently have available fentanyl quota to produce ACTIQ and generic OTFC, in the future we could face shortages of quota that could negatively impact our ability to supply product to Barr or to produce ACTIQ or our generic OTFC product. If we are unable to provide product to Barr, it is possible that either Barr or the FTC could claim that such a failure would constitute a breach of our agreements with these parties.

Competition

Both long-acting and short-acting formulations are prescribed to treat cancer pain. Persistent pain is typically treated by around-the-clock administration of long- or short-acting opioids. Breakthrough cancer pain is usually treated with a short-acting product, such as FENTORA, ACTIQ or generic OTFC, that is used in conjunction with an around-the-clock formulation.

Long-acting products, which have a slower onset and longer duration of action relative to FENTORA, ACTIQ and generic OTFC, are commonly prescribed to treat persistent pain. Three long-acting opioid analgesics and their generic equivalents currently marketed for chronic pain dominate this market: Johnson & Johnson’s DURAGESIC® and Purdue Pharmaceuticals’ OXYCONTIN® and MS-CONTIN®. Persistent cancer pain also is treated with short-acting opioid tablets, capsules and elixirs, as well as quick-acting invasive opioid delivery systems (i.e., intravenous, intramuscular and subcutaneous), many of which have been available for many years and are available in inexpensive generic form.

The overwhelming majority of prescriptions written to treat breakthrough cancer pain are for short-acting opioids other than FENTORA, ACTIQ or generic OTFC, such as morphine and combination products (with acetaminophen and oxycodone or hydrocodone), as well as quick-acting opioids delivered via invasive delivery systems. In some cases, physicians also may attempt to manage breakthrough pain by increasing the dose of a long-acting opioid.

We are aware of numerous companies developing other technologies for rapid delivery of opioids to treat breakthrough pain, including transmucosal, transdermal, nasal spray, and inhaled delivery systems, among others. If these technologies are successfully developed and approved over the next few years, they could represent significant competition for FENTORA, ACTIQ and generic OTFC.

The existence of generic OTFC has and will likely continue to impact sales of ACTIQ and could negatively impact the growth of FENTORA. Since the launch of generic OTFC in September 2006, ACTIQ sales have been meaningfully eroded and we expect this erosion will continue during 2007. In

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addition, sales of our own generic OTFC could be significantly impacted by the entrance into the market of additional generic OTFC products, which could occur at any time.

ONCOLOGY

Our U.S. oncology portfolio includes one marketed product and two product candidates to treat patients with hematologic cancers: TRISENOX®, an intravenous arsenic-based targeted therapy currently marketed in the U.S., as well as in Europe; CEP-701 (lestaurtinib), an oral small molecule tyrosine kinase inhibitor; and TREANDA® (bendamustine hydrochloride), a multi-functional hybrid cytotoxic. In Europe, we have two commercialized oncology products in our portfolio: MYOCET® (liposomal doxorubicin), a cardio-protective chemotherapy agent used to treat late-stage breast cancer and TARGRETIN® (bexarotene), a treatment for cutaneous T-cell lymphoma. In addition, we market and sell ABELCET® (amphotericin B lipid complex), an anti-fungal product used by cancer patients.

TRISENOX

In July 2005, we acquired substantially all of the assets related to the TRISENOX injection business from Cell Therapeutics, Inc. TRISENOX was approved for marketing in the United States and Europe in 2000 and 2002, respectively, for the treatment of patients with relapsed or refractory acute promyelocytic leukemia (“APL”), a life threatening hematologic cancer. APL is one of eight subtypes of acute myeloid or myelogenous leukemia (“AML”). According to the American Cancer Society, approximately 12,000 patients are diagnosed with AML in the United States every year, 10 to 15 percent of whom will have the APL subtype. Research indicates that approximately 10 to 30 percent of patients with APL will not respond to, or will relapse from, first-line therapy.

TRISENOX is a highly purified salt of arsenic, a natural element. TRISENOX appears to have multiple targets and mechanisms of antileukemic activity; it degrades a protein that causes abnormal levels of immature white blood cells while simultaneously forcing immature cancer cells to self-destruct through a process called programmed cell death or apoptosis. Apoptosis is a normal part of a cell’s life cycle. Because cancer is often associated with a malfunction of the normal process of apoptosis, drugs that can induce apoptosis offer the hope of affecting cancer cells more selectively without the typical toxic side effects of conventional treatments. Direct induction of apoptosis represents a relatively new method of killing tumor cells that is different than the majority of conventional cancer drugs. As a result, in addition to its use as a single-agent therapy, TRISENOX may work well when administered in combination with other cancer therapies to produce more durable response rates.

In January 2007, the National Cancer Institute and one of its Cooperative Clinical Trial Groups announced positive results from a clinical trial using TRISENOX in newly diagnosed patients with APL. According to the NCI, the results of the trial showed that adult patients with previously untreated APL who had standard chemotherapy to induce remission of their disease, and who then received TRISENOX to maintain remission, had significantly better event-free survival and better overall survival than those who received only standard chemotherapy. We are continuing to investigate uses of TRISENOX, as a single agent or in combination with other treatments, to treat APL and other forms of hematologic cancers.

Intellectual Property Position

We have a license to patents and patent applications covering methods of treating APL with the active ingredient arsenic trioxide that protect this product until 2018. TRISENOX is also protected by orphan drug exclusivity until 2007. We also hold rights to the TRISENOX trademark.

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Manufacturing and Product Supply

We have one third-party manufacturer that produces the active drug substance arsenic trioxide for us and two third-party manufacturers that provide finished commercial supplies of TRISENOX to us in the United States and Europe. We seek to maintain inventories of active drug substance and finished commercial supplies to protect against supply disruptions.

Competition

The pharmaceutical market for the treatment of patients with relapsed or refractory APL is served by a number of available therapeutics, such as VESANOID® by Roche in combination with chemotherapy.

CEP-701

CEP-701 is under development as a treatment for flt-3-mutated AML, a hematologic cancer characterized by uncontrolled growth of myeloid cells of the blood and bone marrow. According to the American Cancer Society, in 2007, an estimated 12,700 people in the United States will be diagnosed with AML and approximately 9,000 people will die from AML. Approximately 25 to 30 percent of AML patients have a flt-3 genetic mutation that is associated with a poorer prognosis for relapse and survival.

We are currently conducting a Phase 2/3 study of approximately 200 patients with AML who bear a flt-3 activating mutation at first relapse from standard induction chemotherapy. In December 2005, we announced that the preliminary data of 44 patients in this study suggest that chemotherapy followed by the oral compound CEP-701 may offer a clinical benefit compared to chemotherapy alone. A clinical response has been achieved in all patients who showed an 85 percent or greater inhibition of flt-3 activity and baseline cellular sensitivity to CEP-701. Patients with low flt-3-inhibitory activity or cells insensitive to CEP-701 had a very low rate of clinical response. These data suggest that there may be the potential to predict which patients will respond positively to CEP-701. Preliminary safety analyses indicate that CEP-701 is generally well tolerated, with only a modest increase in gastrointestinal events such as nausea and dyspepsia reported.

As of December 31, 2006, 112 patients have been randomly assigned to one of two treatment arms in the Phase 2/3 clinical trial: standard chemotherapy alone, or chemotherapy followed two days later by a daily 80-mg orally administered dose of CEP-701, continued for up to 113 days. We are targeting late 2007 for the completion of this study, with an NDA submission planned for early 2008. We also are planning to initiate studies of CEP-701 in patients with myeloproliferative disorder in 2007. CEP-701 is not presently indicated or approved by the FDA for the treatment of any disease.

Intellectual Property Position

We have a license to a composition of matter patent directed to CEP-701 that is set to expire in 2008 in the United States. If we are successful in attaining FDA approval for this compound in 2008, we would anticipate that the term of this patent would be extended under the Hatch-Waxman Act until 2013. In addition, assuming this same timetable for approval, we would expect to receive a five year New Chemical Entity period of marketing exclusivity (until 2013). In April 2006, the FDA granted orphan drug designation for CEP-701 for the treatment of AML. The orphan drug designation will provide a seven-year period of marketing exclusivity for the treatment of AML with CEP-701 from the date of final FDA marketing approval of CEP-701. We also hold rights to other patent applications directed to methods of treatment, formulations and polymorphs for CEP-701.

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Competition

If approved, CEP-701 would compete with a number of available therapeutics, particularly those that are indicated for the treatment of hematologic cancers. We understand that Novartis and Millennium Pharmaceuticals are each developing drugs with a similar mechanism of action.

TREANDA

We obtained the rights to market TREANDA in June 2005. TREANDA is an investigational therapeutic under development for the treatment of indolent (slowly progressing) non-Hodgkin’s lymphoma (“NHL”). According to the National Cancer Institute, NHL is the sixth most prevalent cancer in the United States. NHL occurs when lymphatic cells divide too much and too fast. Growth control is lost, and the lymphatic cells may overcrowd, invade and destroy lymphoid tissues and spread to other organs. There are two broad subtypes of NHL—indolent, also referred to as slow growing or low-grade, and aggressive. Indolent disease may “transform” into a more aggressive condition. According to the American Cancer Society, there were almost 63,000 new cases of NHL in the U.S. in 2007; nearly 19,000 die from the disease annually.

TREANDA is a novel hybrid cytotoxic alkylating agent that differs from conventional compounds in its apparent multi-functional mechanism of action. In addition to killing cells by damaging their DNA and triggering apoptosis—which is typical of alkylating agents—researchers demonstrated that TREANDA also causes the disruption of cell division. Bendamustine hydrochloride is currently marketed in Germany by a third party for the treatment of NHL, chronic lymphocytic leukemia (CLL), multiple myeloma, metastatic breast cancer and other solid tumors.

In a Phase 2 study of patients with advanced indolent NHL who were previously exposed to multiple courses of therapy, 74 percent responded to TREANDA, including 35 percent with a complete response. All study participants had progressive disease after prior treatment with the antibody therapy rituximab (Rituxan®); a subgroup also had not responded to traditional alkylating agents. Rituximab and alkylators are commonly prescribed to treat NHL. In another Phase 2 study, TREANDA in combination with rituximab in patients with refractory and relapsed NHL produced a high overall response rate (87 percent) with minimal toxicity and no hair loss. We are conducting a Phase 3 trial of TREANDA in indolent NHL refractory to rituximab at sites in the United States and Canada and are targeting study completion for late 2007. If results from this study are positive, we would expect to file an NDA for TREANDA in the fourth quarter of 2007. We also are planning to study TREANDA for the treatment of CLL, mantle cell lymphoma and small cell lung cancer.

Intellectual Property Position

We own method of treatment and formulation patent applications that, if issued, we expect will protect this product until 2025 and 2026, respectively. In addition, we expect to receive a five year New Chemical Entity exclusivity which prevents the FDA from accepting an ANDA for this product for a period of five years from the date of approval (four years if the ANDA contains a Paragraph IV certification). We also own rights to the TREANDA trademark.

Manufacturing and Product Supply

We have one third party supplier of the active drug substance bendamustine hydrochloride and one third party supplier of finished supplies of TREANDA for our use in clinical trials. If TREANDA is approved by the FDA, we expect to qualify our current manufacturers of the active drug substance and the finished supplies and to qualify additional manufacturers as may be necessary to meet commercial demands and to protect against supply disruptions.

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Competition

If approved, TREANDA would compete with traditional methods of treating indolent NHL, including treatments involving chemotherapy with a combination of drugs such as cyclophosphamide, vincristine and prednisolone and with drugs currently marketed (such as BEXXAR® (131-I tositumomab) by GlaxoSmithKline) or being developed to treat indolent NHL refractory to rituximab.

ADDICTION

Our addiction therapeutic focus currently consists of one product, VIVITROL. In June 2006, we launched VIVITROL, which was approved by the FDA in April 2006. VIVITROL is indicated for alcohol dependent patients who are able to abstain from alcohol in an outpatient setting and are not actively drinking when initiating treatment. Treatment with VIVITROL should be used in combination with psychosocial support, such as counseling or group therapy. VIVITROL utilizes Alkermes’ proprietary Medisorb® drug delivery technology in a once-a-month injectable formulation of naltrexone. Naltrexone is a FDA-approved drug that is currently available in daily oral dosage form for the treatment of alcohol dependence and for the blockade of effects of exogenously administered opioids.

In the United States, approximately 18 million people are dependent on or abuse alcohol and an estimated 2.3 million adults seek treatment each year. Even among individuals currently seeking treatment, the majority relapse. Taking prescribed medication, an important determinant in therapeutic outcomes, is particularly challenging for patients with addictive disorders such as alcohol dependence. Alcohol is causally related to more than 60 medical conditions, including heart disease, liver disease, infectious disease and cancer, and contributes to more than 100,000 deaths in the United States each year.

A VIVITROL injection provides continuous medication for one month; therefore, patients do not need to make a decision to take their medication every day. VIVITROL works by binding to opioid receptors in the brain. Although the mechanism responsible for the reduction in alcohol consumption observed with VIVITROL treatment is not entirely understood, preclinical data suggests that occupation of the opioid receptors results in the blockade of the neurotransmitters in the brain that are believed to be involved with alcohol dependence. This blockade may result in the reduction in alcohol consumption observed in patients treated with VIVITROL.

License and Collaboration Agreement with Alkermes

In June 2005, we entered into a license and collaboration agreement with Alkermes to develop and commercialize VIVITROL in the United States for the treatment of alcohol dependence. Under the terms of the collaboration agreement, we made an initial payment of $160 million to Alkermes and an additional $110 million payment following FDA approval of VIVITROL. Alkermes could receive up to an additional $220 million in milestone payments that are contingent on attainment of certain agreed-upon sales levels of VIVITROL. We have formed a joint commercialization team with Alkermes, and the parties will share responsibility for developing the commercial strategy for VIVITROL. We have primary responsibility for all marketing and sale efforts and currently have approximately 135 persons focused on the marketing and sale of VIVITROL; Alkermes is augmenting this effort with a team of 28 managers of market development. Alkermes also is responsible for manufacturing the supply of VIVITROL. Until December 31, 2007, Alkermes is responsible for any cumulative losses up to $120 million and we are responsible for any cumulative losses in excess of $120 million. Pre-tax profit, as adjusted for certain items, and losses incurred after December 31, 2007 will be split equally between the parties. We began recognizing revenue for VIVITROL effective in the third quarter of 2006.

In October 2006, we amended the existing license and collaboration agreement with Alkermes to provide that we would be responsible for our own VIVITROL-related costs during the period August 1, 2006 through December 31, 2006 and, for that period, such costs will not be chargeable to the

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collaboration and against the $120 million cumulative loss cap. The parties also amended the existing supply agreement to provide that we will purchase from Alkermes two VIVITROL manufacturing lines (and related equipment). At December 31, 2006, we incurred approximately $25.4 million related to the construction of these two manufacturing lines. We expect to incur up to an additional $45.6 million for certain future capital improvements related to these two manufacturing lines. We also have granted Alkermes an option, exercisable after two years, to purchase these manufacturing lines at the then-current net book value of the assets.

Intellectual Property Position

Through our collaboration with Alkermes, we have a license to several U.S. patents and patent applications directed to VIVITROL that will expire between 2013 and 2024. Most of the patents and patent applications are directed generally to the processes involved in the Alkermes microsphere technology, while several are directed to the naltrexone drug product and to the injectable solution. We also hold rights to the VIVITROL trademark in the United States.

Manufacturing and Product Supply

Concurrent with the execution of the collaboration agreement, we entered into a supply agreement, as amended as described above, under which Alkermes will provide to us finished commercial supplies of VIVITROL. Alkermes has limited experience in manufacturing products for commercial sale. If Alkermes is unable to continue to successfully manufacture VIVITROL at commercial scale, there could be a shortage in supply of such product, which would have a negative impact on sales of VIVITROL. In addition, Alkermes is responsible for the entire supply chain for VIVITROL, including the sourcing of raw materials and active pharmaceutical agents from third parties. Any issues with its supply sources could have an adverse effect on the commercial prospects for VIVITROL.

Competition

VIVITROL faces competition from CAMPRAL by Forest Laboratories and currently marketed drugs also formulated from naltrexone, such as REVIA® by Duramed Pharmaceuticals, NALOREX® by Bristol-Myers Squibb and DEPADE® by Mallinckrodt. Other pharmaceutical companies are investigating product candidates that have shown some promise in treating alcohol dependence and that, if approved by the FDA, would compete with VIVITROL.

EUROPEAN OPERATIONS

Commercial Products

We market and sell over 25 products in nearly 20 European markets. For the year ended December 31, 2006, aggregate net sales in Europe accounted for approximately 16% of our total consolidated net sales. In 2006, our five largest products in terms of net product sales in Europe were SPASFON® (phloroglucinol), PROVIGIL, MYOCET, ACTIQ and ABELCET. Together, these products accounted for 64% of our total European net sales.

Following our acquisition of Zeneus in December 2005, we now have the sales, marketing, regulatory and clinical infrastructure necessary to grow our commercial presence in Europe and we have supplemented our growing presence in oncology. We have a strong presence in the five key European pharmaceutical markets: France, Germany, Italy, Spain and the United Kingdom.

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The following is a summary of the most significant products we market and sell in Europe as of December 31, 2006:

Product

 

 

 

Indication

 

Key Market(s)

ABELCET (amphotericin B lipid complex)(1)

 

Anti-fungal

 

France, Germany, Italy, Spain, U.K.

 

ACTIQ (oral transmucosal fentanyl citrate)

 

Breakthrough cancer pain

 

France, Germany, U.K.

 

FONZYLANE® (buflomedil)

 

Cerebral vascular disorders

 

France

 

GABITRIL (tiagabine hydrochloride)

 

Partial seizures

 

France, Germany, U.K.

 

MYOCET (liposomal doxorubicin)

 

Late stage breast cancer

 

France, Germany, Italy, Spain, U.K.

 

NAXY® and MONO-NAXY® (clarithromycin)(2)

 

Antibiotic

 

France

 

PROVIGIL (modafinil)(3)

 

Excessive sleepiness associated with narcolepsy and certain other conditions

 

France, Germany, U.K.

 

SPASFON® (phloroglucinol)

 

Biliary/urinary tract spasm and irritable bowel syndrome

 

France

 

TARGRETIN (bexarotene)(4)

 

Cutaneous T-cell lymphoma

 

France, Germany, U.K.

 


(1)             ABELCET is licensed from Bristol Myers Squibb.

(2)             NAXY and MONO-NAXY are licensed from Abbott France.

(3)             Marketed under the name MODIODAL® (modafinil) in France and under the name VIGIL® (modafinil) in Germany.

(4)             TARGRETIN is licensed from Ligand Pharmaceuticals.

In early 2006, we and Novartis agreed to terminate our exclusive collaboration arrangement established in November 2000. Under this collaboration agreement, we had marketed PROVIGIL, TEGRETOL® (carbamazepine), RITALIN® (methylphenidate), ANAFRANIL® (clomipramine) and LIORESAL® (baclofen) in the United Kingdom and had shared with Novartis the earnings from sales of the four Novartis products and PROVIGIL in the United Kingdom.

Manufacturing Operations

At our manufacturing facility in Mitry-Mory, France, we produce modafinil, which is used in the production of PROVIGIL and NUVIGIL. We manufacture certain other products at this facility and at our other facilities in France for sale in Europe and also perform warehousing, packaging and distribution activities for certain products sold in France and other export territories from these facilities. NAXY, MONO-NAXY, MYOCET, ABELCET, TARGRETIN and GABITRIL are among our European products that are manufactured for us by third party manufacturers. For these and most of our other European products, we depend on single sources for the manufacture of both the active drug substances contained in our products and for finished commercial supplies.

European Competitive and Regulatory Environment

In Europe, we face competition from generic versions of a number of the branded products we market. In addition, European Union pricing laws also allow the parallel importation of branded drugs between member countries. Due to pricing variations within the European Union, it is possible that our overall margins on our branded drugs could be impacted negatively as a result of the importation of product from relatively lower-margin member countries to relatively higher-margin member countries.

In addition, the manufacture and sale of our products in Europe are subject to extensive regulation by European governmental authorities. Government efforts to control healthcare costs may result in further growth of generic competition to our proprietary products or a decrease in the selling prices of any of our

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proprietary products due to associated decreases in the amount the government health care authority will reimburse for any of those products. For example, we are aware of governmental efforts in France to limit or eliminate reimbursement for some of our products, particularly FONZYLANE, FONLIPOL and OLMIFON, which could impact revenues from our French operations.

RESEARCH AND DEVELOPMENT

In addition to ongoing clinical programs supporting our marketed products, our research and development efforts focus primarily on two therapeutic areas: disorders of the central nervous system and cancers. For many years, our research efforts were targeted at a family of CNS disorders termed “Neurodegenerative disorders,” which include Alzheimer’s and Parkinson’s Diseases, among others. These disorders are characterized by the death of neurons, the specialized conducting cells of the nervous system, which, in turn, results in the loss of many functions, including memory, mood and motor coordination. We have recently expanded our therapeutic and research interests in CNS disorders and are exploring new therapeutic approaches in sleep medicine, psychiatry, pain, ADHD and cognition.

Our efforts in oncology grew from our interests in understanding pathways involved in cell survival and death. Cancers are characterized by the uncontrolled survival and proliferation of cells that form tumors. Our research has focused on kinases, key intracellular messenger systems integral to cellular integrity, cellular proliferation and survival. We have developed a proprietary library of novel, small, orally-active synthetic kinase inhibitors that specifically target key kinases involved in tumor growth, the inhibition of which can promote tumor regression.

We expect these approaches in CNS and oncology to provide a risk balanced, expanded pipeline of therapeutic opportunity in the future.

CNS Disorders

Within the category of CNS disorders, our research programs in neurodegenerative diseases have been the foundation on which to grow our overall research strategies. The objective of this work was to discover therapies that would halt the progress of neurodegenerative disease.  We identified the stress activated protein kinase pathway as integral to the cell death process, targeting the mixed lineage kinase family as integral to this process. We identified and developed proprietary compounds, like CEP-1347, that are efficacious in preclinical models of disease. As research in neurodegeneration is relatively high risk given how little is known about disease etiology and progression, we have taken advantage of what we have learned from the commercialization of products in sleep medicine, pain and psychiatry to compliment and balance our ongoing discovery efforts targeting unique GPCR’s (G-Protein Coupled Receptors), proteins that represent the targets through which many CNS drugs act. This research is focused on discovering the next generation of medicines to treat psychiatric, cognitive and sleep disorders and pain.

Oncology

Our current oncology research program includes two main therapeutic targets: solid tumors, which are associated with a broad range of cancers, and hematological cancers, including AML and multiple myeloma.

In normal tissues, cellular proliferation is balanced by cellular death. Generally, both processes are controlled in part by a class of molecules (known as growth factors) that bind to cell surface receptors (many of which are kinases). Kinases control the lifecycle of a cell by regulating when it should replicate, cease replication, perform its functions in a healthy state, or undergo programmed cell death. In cancer, the normal mechanisms of cell death are either blocked or overactive, allowing cells to escape programmed death and leaving cell proliferation unchecked.

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Current cancer therapies are designed to arrest and kill rapidly dividing cells non-selectively. Thus, traditional chemotherapy and radiation therapy kill all rapidly dividing cells, including both normal and cancerous cells, and the benefits of these therapies are often limited by their toxicity to normal cells. We believe that by discovering the mechanisms blocking cell-death programs and developing compounds to inhibit those mechanisms, our researchers can deliver more selective therapies to the marketplace and reduce toxic side effects associated with current cancer treatments.

Solid Tumors

Solid tumors account for roughly 80 to 90 percent of all cancers. Cancers of the lung, breast, colon, and prostate—each of which involves the formation and spread of tumors—are among the most prevalent and deadly forms of cancer. Given this broad impact, one of our current research efforts is the development of anti-angiogenic compounds for treatment of solid tumors. Angiogenesis, the natural process used by the human body to produce blood vessels, occurs as a pathological process in the development of solid tumors such as breast and lung cancers. All living organisms, including tumors, need blood vessels to supply nutrients to survive and grow.

In studying the cell signaling pathways that regulate angiogenesis, in collaboration with Sanofi-Aventis, we have targeted a receptor family responsible for survival of individual capillary cells: a protein receptor kinase called VEGF. Our scientists have synthesized a number of proprietary, orally active molecules that are potent and selective inhibitors of the VEGF receptor. These molecules have been shown to inhibit the formation of blood vessels and thereby slow the growth of a variety of tumors in preclinical models.

Our researchers also are investigating the Tie-2 receptor kinase as an anti-angiogenic target. The Tie-2 receptor kinase works in concert with VEGF receptor systems to form new blood vessels. Inhibition of this kinase also may become another important weapon used to fight tumor angiogenesis.

From this research, a potential drug candidate has been identified incorporating both of these important mechanisms. Pre-clinical development activities are underway with the expectation of initiating human trials of this candidate in 2007.

Hematological Cancers

Hematologic (blood) cancers such as leukemia, lymphoma and multiple myeloma continue to have a significant impact on human life. Hematologic cancers arise due to errors in the genetic information of an immature blood cell. As a consequence of these errors, the cell’s development is arrested so that it does not mature further, but is instead replicated over and over again, resulting in a proliferation of abnormal blood cells that eventually crowd out and destroy normal blood cells.

For patients suffering from AML, a malignant cancer that originates in the bone marrow cells, there is an uncontrolled proliferation of myeloid cells of the blood and bone marrow. The lack of normal white cells impairs the body’s ability to fight infections. A shortage of platelets results in bruising and easy bleeding. According to the American Cancer Society, in 2006, approximately 12,000 people in the United States will be diagnosed with AML, making it the most common form of adult leukemia and the second most common childhood leukemia.

Our researchers, with our collaborators, found that in a subset of patients, their AML is caused by a mutation in a kinase called flt-3. Normally, flt-3 is involved in the growth and maturation of healthy blood cells. In AML patients with flt-3 mutations, the cell signaling pathways promote uncontrolled cell growth. Our compound, CEP-701, has been shown to block the signaling ability of the mutant flt-3 kinase in preclinical studies. We are currently conducting Phase 2/3 clinical trials with CEP-701 in combination with current standard of care therapies, to study its effect in patients suffering from AML.

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In addition, we are actively pursuing the development of novel inhibitors of the proteosome, a multifunctional protease integral to normal cellular functioning. Clinical and pre-clinical studies provide a strong rationale for the utility of proteosome inhibitors in hematological cancers. We have identified proprietary proteosome inhibitors that in preclinical models of cancer display greater efficacy and tolerability than currently available therapies. Clinical investigations of one of these inhibitors are expected to begin in 2007.

Neurotrophic Factors

Under a collaboration with Chiron Corporation that was terminated in February 2001, we conducted clinical trials using IGF-I, also known as MYOTROPHIN® (mecasermin) Injection, in patients in North America and Europe suffering from amyotrophic lateral sclerosis (ALS). ALS is a fatal disorder of the nervous system characterized by the chronic, progressive degeneration of motor neurons, which leads to muscle weakness, muscle atrophy and, eventually, to the patient’s death. In February 1997, we submitted an NDA to the FDA for approval to market MYOTROPHIN in the United States for the treatment of ALS. In May 1998, the FDA issued a letter stating that the NDA was “potentially approvable,” under certain conditions. We do not believe those conditions can be met without conducting an additional Phase 3 clinical study, and we have no plans to conduct such a study at this time. However, certain physicians have obtained governmental and non-governmental funding to be used to conduct such a study. We have agreed with these physicians to allow reference to our IND and have agreed to supply MYOTROPHIN in quantities sufficient for them to conduct the study in exchange for the right to use any clinical data generated by such study in support of FDA approval of our pending NDA. These physicians commenced the study in mid-2003 and enrollment was completed in August 2005. The study should be completed in mid-2007. Even if positive, the results of this study may not be sufficient to obtain regulatory approval to market the product. Furthermore, we do not have a source for finished commercial supply of MYOTROPHIN in the event regulatory approval is obtained.

Other Discovery Research Efforts

Since our inception, we have been engaged in research to discover innovative medicines. This research has resulted in the discovery of compounds that could potentially be useful in treating important clinical conditions beyond those for which we have active development programs. In these and other cases, we often seek to establish collaborative partnerships with companies whose clinical development and marketing capabilities will maximize the value of these discoveries. For example, we have a collaboration with Euroscreen s.a. to discover and develop small molecule therapeutics targeting G-Protein Coupled Receptors, or GPCR, a family of receptors that play a major role in cell signaling. We are working with Pharmacopeia Drug Discovery, Inc. to identify new chemical entities as candidates for drug development in various therapeutic areas. We also have a collaboration with AMBIT Biosciences Inc, a biotechnology company with specialized technology in interrogating the kinome, that portion of the human genome that codes for protein kinases, that we believe will amplify and enhance our internal discovery programs  These collaborations strengthen our internal efforts to provide a more diverse therapeutic breadth and depth to our research efforts. In addition, we sponsor a number of external research collaborations with academic laboratories to compliment our internal expertise.

Drug Delivery Research and Development

We pursue collaborative relationships with pharmaceutical companies that leverage the capabilities of these partners with our drug delivery and manufacturing capabilities to deliver new products incorporating our ORASOLV® or DURSOLV® orally disintegrating drug delivery technologies or our ORAVESCENT® drug delivery technology. Revenues from these arrangements consist of net sales of manufactured products to partners, product development and licensing fees and royalties, and totaled approximately 3.9% of our total consolidated revenue for the year ended December 31, 2006. We currently collaborate with many partners, including AstraZeneca, Novartis, Organon, Schering-Plough and Wyeth.

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We have three manufacturing lines at our Eden Prairie, Minnesota facility for product requiring blister packaging and a manufacturing line at our Brooklyn Park, Minnesota facility for bottled product. We also have granulation and taste masking capabilities at our Eden Prairie facility. We believe that our production capacity will be adequate to meet our partners’ needs for the foreseeable future.

Drug delivery technologies have been developed for a variety of therapeutic compounds, improving safety, efficacy, ease of patient use and patient compliance. In addition, drug delivery technologies can be used to expand markets for existing products, as well as to develop new products. We have focused our research and development efforts on developing new product applications using two primary drug delivery technologies: Orally Disintegrating Tablet (“ODT”) technologies and Oral Transmucosal (“OTM”) technologies.

ODT technology has emerged as an important drug delivery technology that enables tablets to disintegrate quickly in the mouth without the use of water or chewing. ODT may improve compliance with a prescribed drug regimen, may improve dosing accuracy relative to liquid formulations and often is preferred by patients to conventional tablets and other formulations. Our two primary ODT technologies are ORASOLV® and DURASOLV®. Our ORASOLV technology incorporates taste masked active drug ingredients in orally disintegrating tablets. The low level of compaction pressure applied to ORASOLV tablets allows higher porosity, faster disintegration time and larger amounts of taste masked active drug ingredients to be compressed into the tablets. The U.S. patent for our ORASOLV technology expires in 2010.

Our DURASOLV technology uses higher compaction forces than ORASOLV to produce orally disintegrating tablets incorporating active drug ingredients in a more durable orally disintegrating tablet. Due to their greater durability, DURASOLV tablets are easier to handle and package, and may cost less to produce and package. The U.S. patents for our DURASOLV technology expire in 2018.

In addition to our ORASOLV and DURASOLV technologies, we continue to develop our LYOC® technology to create ODT using freeze drying methods to manufacture tablets. We have a fully dedicated LYOC manufacturing site in Nevers, France, which we expect to expand to increase capacity. Once complete, we will have additional capacity for both in-house and third party manufacturing. We currently manufacture and sell several drugs in France using our LYOC technology, including SPASFON LYOC®, PARALYOC®, PROXALYOC® and LOPERAMIDE LYOC®.

OTM technologies are designed to increase the absorption of active drug ingredients across the mucosal membranes lining the oral cavity, gastrointestinal tract and colon. In the area of OTM technologies, we are investing in research and development of our proprietary ORAVESCENT technologies. Our ORAVESCENT drug delivery technologies include ORAVESCENT SL for drug delivery under the tongue (“sublingual”) and ORAVESCENT BL for drug delivery between the gum and the cheek (“buccal”). The U.S. patents for our ORAVESCENT technology begin to expire in 2019. In addition to our ORAVESCENT technologies, we continue to assess the potential uses of certain other proprietary buccal delivery systems in several therapeutic areas in which we focus.

CUSTOMERS

Our principal customers are wholesale drug distributors. These customers comprise a significant part of the distribution network for all pharmaceutical products in the United States. Three large wholesale drug distributors, Cardinal Health, Inc., McKesson Corporation and AmerisourceBergen Corporation, control a significant share of this network. These three wholesale customers, in the aggregate, accounted for 71% of our total consolidated gross sales for the year ended December 31, 2006. The loss or bankruptcy of any of these customers could have an adverse affect on our results of operation and financial condition.

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COMPETITION

We face intense competition and rapid technological change in the pharmaceutical marketplace. Large and small companies, academic institutions, governmental agencies, and other public and private research organizations conduct research, seek patent protection and establish collaborative arrangements for product development in competition with us. Products developed by any of these entities may compete directly with those we develop or sell. In addition, many of the companies and institutions that compete against us have substantially greater capital resources, research and development staffs and facilities than we have, and substantially greater experience in conducting clinical trials, obtaining regulatory approvals and manufacturing and marketing pharmaceutical products. These entities represent significant competition for us. Our products also face potential competition from companies seeking to develop and sell generic formulations of our products at a substantial price discount to the current price of our products. In addition, competitors who are developing products for the treatment of neurological or oncological disorders might succeed in developing technologies and products that are more effective than any that we develop or sell or that would render our technology and products obsolete or noncompetitive. Competition and innovation from these or other sources potentially could negatively affect sales of our products or make them obsolete. Advances in current treatment methods also may adversely affect the market for such products. In addition, we may be at a competitive marketing disadvantage against companies that have broader product lines and whose sales personnel are able to offer more complementary products than we can. Any failure to maintain our competitive position could adversely affect our business and results of operations.

As discussed in more detail above, our products face competition in the marketplace. We cannot be sure that we will be able to demonstrate the potential advantages of our products to prescribing physicians and their patients on an absolute basis and/or in comparison to other presently marketed products. We also need to demonstrate to physicians, patients and third party payers that the cost of our products is reasonable and appropriate in the light of their safety and efficacy, the price of competing products and the related health care benefits to the patient.

GOVERNMENT REGULATION

The manufacture and sale of therapeutics are subject to extensive regulation by U.S. and foreign governmental authorities. In particular, pharmaceutical products are subject to rigorous preclinical and clinical trials and other approval requirements as well as other post-approval requirements by the FDA under the Federal Food, Drug, and Cosmetic Act and by analogous agencies in countries outside the United States.

As an initial step in the FDA regulatory approval process, preclinical studies are typically conducted in animals to identify potential safety problems and, in some cases, to evaluate potential efficacy. The results of the preclinical studies are submitted to regulatory authorities as a part of an IND that is filed with regulatory agencies prior to beginning studies in humans. However, for several of our drug candidates, no animal model exists that is potentially predictive of results in humans. As a result, no in vivo indication of efficacy is available until these drug candidates progress to human clinical trials.

Clinical trials are typically conducted in three sequential phases, although the phases may overlap. Phase 1 typically begins with the initial introduction of the drug into human subjects prior to introduction into patients. In Phase 1, the compound is tested for safety, dosage tolerance, absorption, biodistribution, metabolism, excretion and clinical pharmacology, as well as, if possible, to gain early information on effectiveness. Phase 2 typically involves studies in a small sample of the intended patient population to assess the efficacy of the drug for a specific indication, determine dose tolerance and the optimal dose range, and to gather additional information relating to safety and potential adverse effects. Phase 3 trials are undertaken to further evaluate clinical safety and efficacy in an expanded patient population, generally at multiple study sites, to determine the overall risk-benefit ratio of the drug and to provide an adequate

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basis for product labeling. Each trial is conducted in accordance with certain standards under protocols that detail the objectives of the study, the parameters to be used to monitor safety and the efficacy criteria to be evaluated. In the United States, each protocol must be submitted to the FDA as part of the IND. Further, one or more independent Institutional Review Boards must evaluate each clinical study. The Institutional Review Board considers, among other things, ethical factors, the safety of the study, the adequacy of informed consent by human subjects and the possible liability of the institution. Similar procedures and requirements must be fulfilled to conduct studies in other countries. The process of completing clinical trials for a new drug is likely to take a number of years and require the expenditure of substantial resources.

Promising data from preclinical and clinical trials are submitted to the FDA in an NDA for marketing approval and to foreign regulatory authorities under applicable requirements. Preparing an NDA or foreign application involves considerable data collection, verification, analyses and expense, and there can be no assurance that the applicable regulatory authority will accept the application or grant an approval on a timely basis, if at all. The marketing or sale of pharmaceuticals in the United States may not begin without FDA approval. The approval process is affected by a number of factors, including primarily the safety and efficacy demonstrated in clinical trials and the severity of the disease. Regulatory authorities may deny an application if, in their sole discretion, they determine that applicable regulatory criteria have not been satisfied or if, in their judgment, additional testing or information is required to ensure the efficacy and safety of the product. One of the conditions for initial marketing approval, as well as continued post-approval marketing, is that a prospective manufacturer’s quality control and manufacturing procedures conform to the current Good Manufacturing Practice regulations of the regulatory authority. In complying with these regulations, a manufacturer must continue to expend time, money and effort in the area of production, quality control and quality assurance to ensure full compliance. Manufacturing establishments, both foreign and domestic, also are subject to inspections by or under the authority of the FDA and by other federal, state, local or foreign agencies. Discovery of previously unknown problems with a product or manufacturer may result in restrictions on such product or manufacturer, including withdrawal of the product from the market.

After regulatory approval has been obtained, further studies, including Phase 4 post-marketing studies, may be required to provide additional data on safety, to validate surrogate efficacy endpoints, or for other reasons, and the failure of such studies can result in a range of regulatory actions, including withdrawal of the product from the market. Further studies will be required to gain approval for the use of a product as a treatment for clinical indications other than those for which the product was initially approved. Results of post-marketing programs may limit or expand the further marketing of the products. Further, if there are any modifications to the drug, including any change in indication, manufacturing process, labeling or manufacturing facility, it may be necessary to submit an application seeking approval of such changes to the FDA or foreign regulatory authority. Finally, the FDA can place restrictions on approval and marketing utilizing its authority under applicable regulations. For example, ACTIQ was approved under subpart H of FDA approval regulations, which gives the FDA the authority to pre-approve promotional materials and permits an expedited market withdrawal procedure if issues arise regarding the safe use of ACTIQ. Moreover, marketed products are subject to continued regulatory oversight by the Office of Medical Policy Division of Drug Marketing, Advertising, and Communications, and the failure to comply with applicable regulations could result in marketing restrictions, financial penalties and/or other sanctions.

Whether or not FDA approval has been obtained, approval of a product by regulatory authorities in foreign countries must be obtained prior to the commencement of commercial sales of the product in such countries. The requirements governing the conduct of clinical trials and product approvals vary widely from country to country, and the time required for approval may be longer or shorter than that required for FDA approval. Although there are procedures for unified filings for most European countries, in

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general, each country also has its own additional procedures and requirements, especially related to pricing of new pharmaceuticals. Further, the FDA and other federal agencies regulate the export of products produced in the United States and, in some circumstances, may prohibit or restrict the export even if such products are approved for sale in other countries.

In the United States, the Orphan Drug Act provides incentives to drug manufacturers to develop and manufacture drugs for the treatment of rare diseases, currently defined as diseases that affect fewer than 200,000 individuals in the United States, or for a disease that affects more than 200,000 individuals in the United States, where the sponsor does not realistically anticipate its product becoming profitable. For example, the FDA has designated CEP-701 as an orphan drug for use in treating AML, because this disease currently affects fewer than 200,000 individuals in the United States. Under the Orphan Drug Act, a manufacturer of a designated orphan product can seek certain tax benefits, and the holder of the first FDA approval of a designated orphan product will be granted a seven-year period of marketing exclusivity for that product for the orphan indication. While the marketing exclusivity of an orphan drug would prevent other sponsors from obtaining approval of the same drug compound for the same indication unless the subsequent sponsors could demonstrate clinical superiority or a market shortage occurs, it would not prevent other sponsors from obtaining approval of the same compound for other indications or the use of other types of drugs for the same use as the orphan drug. Orphan drug designation generally does not confer any special or preferential treatment in the regulatory review process. The U.S. Congress has considered, and may consider in the future, legislation that would restrict the duration or scope of the market exclusivity of an orphan drug and, thus, we cannot be sure that the benefits of the existing statute will remain in effect. Additionally, we cannot be sure that other governmental regulations applicable to our products will not change.

In addition to the market exclusivity period under the Orphan Drug Act, the U.S. Drug Price Competition and Patent Term Restoration Act of 1984 permits a sponsor to petition for an extension of the term of a patent for a period of time following the initial FDA approval of an NDA. The statute specifically allows a patent owner acting with due diligence to extend the term of the patent for a period equal to one-half the period of time elapsed between the approval of the IND and the filing of the corresponding NDA, plus the period of time between the filing of the NDA and FDA approval, up to a maximum of five years of patent term extension. Any such extension, however, cannot extend the patent term beyond a maximum term of fourteen years following FDA approval and is subject to other restrictions. Additionally, under this statute, five years of marketing exclusivity is granted for the first approval of a New Chemical Entity (“NCE”). During this period of exclusivity, an ANDA or a 505(b)(2) application cannot be submitted to the FDA for a drug product equivalent or identical to the NCE. An ANDA is the application form typically used by manufacturers seeking approval of a generic version of an approved drug. There is also a possibility that Congress will revise the underlying statute in the next few years, which may affect these provisions in ways that we cannot foresee. Additionally, the FDA regulates the labeling, storage, record keeping, advertising and promotion of prescription pharmaceuticals. Drug manufacturing establishments must register with the FDA and list their products with the FDA.

The Controlled Substances Act imposes various registration, record-keeping and reporting requirements, procurement and manufacturing quotas, labeling and packaging requirements, security controls and a restriction on prescription refills on certain pharmaceutical products. A principal factor in determining the particular requirements of this act, if any, applicable to a product is its actual or potential abuse profile. A pharmaceutical product may be listed as a Schedule II, III, IV or V substance, with Schedule II substances considered to present the highest risk of substance abuse and Schedule V substances the lowest. Modafinil, the active drug substance in PROVIGIL, has been scheduled under the Controlled Substances Act as a Schedule IV substance. Schedule IV substances are subject to special handling procedures relating to the storage, shipment, inventory control and disposal of the product.

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Fentanyl, the active ingredient in FENTORA, ACTIQ and generic OTFC, is a Schedule II controlled substance. Schedule II substances are subject to even stricter handling and record keeping requirements and prescribing restrictions than Schedule III or IV products. In addition to federal scheduling, PROVIGIL, FENTORA, ACTIQ and generic OTFC are subject to state controlled substance regulation, and may be placed in more restrictive schedules than those determined by the DEA and FDA. However, to date, neither modafinil nor fentanyl has been placed in a more restrictive schedule by any state.

In addition to the statutes and regulations described above, we also are subject to regulation under the Occupational Safety and Health Act, the Environmental Protection Act, the Toxic Substances Control Act, the Resource Conservation and Recovery Act and other federal, state and local regulations.

LEGAL MATTERS

For a summary of legal matters, see Note 13 of the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K, which is incorporated herein by reference.

EMPLOYEES

As of December 31, 2006, we had a total of 2,895 full-time employees, of which 2,088 were employed in the United States and 807 were located at our various facilities in Europe. We believe that we have been successful in attracting skilled and experienced personnel; however, competition for such personnel is intense.

ITEM 1A.        RISK FACTORS

You should carefully consider the risks described below, in addition to the other information contained in this report, before making an investment decision. Our business, financial condition or results of operations could be harmed by any of these risks. The risks and uncertainties described below are not the only ones we face. Additional risks not presently known to us or other factors not perceived by us to present significant risks to our business at this time also may impair our business operations.

A significant portion of our revenue is derived from our two largest products, and our future success will depend on the continued growth and acceptance of PROVIGIL and the growth of FENTORA.

For the year ended December 31, 2006, approximately 34% and 43% of our total consolidated net sales were derived from sales of ACTIQ and PROVIGIL, respectively. In September 2006, Barr entered the market with generic OTFC. Since that time, we have experienced meaningful erosion of ACTIQ sales in the United States and we expect this will continue during 2007. For FENTORA, which we launched in the fourth quarter of 2006 as our next-generation pain product, we cannot be sure that it will achieve projected levels of growth. With respect to PROVIGIL, we cannot be certain that it will continue to be accepted in its market. Specifically, the following factors, among others, could affect the level of market acceptance of these products:

·       a change in the perception of the healthcare community of the safety and efficacy of the products, both in an absolute sense and relative to that of competing products;

·       the level and effectiveness of our sales and marketing efforts and, with respect to PROVIGIL, those of Takeda;

·       any unfavorable publicity regarding these or similar products;

·       the price of the products relative to other competing drugs or treatments, including the impact of the availability of generic OTFC on market acceptance of FENTORA;

·       any changes in government and other third-party payer reimbursement policies and practices; and

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·       regulatory developments affecting the manufacture, marketing or use of these products, including, for example, any changes to the PROVIGIL label resulting from the SPARLON clinical studies and the finalization of the NUVIGIL label.

Any adverse developments with respect to the sale or use of PROVIGIL or FENTORA could significantly reduce our product revenues and have a material adverse effect on our ability to generate net income and positive net cash flow from operations.

We may not be able to maintain adequate protection for our intellectual property or market exclusivity for our key products and, therefore, competitors may develop competing products, which could result in a decrease in sales and market share, cause us to reduce prices to compete successfully and limit our commercial success.

We place considerable importance on obtaining patent protection for new technologies, products and processes. To that end, we file applications for patents covering the compositions or uses of our drug candidates or our proprietary processes. The patent positions of pharmaceutical and biotechnology companies can be highly uncertain and involve complex legal, scientific and factual questions. Accordingly, the patents and patent applications relating to our products, product candidates and technologies may be challenged, invalidated or circumvented by third parties and might not protect us against competitors with similar products or technology. Patent disputes in our industry are frequent and can preclude commercialization of products. If we ultimately engage in and lose any such disputes, we could be subject to competition or significant liabilities, we could be required to enter into third party licenses or we could be required to cease using the technology or product in dispute. In addition, even if such licenses are available, the terms of any license requested by a third party could be unacceptable to us.

PROVIGIL / NUVIGIL

The U.S. composition of matter patent for modafinil expired in 2001. We own U.S. and foreign patent rights that expire between 2014 and 2015 and cover pharmaceutical compositions and uses of modafinil, specifically, certain particle sizes of modafinil contained in the pharmaceutical composition of PROVIGIL. With respect to NUVIGIL, we successfully obtained issuance of a U.S. patent in November 2006 claiming the Form I polymorph of armodafinil, the active drug substance in NUVIGIL. This patent is currently set to expire in 2023. Foreign patent applications directed to the use of the Form I polymorph of armodafinil in treating sleep disorders are pending in Europe and elsewhere. Ultimately, these patents might be found invalid as the result of a challenge by a third party, or a potential competitor could develop a competing product or product formulation that avoids infringement of these patents. While we intend to vigorously defend the validity of these patents and prevent infringement, these efforts will be both expensive and time consuming and, ultimately, may not be successful. The loss of patent protection for PROVIGIL would significantly and negatively impact future PROVIGIL sales.

As of the filing date of this Annual Report on Form 10-K, we are aware of seven ANDAs on file with the FDA for pharmaceutical products containing modafinil. Each of these ANDAs contains a Paragraph IV certification in which the ANDA applicant certified that the U.S. particle-size modafinil patent covering PROVIGIL either is invalid or will not be infringed by the ANDA product. In March 2003, we filed a patent infringement lawsuit against four companies—Teva Pharmaceuticals USA, Inc., Mylan Pharmaceuticals, Inc., Ranbaxy Laboratories Limited and Barr Laboratories, Inc.—based upon the ANDAs filed by each of these companies with the FDA seeking approval to market a generic form of modafinil. We believe that these four companies were the first to file ANDAs with Paragraph IV certifications and thus are eligible for the 180-day exclusivity provided by the provisions of the Federal Food, Drug and Cosmetic Act.

In late 2005 and early 2006, we entered into settlement agreements with each of these four defendants. As part of these separate settlements, we agreed to grant to each of Teva, Mylan, Ranbaxy and

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Barr a non-exclusive royalty-bearing right to market and sell a generic version of PROVIGIL in the United States. These licenses will become effective in April 2012. An earlier entry may occur based upon the entry of another generic version of PROVIGIL. Each of these settlements, as well as the ACTIQ settlement agreement described below, has been filed with both the FTC and the Antitrust Division of the DOJ as required by the Medicare Modernization Act. The FTC has requested from us, and we have provided, certain information in connection with its review of the settlements. In July 2006, the FTC requested that we voluntarily submit additional information and documents in connection with its investigation of the PROVIGIL settlements. We are cooperating fully with this request. The FTC could challenge in an administrative or judicial proceeding any or all of the settlements if they believe that the agreements violate the antitrust laws, although we believe that such a challenge would take years to resolve.

We also are aware of a number of civil antitrust complaints, purportedly filed as class actions, filed by private parties in U.S. District Court for the Eastern District of Pennsylvania, each naming Cephalon, Barr, Mylan, Teva and Ranbaxy as co-defendants and claiming, among other things, that the patent litigation settlements concerning PROVIGIL violate the antitrust laws of the United States and certain state laws. The proposed consolidated class action complaints have been designated by plaintiffs, each of which seeks to certify separate, purported classes of plaintiffs: direct purchasers of PROVIGIL, and consumers and other indirect purchasers of PROVIGIL. The plaintiffs in both cases are seeking monetary damages and/or equitable relief. Separately, in June 2006, Apotex, Inc., a subsequent ANDA filer seeking FDA approval of a generic form of modafinil, filed suit against us also in the U.S. District Court for the Eastern District of Pennsylvania alleging similar violations of antitrust laws and state law. Apotex asserts that the PROVIGIL settlement agreements improperly prevent it from obtaining FDA approval of its ANDA, and seeks monetary and equitable remedies, including a declaratory judgment that our U.S. Patent No. RE37,516 (the “‘516 Patent”) is invalid and unenforceable. We filed a motion to dismiss the Apotex case in late September 2006. We believe that both the purported class action cases and the Apotex case are without merit. While we intend to vigorously defend ourselves and the propriety of the settlement agreements, these efforts will be both expensive and time consuming and, ultimately, due to the nature of litigation, there can be no assurance that these efforts will be successful.

In early 2005, we also filed a patent infringement lawsuit against Carlsbad Technology, Inc. based upon the Paragraph IV ANDA filed related to modafinil that Carlsbad filed with the FDA. In August 2006, we entered into a settlement agreement with Carlsbad and its development partner, Watson Pharmaceuticals, Inc., which we understand has the right to commercialize the Carlsbad modafinil product if approved by FDA. As part of this settlement, we agreed to grant to Watson a non-exclusive royalty-bearing right to market and sell a generic version of PROVIGIL in the United States. This license will become effective on or after April 6, 2012, subject to applicable regulatory considerations. An earlier entry may occur based upon the entry of another generic version of PROVIGIL. This agreement has been filed with both the FTC and DOJ, as required by the Medicare Modernization Act.

In November 2005 and March 2006, we received notice that Caraco Pharmaceutical Laboratories, Ltd. and Apotex, Inc., respectively, also filed Paragraph IV ANDAs with the FDA in which each firm is seeking to market a generic form of PROVIGIL. We have not filed patent infringement lawsuits against either Caraco or Apotex as of the filing date of this report, although Apotex has filed suit against us, as described above.

ACTIQ

With respect to ACTIQ, the U.S. patents covering the currently marketed compressed powder pharmaceutical composition and methods for administering fentanyl via this composition expired on September 5, 2006. Corresponding patents in foreign countries are set to expire between 2009 and 2010. Our patent protection with respect to the ACTIQ formulation we sold prior to June 2003 expired in May 2005.

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Under two separate agreements with Barr Laboratories, Inc., we licensed to Barr our U.S. rights to any intellectual property related to ACTIQ. The rights we granted to Barr became effective on September 5, 2006 and Barr entered the market with generic OTFC on September 27, 2006. As a result, ACTIQ sales have been meaningfully eroded and we expect this erosion will continue during 2007. Moreover, sales of our own generic OTFC could be significantly impacted by the entrance into the market of additional generic OTFC products, which could occur at any time.

We also rely on trade secrets, know-how and continuing technological advancements to support our competitive position. Although we have entered into confidentiality and invention rights agreements with our employees, consultants, advisors and collaborators, these parties could fail to honor such agreements or we could be unable to effectively protect our rights to our unpatented trade secrets and know-how. Moreover, others could independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets and know-how. In addition, many of our scientific and management personnel have been recruited from other biotechnology and pharmaceutical companies where they were conducting research in areas similar to those that we now pursue. As a result, we could be subject to allegations of trade secret violations and other claims.

Our activities and products are subject to significant government regulations and approvals, which are often costly and could result in adverse consequences to our business if we fail to comply.

We currently have a number of products that have been approved for sale in the United States, foreign countries or both. All of our approved products are subject to extensive continuing regulations relating to, among other things, testing, manufacturing, quality control, labeling, and promotion. The failure to comply with any rules and regulations of the FDA or any foreign medical authority, or the post-approval discovery of previously unknown problems relating to our products, could result in, among other things:

·       fines, recalls or seizures of products;

·       total or partial suspension of manufacturing or commercial activities;

·       non-approval of product license applications;

·       restrictions on our ability to enter into strategic relationships; and

·       criminal prosecution.

Over the past few years, a significant number of pharmaceutical and biotechnology companies have been the target of inquiries and investigations by various federal and state regulatory, investigative, prosecutorial and administrative entities, including the DOJ and various U.S. Attorney’s Offices, the Office of Inspector General of the Department of Health and Human Services, the FDA, the FTC and various state Attorneys General offices. These investigations have alleged violations of various federal and state laws and regulations, including claims asserting antitrust violations, violations of the Food, Drug and Cosmetic Act, the False Claims Act, the Prescription Drug Marketing Act, anti-kickback laws, and other alleged violations in connection with off-label promotion of products, pricing and Medicare and/or Medicaid reimbursement.

Because of the broad scope and complexity of these laws and regulations, the high degree of prosecutorial resources and attention being devoted to the sales practices of pharmaceutical companies by law enforcement authorities, and the risk of potential exclusion from federal government reimbursement programs, numerous companies have determined that it is highly advisable that they enter into settlement agreements in these matters, particularly those brought by federal authorities and even where such companies believe the investigations are without merit. Companies that have chosen to settle these alleged violations have typically paid multi-million dollar fines to the government and agreed to abide by corporate integrity agreements.

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In September 2004, we announced that we had received subpoenas from the U.S. Attorney’s Office in Philadelphia. That same month, we received a voluntary request for information from the Office of the Connecticut Attorney General. Both the subpoenas and the voluntary request for information appear to be focused on Cephalon’s sales and promotional practices with respect to ACTIQ, GABITRIL and PROVIGIL, including the extent of off-label prescribing of our products by physicians. We are cooperating with the U.S. Attorney’s Office and the Office of the Connecticut Attorney General, are providing documents and other information to both offices in response to these and additional requests and are engaged in ongoing discussion with both parties. These matters may involve the bringing of criminal charges and fines, and/or civil penalties. We cannot predict or determine the outcome of these matters or reasonably estimate the amount or range of amounts of any fines or penalties that might result from a settlement or an adverse outcome. However, a settlement or an adverse outcome could have a material adverse effect on our financial position, liquidity and results of operations.

It is both costly and time-consuming for us to comply with these inquiries and with the extensive regulations to which we are subject. Additionally, incidents of adverse drug reactions, unintended side effects or misuse relating to our products could result in additional regulatory controls or restrictions, or even lead to withdrawal of a product from the market.

With respect to our product candidates, we conduct research, preclinical testing and clinical trials, each of which requires us to comply with extensive government regulations. We cannot market these product candidates or these new indications in the United States or other countries without receiving approval from the FDA or the appropriate foreign medical authority. The approval process is highly uncertain and requires substantial time, effort and financial resources. Ultimately, we may never obtain approval in a timely manner, or at all. Without these required approvals, our ability to substantially grow revenues in the future could be adversely affected.

In addition, because our products PROVIGIL, FENTORA, ACTIQ and generic OTFC and our product candidate NUVIGIL contain active ingredients that are controlled substances, we are subject to regulation by the DEA and analogous foreign organizations relating to the manufacture, shipment, sale and use of the applicable products. These regulations also are imposed on prescribing physicians and other third parties, making the storage, transport and use of such products relatively complicated and expensive. With the increased concern for safety by the FDA and the DEA with respect to products containing controlled substances and the heightened level of media attention given to this issue, it is possible that these regulatory agencies could impose additional restrictions on marketing or even withdraw regulatory approval for such products. In addition, adverse publicity may bring about a rejection of the product by the medical community. If the DEA, FDA or a foreign medical authority withdrew the approval of, or placed additional significant restrictions on the marketing of any of our products, our ability to promote our products and product sales could be substantially affected.

We rely on third parties for the timely supply of specified raw materials, equipment, contract manufacturing, formulation or packaging services, product distribution services, customer service activities and product returns processing. Although we actively manage these third party relationships to ensure continuity and quality, some events beyond our control could result in the complete or partial failure of these goods and services. Any such failure could have a material adverse effect on our financial condition and result of operations.

Manufacturing, supply and distribution problems may create supply disruptions that could result in a reduction of product sales revenue and an increase in costs of sales, and damage commercial prospects for our products.

The manufacture, supply and distribution of pharmaceutical products, both inside and outside the United States, is highly regulated and complex. We, and the third parties we rely upon for the

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manufacturing and distribution of our products, must comply with all applicable regulatory requirements of the FDA and foreign authorities, including current Good Manufacturing Practice (“cGMP”) regulations.

We also must comply with all applicable regulatory requirements of the DEA and analogous foreign authorities for certain of our products that contain controlled substances. The DEA also has authority to grant or deny requests for quota of controlled substances such as the fentanyl citrate that is the active ingredient in ACTIQ. Under our license and supply agreement with Barr, we are obligated to sell generic OTFC to Barr for its resale in the United States. While we currently have available fentanyl quota to produce ACTIQ and generic OTFC, in the future we could face shortages of quota that could negatively impact our ability to supply product to Barr or to produce ACTIQ or our generic OTFC product. If we are unable to provide product to Barr, it is possible that either Barr or the FTC could claim that such a failure would constitute a breach of our agreements with these parties.

The facilities used to manufacture, store and distribute our products also are subject to inspection by regulatory authorities at any time to determine compliance with regulations. These regulations are complex, and any failure to comply with them could lead to remedial action, civil and criminal penalties and delays in production or distribution of material.

For certain of our products in the United States and abroad, we depend upon single sources for the manufacture of both the active drug substances contained in our products and for finished commercial supplies. The process of changing or adding a manufacturer or changing a formulation requires prior FDA and/or European medical authority approval and is very time-consuming. If we are unable to manage this process effectively or if an unforeseen event occurs at any facility, we could face supply disruptions that would result in significant costs and delays, undermine goodwill established with physicians and patients, damage commercial prospects for our products and adversely affect operating results.

With respect to VIVITROL, Alkermes is obligated to provide to us finished commercial supplies of the product under the terms of a supply agreement. We cannot be sure that they will be able to continue to successfully manufacture VIVITROL at a commercial scale in a timely or economical manner. If Alkermes is unable to successfully manufacture VIVITROL, the commercial prospects for the product could be impacted. In addition, Alkermes is responsible for the entire supply chain for VIVITROL, including the sourcing of raw materials and active pharmaceutical agents from third parties. Any issues with its supply sources could impair its ability to supply VIVITROL under the supply agreement and have a material adverse effect on the commercial prospects for VIVITROL.

As our products are used commercially, unintended side effects, adverse reactions or incidents of misuse may occur that could result in additional regulatory controls, changes to product labeling, adverse publicity and reduced sales of our products.

During research and development, the use of pharmaceutical products, such as ours, is limited principally to clinical trial patients under controlled conditions and under the care of expert physicians. The widespread commercial use of our products could identify undesirable or unintended side effects that have not been evident in our clinical trials or the commercial use as of the filing date of this report. For example, in February 2005, working with the FDA, we updated our prescribing information for GABITRIL to include a bolded warning describing the risk of new onset seizures in non-induced patients without epilepsy. In addition, in patients who take multiple medications, drug interactions could occur that can be difficult to predict. Additionally, incidents of product misuse, product diversion or theft may occur, particularly with respect to products such as FENTORA, ACTIQ and PROVIGIL, which contain controlled substances. More recently, an FDA Advisory Committee reviewing SPARLON expressed concern regarding a possible case of SJS in a child who participated in one of the Phase 3 clinical trials. In light of the FDA’s ongoing review of our NUVIGIL NDA, we expect that the safety information in the

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PROVIGIL label will be appropriately modified to reflect the final NUVIGIL label and we are in discussions with the FDA to reach agreement on the final safety language.

These events, among others, could result in adverse publicity that harms the commercial prospects of our products or lead to additional regulatory controls that could limit the circumstances under which the product is prescribed or even lead to the withdrawal of the product from the market. In particular, FENTORA and ACTIQ have been approved under regulations concerning drugs with certain safety profiles, under which the FDA has established special restrictions to ensure safe use. Any violation of these special restrictions could lead to the imposition of further restrictions or withdrawal of the product from the market.

We may be unsuccessful in our efforts to obtain regulatory approval for new products or for new formulations of our existing products, which would significantly hamper future sales and earnings growth.

Our long-term prospects, particularly with respect to the growth of our future sales and earnings, depend to a large extent on our ability to obtain FDA approval for our product candidates, including NUVIGIL. There can be no assurance that our applications to market our product candidates will be reviewed in a timely manner or that our applications will be approved by the FDA on the basis of the data contained in the applications. Should approval be granted to market a product candidate, there can be no assurance that we will be able to successfully commercialize the product or achieve a profitable level of sales. With respect to NUVIGIL, we do not know whether we will succeed in obtaining final regulatory approval to market NUVIGIL or, if approved, what level of market acceptance NUVIGIL may achieve.

We face significant product liability risks, which may have a negative effect on our financial performance.

The administration of drugs to humans, whether in clinical trials or commercially, can result in product liability claims whether or not the drugs are actually at fault for causing an injury. Furthermore, our products may cause, or may appear to have caused, adverse side effects (including death) or potentially dangerous drug interactions that we may not learn about or understand fully until the drug has been administered to patients for some time. As our products are used more widely and in patients with varying medical conditions, the likelihood of an adverse drug reaction, unintended side effect or incidence of misuse may increase. Product liability claims can be expensive to defend and may result in large judgments or settlements against us, which could have a negative effect on our financial performance. The cost of product liability insurance has increased in recent years, and the availability of coverage has decreased. Nevertheless, we maintain product liability insurance in amounts we believe to be commercially reasonable but which would be unlikely to cover the potential liability associated with a significant unforeseen safety issue. Any claims could easily exceed our current coverage limits. Even if a product liability claim is not successful, the adverse publicity and time and expense of defending such a claim may interfere with our business.

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Our product sales and related financial results will fluctuate, and these fluctuations may cause our stock price to fall, especially if investors do not anticipate them.

A number of analysts and investors who follow our stock have developed models to attempt to forecast future product sales and expenses, and have established earnings expectations based upon those models. These models, in turn, are based in part on estimates of projected revenue and earnings that we disclose publicly. Forecasting future revenues is difficult, especially when we only have a few years of commercial history and when the level of market acceptance of our products is changing rapidly. As a result, it is reasonably likely that our product sales will fluctuate to an extent, that may not meet with market expectations and that also may adversely affect our stock price. There are a number of other factors that could cause our financial results to fluctuate unexpectedly, including:

·       cost of product sales;

·       achievement and timing of research and development milestones;

·       collaboration revenues;

·       cost and timing of clinical trials, regulatory approvals and product launches;

·       marketing and other expenses;

·       manufacturing or supply disruptions; and

·       costs associated with the operations of recently-acquired businesses and technologies.

We may be unable to repay our substantial indebtedness and other obligations.

Nearly all of our indebtedness outstanding contain restricted conversion prices that are either below or close to our stock price as of the date of the filing of this Form 10-K. As a result, certain of our convertible notes have been classified as current liabilities on our consolidated balance sheet at December 31, 2006. Under the terms of the indentures governing the notes, we are obligated to repay in cash the aggregate principal balance of any such notes presented for conversion. As of the filing date of this report, we do not have available cash, cash equivalents and investments sufficient to repay all of the convertible notes, if presented. In addition, there are no restrictions on our use of this cash and the cash available to repay indebtedness may decline over time. If we do not have sufficient funds available to repay the principal balance of notes presented for conversion, we will be required to raise additional funds. Because the financing markets may be unwilling to provide funding to us or may only be willing to provide funding on terms that we would consider unacceptable, we may not have cash available or be able to obtain funding to permit us to meet our repayment obligations, thus adversely affecting the market price for our securities.

Our research and development and marketing efforts are often dependent on corporate collaborators and other third parties who may not devote sufficient time, resources and attention to our programs, which may limit our efforts to develop and market potential products.

To maximize our growth opportunities, we have entered into a number of collaboration agreements with third parties. For example, in the United States, we have an agreement with Takeda under which it will co-promote PROVIGIL for up to three years. Our ability to increase PROVIGIL sales in the future will depend to a significant degree on the efforts of our partner. If Takeda fails to meet its obligations under the co-promotion agreement, is ineffective in its efforts, or determines to terminate the agreement prior to the end of its term, the growth of PROVIGIL sales could be materially and negatively impacted.

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In certain countries outside the United States, we have entered into agreements with a number of partners with respect to the development, manufacturing and marketing of our products. In some cases, our collaboration agreements call for our partners to control:

·       the supply of bulk or formulated drugs for use in clinical trials or for commercial use;

·       the design and execution of clinical studies;

·       the process of obtaining regulatory approval to market the product; and/or

·       marketing and selling of an approved product.

In each of these areas, our partners may not support fully our research and commercial interests because our program may compete for time, attention and resources with the internal programs of our corporate collaborators. As such, our program may not move forward as effectively, or advance as rapidly, as it might if we had retained complete control of all research, development, regulatory and commercialization decisions. We also rely on some of these collaborators and other third parties for the production of compounds and the manufacture and supply of pharmaceutical products. Additionally, we may find it necessary from time to time to seek new or additional partners to assist us in commercializing our products, though we ultimately might not be successful in establishing any such new or additional relationships.

The efforts of government entities and third party payers to contain or reduce the costs of health care may adversely affect our sales and limit the commercial success of our products.

In certain foreign markets, pricing or profitability of pharmaceutical products is subject to various forms of direct and indirect governmental control, including the control over the amount of reimbursements provided to the patient who is prescribed specific pharmaceutical products. For example, we are aware of governmental efforts in France to limit or eliminate reimbursement for some of our products, particularly FONZYLANE, FONLIPOL and OLMIFON, which could impact revenues from our French operations.

In the United States, there have been, and we expect there will continue to be, various proposals to implement similar controls. The commercial success of our products could be limited if federal or state governments adopt any such proposals. In addition, in the United States and elsewhere, sales of pharmaceutical products depend in part on the availability of reimbursement to the consumer from third party payers, such as government and private insurance plans. These third party payers are increasingly utilizing their significant purchasing power to challenge the prices charged for pharmaceutical products and seek to limit reimbursement levels offered to consumers for such products. Moreover, many governments and private insurance plans have instituted reimbursement schemes that favor the substitution of generic pharmaceuticals for more expensive brand-name pharmaceuticals. In the United States in particular, generic substitution statutes have been enacted in virtually all states and permit or require the dispensing pharmacist to substitute a less expensive generic drug instead of an original branded drug. These third party payers could focus their cost control efforts on our products, especially with respect to prices of and reimbursement levels for products prescribed outside their labeled indications. In these cases, their efforts could negatively impact our product sales and profitability.

We experience intense competition in our fields of interest, which may adversely affect our business.

Large and small companies, academic institutions, governmental agencies and other public and private research organizations conduct research, seek patent protection and establish collaborative arrangements for product development in competition with us. Products developed by any of these entities may compete directly with those we develop or sell.

The conditions that our products treat, and some of the other disorders for which we are conducting additional studies, are currently treated with many drugs, several of which have been available for a

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number of years or are available in inexpensive generic forms. With respect to PROVIGIL, and, if approved, NUVIGIL, there are several other products used for the treatment of excessive sleepiness or narcolepsy in the United States, including methylphenidate products such as RITALIN® by Novartis, and in our other territories, many of which have been available for a number of years and are available in inexpensive generic forms. With respect to FENTORA, we face competition from numerous short-and long-acting opioid products, including three products—Johnson & Johnson’s DURAGESIC® and Purdue Pharmaceutical’s OXYCONTIN® and MS-CONTIN®—that dominate the market. In addition, we are aware of numerous other companies developing other technologies for rapidly delivering opioids to treat breakthrough pain that will compete against FENTORA. In addition, it is possible that the existence of generic OTFC could negatively impact the growth of FENTORA. With respect to ACTIQ, generic competition from Barr has meaningfully eroded branded ACTIQ sales and impacted sales of our own generic OTFC through Watson. Our generic sales also could be significantly impacted by the entrance into the market of additional generic OTFC products. With respect to VIVITROL, we face competition from CAMPRAL® and oral naltrexone. With respect to TRISENOX, the pharmaceutical market for the treatment of patients with relapsed or refractory APL is served by a number of available therapeutics, such as VESANOID® by Roche in combination with chemotherapy.

For all of our products, we need to demonstrate to physicians, patients and third party payers that the cost of our products is reasonable and appropriate in the light of their safety and efficacy, the price of competing products and the related health care benefits to the patient.

Many of our competitors have substantially greater capital resources, research and development staffs and facilities than we have, and substantially greater experience in conducting clinical trials, obtaining regulatory approvals and manufacturing and marketing pharmaceutical products. These entities represent significant competition for us. In addition, competitors who are developing products for the treatment of neurological or oncological disorders might succeed in developing technologies and products that are more effective than any that we develop or sell or that would render our technology and products obsolete or noncompetitive. Competition and innovation from these or other sources, including advances in current treatment methods, could potentially affect sales of our products negatively or make our products obsolete. Furthermore, we may be at a competitive marketing disadvantage against companies that have broader product lines and whose sales personnel are able to offer more complementary products than we can. Any failure to maintain our competitive position could adversely affect our business and results of operations.

We plan to consider and, as appropriate, make acquisitions of technologies, products and businesses, which may subject us to a number of risks and/or result in us experiencing significant charges to earnings that may adversely affect our stock price, operating results and financial condition.

As part of our efforts to acquire businesses or to enter into other significant transactions, we conduct business, legal and financial due diligence with the goal of identifying and evaluating material risks involved in the transaction. Despite our efforts, we ultimately may be unsuccessful in ascertaining or evaluating all such risks and, as a result, we might not realize the intended advantages of the acquisition. If we fail to realize the expected benefits from acquisitions we may consummate in the future, whether as a result of unidentified risks, integration difficulties, regulatory setbacks or other events, our business, results of operations and financial condition could be adversely affected. For example, in connection with our acquisitions in 2005 of Zeneus, Salmedix and TRISENOX and the license and collaboration agreement with Alkermes, we estimated the values of these transactions by making certain assumptions about, among other things, likelihood of regulatory approval for unapproved products and the market potential for each of the marketed products and the product candidates. Ultimately, our assumptions may prove to be incorrect, which could cause us to fail to realize the anticipated benefits of these transactions.

In addition, we have experienced, and will likely continue to experience, significant charges to earnings related to our efforts to consummate acquisitions. For transactions that ultimately are not

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consummated, these charges may include fees and expenses for investment bankers, attorneys, accountants and other advisers in connection with our efforts. Even if our efforts are successful, we may incur as part of a transaction substantial charges for closure costs associated with the elimination of duplicate operations and facilities and acquired in-process research and development charges. In either case, the incurrence of these charges could adversely affect our results of operations for particular quarterly or annual periods.

We may be unable to successfully consolidate and integrate the operations of businesses we acquire, which may adversely affect our stock price, operating results and financial condition.

We must consolidate and integrate the operations of acquired businesses with our business. Integration efforts often take a significant amount of time, place a significant strain on our managerial, operational and financial resources and could prove to be more difficult and expensive than we predicted. The diversion of our management’s attention and any delays or difficulties encountered in connection with these recent acquisitions, and any future acquisitions we may consummate, could result in the disruption of our ongoing business or inconsistencies in standards, controls, procedures and policies that could negatively affect our ability to maintain relationships with customers, suppliers, employees and others with whom we have business dealings.

The results and timing of our research and development activities, including future clinical trials, are difficult to predict, subject to potential future setbacks and, ultimately, may not result in viable pharmaceutical products, which may adversely affect our business.

In order to sustain our business, we focus substantial resources on the search for new pharmaceutical products. These activities include engaging in discovery research and process development, conducting preclinical and clinical studies and seeking regulatory approval in the United States and abroad. In all of these areas, we have relatively limited resources and compete against larger, multinational pharmaceutical companies. Moreover, even if we undertake these activities in an effective and efficient manner, regulatory approval for the sale of new pharmaceutical products remains highly uncertain because the majority of compounds discovered do not enter clinical studies and the majority of therapeutic candidates fail to show the human safety and efficacy necessary for regulatory approval and successful commercialization.

In the pharmaceutical business, the research and development process generally takes 12 years or longer, from discovery to commercial product launch. During each stage of this process, there is a substantial risk of failure. Preclinical testing and clinical trials must demonstrate that a product candidate is safe and efficacious. The results from preclinical testing and early clinical trials may not be predictive of results obtained in subsequent clinical trials, and these clinical trials may not demonstrate the safety and efficacy necessary to obtain regulatory approval for any product candidates. A number of companies in the biotechnology and pharmaceutical industries have suffered significant setbacks in advanced clinical trials, even after obtaining promising results in earlier trials. For ethical reasons, certain clinical trials are conducted with patients having the most advanced stages of disease and who have failed treatment with alternative therapies. During the course of treatment, these patients often die or suffer other adverse medical effects for reasons that may not be related to the pharmaceutical agent being tested. Such events can have a negative impact on the statistical analysis of clinical trial results.

The completion of clinical trials of our product candidates may be delayed by many factors, including the rate of enrollment of patients. Neither we nor our collaborators can control the rate at which patients present themselves for enrollment, and the rate of patient enrollment may not be consistent with our expectations or sufficient to enable clinical trials of our product candidates to be completed in a timely manner or at all. In addition, we may not be permitted by regulatory authorities to undertake additional clinical trials for one or more of our product candidates. Even if such trials are conducted, our product candidates may not prove to be safe and efficacious or receive regulatory approvals. Any significant delays in, or termination of, clinical trials of our product candidates could impact our ability to generate product sales from these product candidates in the future.

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The price of our common stock has been and may continue to be highly volatile, which may make it difficult for stockholders to sell our common stock when desired or at attractive prices.

The market price of our common stock is highly volatile, and we expect it to continue to be volatile for the foreseeable future. For example, from January 1, 2006 through February 15, 2007 our common stock traded at a high price of $82.92 and a low price of $51.58. Negative announcements, including, among others:

·       adverse regulatory decisions;

·       disappointing clinical trial results;

·       disputes and other developments concerning our patents or other proprietary products; or

·       sales or operating results that fall below the market’s expectations

could trigger significant declines in the price of our common stock. In addition, external events, such as news concerning economic conditions, our competitors or our customers, changes in government regulations impacting the biotechnology or pharmaceutical industries or the movement of capital into or out of our industry, also are likely to affect the price of our common stock, regardless of our operating performance.

Our internal controls over financial reporting may not be considered effective, which could result in possible regulatory sanctions and a decline in our stock price.

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to furnish annually a report on our internal controls over financial reporting. The internal control report must contain an assessment by our management of the effectiveness of our internal control over financial reporting (including the disclosure of any material weakness) and a statement that our independent auditors have attested to and reported on management’s evaluation of such internal controls. The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and internal controls over financial reporting. In order for management to evaluate our internal controls, we must regularly review and document our internal control processes and procedures and test such controls. Ultimately, we or our independent auditors could conclude that our internal control over financial reporting may not be effective if, among others things:

·       any material weakness in our internal controls over financial reporting exist; or

·       we fail to remediate assessed deficiencies.

During 2007, we expect to expand our SAP® implementation to include additional capabilities. This expansion will require changes to certain aspects of our existing system of internal controls over financial reporting. Due to the number of controls to be examined, both with respect to this phase of the implementation and our other internal controls over financial reporting, the complexity of our processes, and the subjectivity involved in determining the effectiveness of controls, we cannot be certain that, in the future, all of our controls will continue to be considered effective by management or, if considered effective by our management, that our auditors will agree with such assessment.

If, in the future, we are unable to assert that our internal control over financial reporting is effective, or if our auditors are unable to attest that our management’s report is fairly stated or they are unable to express an opinion on our management’s evaluation, we could be subject to regulatory sanctions or lose investor confidence in the accuracy and completeness of our financial reports, either of which could have an adverse effect on the market price for our securities.

A portion of our revenues and expenses is subject to exchange rate fluctuations in the normal course of business, which could adversely affect our reported results of operations.

Historically, a portion of our revenues and expenses has been earned and incurred, respectively, in currencies other than the U.S. dollar. For the year ended December 31, 2006, approximately 17% of our revenues were denominated in currencies other than the U.S. dollar. We translate revenues earned and

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expenses incurred into U.S. dollars at the average exchange rate applicable during the relevant period. A weakening of the U.S. dollar would, therefore, increase both our revenues and expenses. Fluctuations in the rate of exchange between the U.S. dollar and the euro and other currencies may affect period-to-period comparisons of our operating results. Historically, we have not hedged our exposure to these fluctuations in exchange rates.

Our customer base is highly concentrated.

Our principal customers are wholesale drug distributors. These customers comprise a significant part of the distribution network for pharmaceutical products in the United States. Three large wholesale distributors, Cardinal Health, Inc., McKesson Corporation and AmerisourceBergen Corporation, control a significant share of this network. These three wholesaler customers, in the aggregate, accounted for 71% of our total consolidated gross sales for the year ended December 31, 2006. Fluctuations in the buying patterns of these customers, which may result from seasonality, wholesaler buying decisions or other factors outside of our control, could significantly affect the level of our net sales on a period to period basis. Because of this, the amounts purchased by these customers during any quarterly or annual period may not correlate to the level of underlying demand evidenced by the number of prescriptions written for such products, as reported by IMS Health Incorporated. Furthermore, the loss or bankruptcy of any of these customers could materially and adversely affect our results of operations and financial condition.

We are involved, or may become involved in the future, in legal proceedings that, if adversely adjudicated or settled, could materially impact our financial condition.

As a biopharmaceutical company, we are or may become a party to litigation in the ordinary course of our business, including, among others, matters alleging employment discrimination, product liability, patent or other intellectual property rights infringement, patent invalidity or breach of commercial contract. In general, litigation claims can be expensive and time consuming to bring or defend against and could result in settlements or damages that could significantly impact results of operations and financial condition. We currently are vigorously defending ourselves against certain litigation matters in addition to those matters specifically described in Note 13 of the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. While we currently do not believe that the settlement or adverse adjudication of these other litigation matters would materially impact our results of operations or financial condition, the final resolution of these matters and the impact, if any, on our results of operations, financial condition or cash flows is unknown but could be material.

Our dependence on key executives and scientists could impact the development and management of our business.

We are highly dependent upon our ability to attract and retain qualified scientific, technical and managerial personnel. There is intense competition for qualified personnel in the pharmaceutical and biotechnology industries, and we cannot be sure that we will be able to continue to attract and retain the qualified personnel necessary for the development and management of our business. Although we do not believe the loss of one individual would materially harm our business, our business might be harmed by the loss of the services of multiple existing personnel, as well as the failure to recruit additional key scientific, technical and managerial personnel in a timely manner. Much of the know-how we have developed resides in our scientific and technical personnel and is not readily transferable to other personnel. While we have employment agreements with our key executives, we do not ordinarily enter into employment agreements with our other key scientific, technical and managerial employees. We do not maintain “key man” life insurance on any of our employees.

We may be required to incur significant costs to comply with environmental laws and regulations, and our related compliance may limit any future profitability.

Our research and development activities involve the controlled use of hazardous, infectious and radioactive materials that could be hazardous to human health and safety or the environment. We store

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these materials, and various wastes resulting from their use, at our facilities pending ultimate use and disposal. We are subject to a variety of federal, state and local laws and regulations governing the use, generation, manufacture, storage, handling and disposal of these materials and wastes, and we may be required to incur significant costs to comply with related existing and future environmental laws and regulations.

While we believe that our safety procedures for handling and disposing of these materials comply with foreign, federal, state and local laws and regulations, we cannot completely eliminate the risk of accidental injury or contamination from these materials. In the event of an accident, we could be held liable for any resulting damages, which could include fines and remedial costs. These damages could require payment by us of significant amounts over a number of years, which could adversely affect our results of operations and financial condition.

Anti-takeover provisions may delay or prevent changes in control of our management or deter a third party from acquiring us, limiting our stockholders’ ability to profit from such a transaction.

Our board of directors has the authority to issue up to 5,000,000 shares of preferred stock, $0.01 par value, of which 1,000,000 have been reserved for issuance in connection with our stockholder rights plan, and to determine the price, rights, preferences and privileges of those shares without any further vote or action by our stockholders. Our stockholder rights plan could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock.

We are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which prohibits us from engaging in a “business combination” with an “interested stockholder” for a period of three years after the date of the transaction in which the person becomes an interested stockholder, unless the business combination is approved in a prescribed manner. The application of Section 203 could have the effect of delaying or preventing a change of control of Cephalon. Section 203, the rights plan, and certain provisions of our certificate of incorporation, our bylaws and Delaware corporate law, may have the effect of deterring hostile takeovers, or delaying or preventing changes in control of our management, including transactions in which stockholders might otherwise receive a premium for their shares over then-current market prices.

ITEM 1B.       UNRESOLVED STAFF COMMENTS

None.

ITEM 2.                PROPERTIES

We lease our corporate headquarters, which is located in Frazer, Pennsylvania and consists of approximately 190,000 square feet of administrative office space. We own approximately 160,000 square feet of research and office space in West Chester, Pennsylvania, at the site of our former corporate headquarters. We also lease approximately 215,000 square feet of office, administrative, research and warehouse space that is near our Frazer and West Chester facilities. In Salt Lake City, Utah, we own approximately 200,000 square feet of manufacturing, warehousing and laboratory space and lease approximately 123,000 square feet for administrative, research and pilot plant functions. At our facilities in Eden Prairie and Brooklyn Park, Minnesota, we own approximately 200,000 square feet of space, most of which is dedicated to our manufacturing and warehousing operations.

We lease office space for our European operations in the U.K. as well as space for our satellite offices in a number of major European countries. In France, we own administrative facilities, an executive and development facility, a manufacturing facility, a packaging facility and various warehouses totaling approximately 326,000 square feet. We also lease the site of our other manufacturing facility in France totaling approximately 29,000 square feet. We believe that our current facilities are adequate for our present purposes.

37




ITEM 3.                LEGAL PROCEEDINGS

The information set forth in Note 13 of the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K is incorporated herein by reference.

ITEM 4.                SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

We did not submit any matters to the vote of security holders during the fourth quarter of 2006.

Executive Officers of the Registrant

The names, ages and positions held by our executive officers as of the filing date of this Annual Report on Form 10-K are as follows:

Name

 

 

 

Age

 

Position

Frank Baldino, Jr., Ph.D.

 

53

 

Chairman and Chief Executive Officer

J. Kevin Buchi

 

51

 

Executive Vice President and Chief Financial Officer

Peter E. Grebow, Ph.D.

 

60

 

Executive Vice President, Worldwide Technical Operations

John E. Osborn

 

49

 

Executive Vice President, General Counsel and Secretary

Robert P. Roche, Jr.

 

51

 

Executive Vice President, Worldwide Pharmaceutical Operations

Lesley Russell, MB.Ch.B., MRCP.

 

46

 

Executive Vice President, Worldwide Medical and Regulatory Operations

Carl A. Savini

 

57

 

Executive Vice President and Chief Administrative Officer

Jeffry L. Vaught, Ph.D.

 

56

 

Executive Vice President and President, Research and Development

 

All executive officers are elected by the Board of Directors to serve in their respective capacities until their successors are elected and qualified or until their earlier resignation or removal.

Dr. Baldino founded Cephalon and has served as Chief Executive Officer and a director since its inception. He was appointed Chairman of the Board of Directors in December 1999. Dr. Baldino received his Ph.D. degree from Temple University, holds several adjunct academic appointments and is a trustee of Temple University. Dr. Baldino currently serves as a director of Pharmacopeia, Inc., a developer of proprietary technology platforms for pharmaceutical companies, Acusphere, Inc., a specialty pharmaceutical company, NicOx S.A., a company engaged in the research, development and commercialization of nitric oxide therapeutics and, until May 2006, ViroPharma, Inc., a biopharmaceutical company.

Mr. Buchi joined Cephalon in March 1991 and has held the position of Chief Financial Officer since 1996. Between 1985 and 1991, Mr. Buchi served in a number of financial positions with E.I. du Pont de Nemours and Company. Mr. Buchi received a master of management degree from the J.L. Kellogg Graduate School of Management, Northwestern University in 1982. Mr. Buchi serves as a member of the board of directors of Lorus Therapeutics Inc., a publicly-traded Canadian biotechnology company, and Encysive Pharmaceuticals Inc., a publicly-traded pharmaceutical company.

Dr. Grebow joined Cephalon in January 1991, and since February 2005 has served as Executive Vice President, Worldwide Technical Operations. Dr. Grebow also has served as Senior Vice President, Worldwide Technical Operations, Senior Vice President, Business Development, and Vice President, Drug Development. From 1988 to 1990, Dr. Grebow served as Vice President of Drug Development for Rorer Central Research, a division of Rhone-Poulenc Rorer Pharmaceuticals Inc., a pharmaceutical company. Dr. Grebow received a Ph.D. in chemistry from the University of California, Santa Barbara.

38




Mr. Osborn joined Cephalon in March 1997 and was appointed Senior Vice President, General Counsel and Secretary in 1998, and Executive Vice President in 2006. From 1992 to 1997, Mr. Osborn was employed by The DuPont Merck Pharmaceutical Company, most recently as Vice President and Associate General Counsel. Prior to that, he served in the George H.W. Bush administration with the U.S. Department of State, practiced corporate law in Boston with the firm of Hale and Dorr, and clerked for a U.S. Court of Appeals judge. He holds a visiting research appointment in politics at Princeton University, and has been elected to membership in the American Law Institute and the Council on Foreign Relations. Mr. Osborn is a member of the board of governors of the East-West Center in Honolulu, an education and research organization established by the U.S. Congress to study the Asia Pacific region and its relationship with the United States. He also serves as a member of the board of directors of Incept BioSystems, Inc., a privately-held biomedical device company in Ann Arbor, Michigan. Mr. Osborn earned a law degree from the University of Virginia and a master’s degree in international public policy from The Johns Hopkins University.

Mr. Roche joined Cephalon in January 1995 and has served as Executive Vice President, Worldwide Pharmaceutical Operations since February 2005. From November 2000 to February 2005, Mr. Roche was Senior Vice President, Pharmaceutical Operations. In June 1999, he was appointed to Senior Vice President of Sales and Marketing, and prior to that was Vice President, Sales and Marketing. Previously, Mr. Roche served as Director and Vice President, Worldwide Strategic Product Development, for SmithKline Beecham’s central nervous system and gastrointestinal products business, and held senior marketing and management positions with that company in the Philippines, Canada and Spain. Mr. Roche serves as a member of the board of directors of LifeCell Corporation, a publicly-traded biotechnology company. Mr. Roche graduated from Colgate University and received a master of business administration degree from The Wharton School, University of Pennsylvania.

Dr. Russell joined Cephalon in January 2000, and since November 2006, has served as Executive Vice President, Worldwide Medical and Regulatory Operations. Dr. Russell was Senior Vice President, Worldwide Medical and Regulatory Operations from August 2006 to October 2006, Senior Vice President of Worldwide Clinical Research from February 2005 to August 2006, and Vice President, Clinical Research prior to such time. From July 1996 to January 2000, Dr. Russell was employed by US Bioscience Inc./ MedImmune Oncology, most recently as Vice President Clinical Research. In that capacity, Dr. Russell was responsible for directing and implementing the clinical programs in oncology and HIV research. Prior to this, Dr. Russell was a Clinical Research Physician at Eli Lilly UK where she focused on oncology clinical programs. Before joining the pharmaceutical industry, Dr. Russell studied in Hematology/Oncology at Royal Infirmary of Edinburgh, and Royal Hospital for Sick Children Edinburgh UK and was a Research Fellow at University of Edinburgh Faculty of Medicine. Dr. Russell received MB.Ch.B. from University of Edinburgh, Scotland, Faculty of Medicine and is a member of the Royal College of Physicians, UK.

Mr. Savini joined Cephalon in June 1993, was appointed Senior Vice President in 1999, and has served as Executive Vice President and Chief Administrative Officer since February 2006. Mr. Savini has served in various capacities with the Company, including Senior Vice President, Administration and Senior Vice President, Human Resources. From 1983 to 1993, Mr. Savini was employed by Bristol-Myers Squibb Company and from 1981 to 1983 he was employed by Johnson & Johnson’s McNeil Pharmaceuticals. Mr. Savini graduated from The Pennsylvania State University and received a master of business administration degree from La Salle College.

Dr. Vaught joined Cephalon in August 1991, and since that time has been responsible for directing Cephalon’s research operations. He currently serves as Executive Vice President and President, Research and Development. Prior to joining Cephalon, Dr. Vaught was employed by the R. W. Johnson Pharmaceutical Research Institute, a subsidiary of Johnson & Johnson. Dr. Vaught received a Ph.D. in pharmacology from the University of Minnesota.

39




PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Our common stock is quoted on the NASDAQ Stock Market under the symbol “CEPH.” The following table sets forth the range of high and low sale prices for the common stock as reported on the NASDAQ Stock Market for the periods indicated below.

 

 

High

 

Low

 

2005

 

 

 

 

 

First Quarter

 

$

52.24

 

$

45.44

 

Second Quarter

 

47.54

 

37.35

 

Third Quarter

 

48.75

 

38.24

 

Fourth Quarter

 

66.92

 

43.50

 

2006

 

 

 

 

 

First Quarter

 

$

82.92

 

$

59.55

 

Second Quarter

 

68.40

 

51.58

 

Third Quarter

 

67.25

 

53.70

 

Fourth Quarter

 

78.38

 

61.42

 

 

As of February 15, 2007 there were 537 holders of record of our common stock. On February 15, 2007, the last reported sale price of our common stock as reported on the NASDAQ Stock Market was $75.22 per share.

We have not paid any dividends on our common stock since our inception and do not anticipate paying any dividends on our common stock in the foreseeable future.

Issuer Purchases of Equity Securities

Period

 

 

 

Total Number
of Shares of
Common Stock
Purchased(1)

 

Average Price
Paid Per Share(2)

 

Total Number of
Shares of Common
Stock Purchased as
Part of Publicly
Announced Plans or
Programs

 

Approximate
Dollar Value of
Common Stock
that May Yet Be
Purchased Under
the Plans or
Programs

 

October 1–31, 2006

 

 

 

 

 

$

 

 

 

 

 

 

 

 

November 1–30, 2006

 

 

 

 

 

 

 

 

 

 

 

 

 

December 1–31, 2006

 

 

54,791

 

 

 

72.72

 

 

 

 

 

 

 

 

December 1–31, 2006

 

 

1,823,847

 

 

 

71.02

 

 

 

 

 

 

 

 

Total

 

 

1,878,638

 

 

 

$

71.07

 

 

 

 

 

 

 

 


(1)          This column reflects the following transactions during the fourth quarter of 2006: (i) the surrender to Cephalon of 54,791 shares of common stock to satisfy tax withholding obligations in connection with the vesting of restricted stock units issued to employees and (ii) the receipt of 1,823,847 shares associated with the exchange of $436.9 million aggregate principal of our convertible notes and concurrent termination of a portion of the convertible note hedge and warrant agreements. For a description of these notes, see Note 10 to our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.

(2)          Price paid per share is a weighted average based on the closing price of our common stock on the various vesting dates.

40




Securities Authorized for Issuance Under Equity Compensation Plans

The following table gives information about our common stock that may be issued upon the exercise of stock options, warrants and rights under all of our existing equity compensation plans as of December 31, 2006, including the 1987 Stock Option Plan (which expired in 1997) (the “1987 Plan”), the 2004 Equity Compensation Plan (the “2004 Plan”) and the 2000 Equity Compensation Plan for Employees and Key Advisors (the “2000 Plan”).

Equity Compensation Plan Information

Plan Category

 

 

 

(a)
Number of Securities to
be Issued Upon Exercise
of Outstanding Options,
Warrants and Rights(1)

 

(b)
Weighted Average
Exercise Price of
Outstanding
Options, Warrants
and Rights(1)

 

(c)
Number of Securities
Remaining Available for
Future Issuance (Excludes
Securities Reflected in
Column (a))(2)

 

Equity compensation plans approved by stockholders

 

 

5,823,382

(3)

 

 

$

46.19

 

 

 

1,005,019

 

 

Equity compensation plans not approved by stockholders(4)

 

 

2,549,088

 

 

 

$

59.85

 

 

 

76,475

 

 

Total

 

 

8,372,470

 

 

 

$

50.35

 

 

 

1,081,494

 

 


(1)          The foregoing does not include stock options assumed under the Anesta Corp. 1993 Stock Option Plan (the “Anesta Plan”) as a result of our acquisition of Anesta Corp. in 2000. As of December 31, 2006, there were 31,728 shares of common stock subject to outstanding stock options under the Anesta Plan, with a weighted average exercise price of these stock options of $27.07 per share. No additional shares are reserved for issuance under the Anesta Plan.

(2)          The 2004 Plan permits our Board of Directors or the Stock Option and Compensation Committee of our Board to award stock options to participants. Up to 286,209 of the securities remaining available for issuance under equity compensation plans approved by stockholders may be issued as restricted stock units. Restricted stock unit awards are not permitted to be made under the terms of the 2000 Plan.

(3)          Includes awards covering 709,900 shares of unvested restricted stock units that are outstanding under the 2004 Plan. Also includes 2,700 shares to be issued upon exercise of outstanding stock options granted under the 1987 Plan. There are no securities that remain available for grant under the 1987 Plan.

(4)          Issued under the 2000 Plan, which does not require the approval of, and has not been approved by, Cephalon stockholders.

2000 Equity Compensation Plan for Employees and Key Advisors

On December 13, 2000, our Board of Directors adopted the 2000 Plan. The 2000 Plan has been amended several times since its adoption, with the most recent amendment to the 2000 Plan on July 25, 2002. The 2000 Plan provides that stock options may be granted to our employees who are not officers or directors of Cephalon and consultants and advisors who perform services for Cephalon. At the time of its initial approval, the 2000 Plan was not submitted to, nor was it required to be submitted to, our stockholders for approval. Amendments to the 2000 Plan, including amendments increasing the number of shares of Common Stock reserved for issuance under the 2000 Plan, also did not require approval of the Company’s stockholders. In light of changes to the NASDAQ shareholder approval requirements for stock option plans, our Board of Directors has decided that it will not further increase the number of shares

41




authorized for issuance under the 2000 Plan, but will continue to use any shares authorized for issuance under the 2000 Plan for future grants until the 2000 Plan expires according to its terms in 2010.

The purpose of the 2000 Plan is to promote our success by linking the personal interests of our non-executive employees and consultants and advisors to those of our stockholders and by providing participants with an incentive for outstanding performance. The 2000 Plan currently authorizes the granting of “non-qualified stock options” (“NQSOs”) only. The 2000 Plan is administered and interpreted by the Stock Option and Compensation Committee of the Board of Directors. The Stock Option and Compensation Committee determines the individuals who will receive a NQSO grant under the 2000 Plan, the number of shares of Common Stock subject to the NQSO, the period during which the NQSO becomes exercisable, the term of the NQSO (but not to exceed 10 years from the date of grant) and the other terms and conditions of the NQSO consistent with the terms of the 2000 Plan. All of the NQSOs that are currently outstanding under the 2000 Plan become exercisable ratably over a four-year period beginning on the date of grant and expire ten years from the date of grant. The exercise price of a NQSO granted under the 2000 Plan will be determined by the Stock Option and Compensation Committee, but may not be less than the fair market value of the underlying stock on the date of grant. A grantee may exercise a NQSO granted under the 2000 Plan by delivering notice of exercise to the Stock Option and Compensation Committee and pay the exercise price (i) in cash, (ii) with approval of the Stock Option and Compensation Committee, by delivering shares of common stock already owned by the grantee and having a fair market value on the date of exercise equal to the exercise price, or through attestation to ownership of such shares, or (iii) through such other method as the Stock Option and Compensation Committee may approve. In the event of a “Corporate Transaction,” (e.g., a merger in which 50% or more of the common stock is transferred to a third party), all outstanding stock options will automatically accelerate and become immediately exercisable, subject to certain limitations.

The Board of Directors has the authority to amend or terminate the 2000 Plan at any time without stockholder approval. The 2000 Plan will terminate on December 12, 2010, unless it is terminated earlier or extended by the Board of Directors. No amendment or termination of the 2000 Plan may adversely affect any stock option previously granted under the 2000 Plan without the written consent of the participant, unless required by applicable law.

42




ITEM 6.                SELECTED FINANCIAL DATA

We completed the acquisitions of issued share capital of Zeneus Holdings Limited on December 22, 2005, substantially all assets related to the TRISENOX injection business from CTI and CTI Technologies, Inc., a wholly-owned subsidiary of CTI on July 18, 2005, outstanding capital stock of Salmedix, Inc. on June 14, 2005 and the outstanding shares of capital stock of CIMA LABS on August 12, 2004. These acquisitions have been accounted for either as business combinations or asset purchases.

(In thousands, except per share data)

 

Year Ended December 31,

 

Statement of operations data

 

 

 

2006

 

2005

 

2004

 

2003

 

2002

 

Sales

 

$

1,720,172

 

$

1,156,518

 

$

980,375

 

$

685,250

 

$

465,943

 

Other revenues

 

43,897

 

55,374

 

35,050

 

29,557

 

40,954

 

Total revenues

 

1,764,069

 

1,211,892

 

1,015,425

 

714,807

 

506,897

 

Impairment charges

 

12,417

 

20,820

 

30,071

 

 

 

Acquired in-process research and development

 

5,000

 

366,815

 

185,700

 

 

 

Debt exchange expense

 

48,122

 

 

28,230

 

 

 

Write-off of deferred debt issuance costs

 

13,105

 

27,109

 

 

 

 

Income tax expense (benefit)

 

93,438

 

(70,164

)

45,629

 

46,456

 

(112,629

)

Income (loss) before cumulative effect of a change in accounting principle

 

$

144,816

 

$

(174,954

)

$

(73,813

)

$

83,858

 

$

175,062

 

Cumulative effect of a change in accounting principle

 

 

 

 

 

(3,534

)

Net income (loss)

 

$

144,816

 

$

(174,954

)

$

(73,813

)

$

83,858

 

$

171,528

 

Basic income (loss) per common share:

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before cumulative effect of a change in accounting principle

 

$

2.39

 

$

(3.01

)

$

(1.31

)

$

1.49

 

$

3.14

 

Cumulative effect of a change in accounting principle

 

 

 

 

 

(0.06

)

 

 

$

2.39

 

$

(3.01

)

$

(1.31

)

$

1.49

 

$

3.08

 

Weighted average number of common shares outstanding

 

60,507

 

58,051

 

56,489

 

55,560

 

55,104

 

Diluted income (loss) per common share:

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before cumulative effect of a change in accounting principle

 

$

2.08

 

$

(3.01

)

$

(1.31

)

$

1.42

 

$

2.82

 

Cumulative effect of a change in accounting principle

 

 

 

 

 

(0.05

)

 

 

$

2.08

 

$

(3.01

)

$

(1.31

)

$

1.42

 

$

2.77

 

Weighted average number of common shares outstanding—assuming dilution

 

69,672

 

58,051

 

56,489

 

64,076

 

66,856

 

 

(In thousands)

 

December 31,

 

Balance sheet data

 

 

 

2006

 

2005

 

2004

 

2003

 

2002

 

Cash, cash equivalents and investments

 

$

521,724

 

$

484,090

 

$

791,676

 

$

1,155,163

 

$

582,688

 

Total assets

 

3,045,497

 

2,819,206

 

2,396,922

 

2,381,656

 

1,689,090

 

Current portion of long-term debt

 

1,023,312

 

933,160

 

5,114

 

9,637

 

15,402

 

Long-term debt (excluding current portion)

 

224,992

 

763,097

 

1,284,410

 

1,409,417

 

860,897

 

Accumulated deficit

 

(425,256

)

(570,072

)

(395,118

)

(321,305

)

(405,163

)

Stockholders’ equity

 

1,309,460

 

612,171

 

830,044

 

770,370

 

642,585

 

 

43




ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide information to assist you in better understanding and evaluating our financial condition and results of operations. We encourage you to read this MD&A in conjunction with our consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K.

EXECUTIVE SUMMARY

Cephalon is an international biopharmaceutical company dedicated to the discovery, development and marketing of innovative products to treat human diseases. We currently focus our efforts in four core therapeutic areas: central nervous system (“CNS”) disorders, pain, cancer and addiction. In addition to conducting an active research and development program, we market six products in the United States and numerous products in various countries throughout Europe. Consistent with our core therapeutic areas, we have aligned our 829-person U.S. field sales and sales management teams by area. In Europe, we have a sales and marketing organization numbering approximately 412 persons that supports our presence in nearly 20 European countries, including France, the United Kingdom, Germany, Italy and Spain.

Our most significant product is PROVIGIL, which comprised approximately 43% of our total consolidated net sales for the year ended December 31, 2006, of which approximately 94% was in the U.S. market. For the year ended December 31, 2006, consolidated net sales of PROVIGIL increased 43% over the year ended December 31, 2005. Under our co-promotion agreement with Takeda Pharmaceuticals North America, Inc., 500 Takeda sales representatives began promoting PROVIGIL in the second position to primary care physicians and other appropriate health care professionals in the United States beginning July 1, 2006. Effective January 1, 2007, an additional 250 Takeda sales representatives were added, all of whom are detailing PROVIGIL in the first position. Together with our CNS field sales and sales management teams, we now have nearly 1,200 persons focused on detailing PROVIGIL in the United States.

Our second most significant product in 2006 was ACTIQ, which comprised approximately 34% of our total consolidated net sales for the year ended December 31, 2006, of which approximately 95% was in the U.S. market. In late September 2006, Barr Laboratories, Inc. entered the U.S. market with generic version of ACTIQ (“generic OTFC”) pursuant to our license and supply agreement. As a result, ACTIQ sales have been meaningfully eroded by generic OTFC products sold by Barr and by us through our sales agent, Watson Pharmaceuticals, Inc., and we expect this erosion will continue during 2007. In addition, under our license and supply agreement with Barr, we are obligated to sell generic OTFC to Barr for its resale in the United States. While we currently have available fentanyl quota to produce ACTIQ and generic OTFC, in the future we could face shortages of quota that could negatively impact our ability to supply product to Barr or to produce ACTIQ or our generic OTFC product. If we are unable to provide product to Barr, it is possible that either Barr or the FTC could claim that this failure is a breach of our agreements with these parties.

During 2006, two of our products were approved by the FDA. In late September 2006, we received FDA approval of our next-generation proprietary pain product, FENTORA, and launched the product in the United States in early October. FENTORA is indicated for the management of breakthrough pain in patients with cancer who are already receiving and are tolerant to opioid therapy for their underlying persistent cancer pain. We are focusing our longer-term clinical strategy on developing FENTORA for patients with breakthrough pain associated with other conditions, including neuropathic pain and back pain. In October 2006 and January 2007, we announced that data from Phase 3 clinical trials of FENTORA demonstrated efficacy in the management of breakthrough pain in opioid-tolerant patients with chronic low back pain and chronic neuropathic pain, respectively. Pending positive data from an

44




ongoing study in patients with non-cancer breakthrough pain, our goal is to submit a sNDA to the FDA in late 2007. This sNDA would seek to expand the labeled indications for FENTORA beyond breakthrough pain in patients with cancer.

In April 2006, the FDA approved VIVITROL, and we launched the product in June. VIVITROL is indicated for the treatment of alcohol dependent patients who are able to abstain from alcohol in an outpatient setting and are not actively drinking when initiating treatment. Treatment with VIVITROL should be used in combination with psychosocial support, such as counseling or group therapy. Under the license and collaboration agreement we signed with Alkermes, Inc. in June 2005, Alkermes is responsible for manufacturing commercial supplies of VIVITROL and we have primary responsibility for the marketing and sale of the product.

We also made progress in 2006 toward the approval of NUVIGIL with an anticipated indication for excessive sleepiness. NUVIGIL is a single-isomer version of modafinil, the active ingredient in PROVIGIL. In May 2006, we received an approvable letter from the FDA; we currently expect a final approval decision from the FDA on or before March 31, 2007. The FDA is continuing to evaluate the single case of serious rash reported in a SPARLON clinical study. We have provided additional information to the FDA to help the agency place this isolated case in the context of the safety profile for modafinil that has been established over more than a decade of commercial use. The reviewing division has not requested any additional information related to NUVIGIL and is working with us to finalize the product’s label. Since NUVIGIL is derived from the active ingredient in PROVIGIL, we expect that the safety information in the PROVIGIL label will be appropriately modified to reflect the safety information in the final NUVIGIL label. NUVIGIL is protected by a composition of matter patent that will expire on December 18, 2023 and covers a novel polymorphic form of armodafinil, the active pharmaceutical ingredient in NUVIGIL.

In March 2006, we announced that the FDA’s Psychopharmacologic Drugs Advisory Committee voted not to recommend approval of SPARLON for the treatment of attention deficit/hyperactivity disorder (“ADHD”) in children and adolescents. This recommendation was the result of concerns expressed by the advisory committee regarding a possible case of Stevens-Johnson syndrome (“SJS”), a rare but serious skin rash condition, in a child who participated in one of the Phase 3 clinical trials. In August 2006, we announced that the FDA had issued a letter indicating that the SPARLON sNDA was “not approvable.’’ In light of the FDA’s decision, we currently are not pursuing development of SPARLON.

As a biopharmaceutical company, our future success is highly dependent on obtaining and maintaining patent protection for our products and technology. We intend to vigorously defend the validity, and prevent infringement, of our patents. The loss of patent protection on any of our existing products, whether by third-party challenge, invalidation, circumvention, license or patent expiration, could materially impact our results of operations. In late 2005 and early 2006, we entered into settlement agreements with each of Teva Pharmaceuticals USA, Inc., Mylan Pharmaceuticals Inc., Ranbaxy Laboratories Limited and Barr Laboratories, Inc. As part of these separate settlements, we agreed to grant to each of these parties a non-exclusive royalty-bearing right to market and sell a generic version of PROVIGIL in the United States. These licenses generally will become effective in April 2012. For more information concerning these settlements, please see Central Nervous Systems Disorders—Modafinil Products and Product Candidates—Intellectual Property Position” in Part I, Item 1 of this Annual Report on Form 10-K.

In connection with the Barr, Ranbaxy and Teva settlements, we also entered into a series of business arrangements related to modafinil with Barr, Ranbaxy and Teva. We received licenses to certain modafinil-related intellectual property developed by each party and in exchange for these licenses, we agreed to make payments to these three companies collectively totaling up to $136.0 million, consisting of upfront payments, milestones and royalties on net sales of our modafinil products. In order to maintain an

45




adequate supply of the active drug substance modafinil, we entered into agreements with three modafinil suppliers whereby we will purchase an annual minimum amount of modafinil over a six year period beginning in 2006, with the aggregate payments over that period totaling approximately $82.6 million.

Our activities and operations are subject to significant government regulations and oversight. In September 2004, we announced that we had received subpoenas from the U.S. Attorney’s Office in Philadelphia. That same month, we received a voluntary request for information from the Office of the Connecticut Attorney General. Both the subpoenas and the voluntary request for information appear to be focused on our sales and promotional practices with respect to ACTIQ, GABITRIL and PROVIGIL, including the extent of off-label prescribing of our products by physicians. We are cooperating with the U.S. Attorney’s Office and the Office of the Connecticut Attorney General, are providing documents and other information to both offices in response to these and additional requests and are engaged in ongoing discussions with both parties. These matters may involve the bringing of criminal charges and fines, and/or civil penalties. We cannot predict or determine the outcome of these matters or reasonably estimate the amount or range of amounts of any fines or penalties that might result from a settlement or an adverse outcome. However, a settlement or an adverse outcome could have a material adverse effect on our financial position, liquidity and results of operations.

We have significant levels of indebtedness outstanding, nearly all of which consists of convertible notes. Under the terms of the indentures governing the notes, we are obligated to repay in cash the aggregate principal balance of any such notes presented for conversion. For a more complete description of these notes, see Note 10 to our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. We do not have available cash, cash equivalents and investments sufficient to repay all of the convertible notes, if presented. In addition, there are no restrictions on our use of this cash, and the cash available to repay indebtedness may decline over time.

As of December 31, 2006, the fair value of both the 2.0% Notes and the Zero Coupon Notes is greater than the value of the shares into which such notes are convertible. We believe that the share price of our common stock would have to significantly increase over the market price as of the filing date of this report before the fair value of the convertible notes would be less than the value of the common stock shares underlying the notes. As such, we believe it is highly unlikely that holders of the 2.0% Notes or Zero Coupon Notes will present significant amounts of such notes for conversion under the current terms. In the unlikely event that a significant conversion did occur, we believe that we have the ability to raise sufficient cash to repay the principal amounts due through a combination of utilizing our existing cash on hand, raising money in the capital markets or selling our note hedge instruments for cash. Because the financing markets may be unwilling to provide funding to us or may only be willing to provide funding on terms that we would consider unacceptable, we may not have cash available or be able to obtain funding to permit us to meet our repayment obligations, thus adversely affecting the market price for our securities.

While we seek to increase profitability and cash flow from operations, we will need to continue to achieve growth of product sales and other revenues sufficient for us to attain these objectives. The rate of our future growth will depend, in part, upon our ability to obtain and maintain adequate intellectual property protection for our currently marketed products, and to successfully develop or acquire and commercialize new product candidates.

RECENT ACQUISITIONS AND TRANSACTIONS

For additional information related to each of the following acquisitions and transactions, please see Note 2 to the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.

46




Co-Promotion Agreement with Takeda

On June 12, 2006, we entered into a co-promotion agreement with Takeda with respect to PROVIGIL in the United States. We also have an option to utilize the Takeda sales force for the promotion of NUVIGIL, assuming FDA approval of this product candidate. The co-promotion agreement has a three-year term. If we undergo a change of control during the three-year term, we have the option to terminate the co-promotion agreement, subject to our obligation to make certain specified payments to Takeda. We will pay Takeda a royalty based on certain sales criteria for PROVIGIL and NUVIGIL during the three-year term and, if specified sales levels are reached, during the three calendar years following the expiration of the co-promotion agreement.

Zeneus Holdings Limited Acquisition

On December 22, 2005, we completed our acquisition of all of the issued share capital of Zeneus Holdings Limited. Total consideration paid in connection with the acquisition was approximately $365.8 million, net of cash acquired.

TRISENOX Acquisition

On July 18, 2005, we completed our acquisition of substantially all assets related to TRISENOX from Cell Therapeutics, Inc. and CTI Technologies, Inc., a wholly-owned subsidiary of CTI. The results of operations of TRISENOX have been included in the consolidated statements of operations since the acquisition date.

VIVITROL License and Collaboration

In June 2005, we entered into a license and collaboration agreement with Alkermes to develop and commercialize VIVITROL in the United States. Concurrent with the execution of this agreement, we entered into a supply agreement under which Alkermes provides to us finished commercial supplies of VIVITROL. We made an initial payment of $160 million to Alkermes upon execution of this agreement. In April 2006, we made an additional payment of $110 million to Alkermes following FDA approval of the product. Alkermes also could receive up to an additional $220 million in milestone payments that are contingent on attainment of certain agreed-upon sales levels of VIVITROL. Until December 31, 2007, Alkermes is responsible for any cumulative losses up to $120 million, and we are responsible for any cumulative losses in excess of $120 million. Pre-tax profit, as adjusted for certain items, and losses incurred after December 31, 2007 will be split equally between the parties. We began recognizing revenue for VIVITROL effective in the third quarter of 2006.

In October 2006, we amended the existing license and collaboration agreement with Alkermes to provide that we would be responsible for our own VIVITROL-related costs during the period August 1, 2006 through December 31, 2006 and, for that period, such costs will not be chargeable to the collaboration and against the $120 million cumulative loss cap. The parties also agreed to amend the existing supply agreement to provide that we will purchase from Alkermes two VIVITROL manufacturing lines (and related equipment). At December 31, 2006, we incurred approximately $25.4 million related to the construction of these two manufacturing lines. We expect to incur up to an additional $45.6 million for certain future capital improvements related to these two manufacturing lines. We also have granted Alkermes an option, exercisable after two years, to purchase these manufacturing lines at the then-current net book value of the assets.

47




Salmedix, Inc. Acquisition

On June 14, 2005, we completed our acquisition of Salmedix, Inc. As a result of the acquisition, we obtained the rights to market TREANDAÔ (bendamustine hydrochloride). The results of operations for Salmedix have been included in our consolidated financial statements as of the acquisition date.

RESULTS OF OPERATIONS
(In thousands)

Year ended December 31, 2006 compared to year ended December 31, 2005:

 

 

Year Ended December 31,

 

 

 

 

 

 

 

 

 

2006

 

2005

 

% Increase (Decrease)

 

 

 

United
States

 

Europe

 

Total

 

United
States

 

Europe

 

Total

 

United
States

 

Europe

 

Total

 

Sales:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

PROVIGIL

 

$

691,779

 

$

43,052

 

$

734,831

 

$

475,557

 

$

37,248

 

$

512,805

 

 

45

%

 

 

16

%

 

 

43

%

 

GABITRIL

 

54,971

 

4,316

 

59,287

 

66,517

 

5,741

 

72,258

 

 

(17

)%

 

 

(25

)%

 

 

(18

)%

 

CNS

 

746,750

 

47,368

 

794,118

 

542,074

 

42,989

 

585,063

 

 

38

%

 

 

10

%

 

 

36

%

 

ACTIQ

 

550,390

 

27,252

 

577,642

 

394,676

 

17,102

 

411,778

 

 

39

%

 

 

59

%

 

 

40

%

 

Generic OTFC

 

54,801

 

 

54,801

 

 

 

 

 

100

%

 

 

%

 

 

100

%

 

FENTORA

 

29,250

 

 

29,250

 

 

 

 

 

100

%

 

 

%

 

 

100

%

 

Pain

 

634,441

 

27,252

 

661,693

 

394,676

 

17,102

 

411,778

 

 

61

%

 

 

59

%

 

 

61

%

 

Other

 

56,084

 

208,277

 

264,361

 

49,695

 

109,982

 

159,677

 

 

13

%

 

 

89

%

 

 

66

%

 

Total Sales

 

1,437,275

 

282,897

 

1,720,172

 

986,445

 

170,073

 

1,156,518

 

 

46

%

 

 

66

%

 

 

49

%

 

Other Revenues

 

35,399

 

8,498

 

43,897

 

47,587

 

7,787

 

55,374

 

 

(26

)%

 

 

9

%

 

 

(21

)%

 

Total Revenues

 

$

1,472,674

 

$

291,395

 

$

1,764,069

 

$

1,034,032

 

$

177,860

 

$

1,211,892

 

 

42

%

 

 

64

%

 

 

46

%

 

 

Sales—In the United States, we sell our products to pharmaceutical wholesalers, the largest three of which accounted for 71% of our total consolidated gross sales for the year ended December 31, 2006. Decisions made by these wholesalers regarding the levels of inventory they hold (and thus the amount of product they purchase from us) can materially affect the level of our sales in any particular period and thus may not necessarily correlate to the number of prescriptions written for our products as reported by IMS Health Incorporated.

In 2005, we finalized distribution service agreements with our major wholesaler customers. These agreements obligate the wholesalers to provide us with periodic retail demand information and current inventory levels for our products held at their warehouse locations; additionally, the wholesalers have agreed to manage the variability of their purchases and inventory levels within specified limits based on product demand.

As of December 31, 2006, we received information from substantially all of our U.S. wholesaler customers about the levels of inventory they held for our U.S. branded products. Based on this information, which we have not independently verified, we believe that total inventory held at these wholesalers is approximately two weeks supply of our U.S. branded products at our current sales levels. During the fourth quarter of 2006, we shipped launch quantities of our generic OTFC. At December 31, 2006, we believe that generic OTFC inventory held at wholesalers and retailers is approximately two to three months.

Sales of our generic OTFC product to wholesalers and retailers include both the right of return of expired product and retroactive price reductions under certain conditions, while sales of FENTORA also include the right of return of expired product. Based on the sales levels and the prescription data during the fourth quarter of 2006, and based on the number of units on hand in the pipeline at December 31, 2006 relative to the overall demand for the products, we have estimated and recorded all applicable product

48




sales allowances related to generic OTFC and FENTORA as of December 31, 2006. We have therefore recognized revenues for generic OTFC and FENTORA based on a fixed and determinable sales price in 2006.

For the year ended December 31, 2006, sales were impacted by changes in the product sales allowances deducted from gross sales as described further below and by changes in the relative levels of the number of units of inventory held at wholesalers and retailers. For the year ended December 31, 2006, total sales increased by 49% over the prior year. The other key factors that contributed to the increase in sales are summarized by product as follows:

·       In CNS, sales of PROVIGIL increased 43 percent. Demand for PROVIGIL increased as evidenced by an increase in U.S. prescriptions for PROVIGIL of 18%, according to IMS Health. For the year ended December 31, 2006, sales of PROVIGIL also were impacted by domestic price increases of approximately 12% from period to period.

·       In Pain, sales increased 61 percent. Sales of ACTIQ were impacted by an increase in domestic prices of approximately 68% from period to period, offset slightly by a decline in demand for ACTIQ as evidenced by a 17% decrease in U.S. prescriptions, according to IMS Health. For the year ended December 31, 2006, we recognized $54.8 million of revenue related to shipments of our generic OTFC to Barr and sales of our own generic OTFC and $29.3 million of revenue related to sales of FENTORA. In 2007, we expect overall sales of our Pain products to decrease based on a shift in market share from ACTIQ to generic OTFC and the potential for further generic entrants into the market, partially offset by the anticipated growth in FENTORA.

·       Other sales, which consist primarily of sales of other products and certain third party products, increased 66 percent. This increase is attributable to sales of products acquired in the TRISENOX® and Zeneus acquisitions in July 2005 and December 2005, respectively.

Other Revenues—The decrease of 21% from period to period is primarily due to a decrease in partner reimbursements on our CEP-1347 program, which was halted in 2006, and a decrease in revenues from clinical studies performed for collaborators.

Analysis of gross sales to net sales—The following table presents the product sales allowances deducted from gross sales to arrive at a net sales figure:

 

 

Year Ended December 31,

 

 

 

 

 

 

 

2006

 

2005

 

Change

 

% Change

 

Gross sales:

 

$

1,890,836

 

$

1,335,602

 

$

555,234

 

 

42

%

 

Product sales allowances:

 

 

 

 

 

 

 

 

 

 

 

Prompt payment discounts

 

32,384

 

22,284

 

10,100

 

 

45

%

 

Wholesaler discounts

 

2,939

 

24,373

 

(21,434

)

 

(88

)%

 

Returns

 

24,735

 

15,853

 

8,882

 

 

56

%

 

Coupons

 

26,853

 

23,313

 

3,540

 

 

15

%

 

Medicaid discounts

 

45,267

 

67,245

 

(21,978

)

 

(33

)%

 

Medicare Part D discounts

 

2,217

 

 

2,217

 

 

100

%

 

Managed care and governmental contracts

 

36,269

 

26,016

 

10,253

 

 

39

%

 

 

 

170,664

 

179,084

 

(8,420

)

 

 

 

 

Net sales

 

$

1,720,172

 

$

1,156,518

 

$

563,654

 

 

49

%

 

Product sales allowances as a percentage of gross sales

 

9.0

%

13.4

%

 

 

 

 

 

 

 

49




Prompt payment discounts and returns allowances increased for the year ended December 31, 2006 as compared to the year ended December 31, 2005 due to the increase in sales. Wholesaler discounts decreased due to the fact that fewer incremental wholesaler discounts were required for the year ended December 31, 2006 as a result of 2006 price increases. Decreases in product sales allowances were also caused by lower Medicaid discounts resulting from a significant number of participants transferring to the new Part D of the Medicare Prescription Drug Improvement and Modernization Act of 2003 (“Medicare Part D”) program effective January 1, 2006. Managed care and governmental contracts increased for the year ended December 31, 2006 as compared to the year ended December 31, 2005 due to additional rebates for certain managed care and governmental programs, offset by a reduction of $13.3 million recognized in the third quarter of 2006, representing amounts paid to the U.S. Department of Defense (“DoD”) under the Tricare program from October 2004 through June 30, 2006. In October 2006, the DoD announced that it would reimburse all companies that had voluntarily made such payments under the Tricare program due to the U.S. Court of Appeals September 2006 ruling. In the future, we expect product sales allowances as a percentage of gross sales to trend upward due to the impact of potential future price increases on Medicaid discounts and potential increases related to Medicaid, Medicare Part D, managed care and governmental contracts sales.

We also recorded discounts for Medicare Part D for the year ended December 31, 2006 of $2.2 million. This reserve was established based on the number of Medicare Part D contracts that we have signed and an estimate of the amounts expected to be incurred under each contract based on expected enrollment and usage. These estimates are based on preliminary data and may change significantly in the future based on actual experience.

 

 

Year Ended December 31,

 

 

 

 

 

 

 

2006

 

2005

 

Change

 

% Change

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

Cost of sales

 

$

257,061

 

$

164,223

 

$

92,838

 

 

57

%

 

Research and development

 

403,367

 

354,826

 

48,541

 

 

14

%

 

Selling, general and administrative

 

675,576

 

443,861

 

231,715

 

 

52

%

 

Depreciation and amortization

 

116,511

 

84,305

 

32,206

 

 

38

%

 

Impairment charge

 

12,417

 

20,820

 

(8,403

)

 

(40

)%

 

Acquired in-process research and development

 

5,000

 

366,815

 

(361,815

)

 

(99

)%

 

 

 

$

1,469,932

 

$

1,434,850

 

$

35,082

 

 

2

%

 

 

Cost of Sales—The cost of sales was 14.9% of net sales for the year ended December 31, 2006 and 14.2% of net sales for the year ended December 31, 2005. The increase is primarily due to an $8.6 million inventory reserve related to SPARLON recorded in the second quarter of 2006 (see Note 6 of the Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K), a $8.9 million inventory reserve related to NUVIGIL recorded throughout 2006 as a result of FDA postponement of their final approval decision until 2007, the inclusion of Zeneus’ product sales for the year ended December 31, 2006 for which the margins are lower than the average margin of our other products, as well as additional royalty expenses for the year ended December 31, 2006 for PROVIGIL. These increases were partially offset by the net effect of price increases and lower product sales allowances on our three major U.S. products.

Research and Development Expenses—Research and development expenses increased $48.5 million, or 14%, for the year ended December 31, 2006 as compared to the year ended December 31, 2005. This increase is primarily attributable to $80.5 million of payments for four research and development collaborations and the recognition of $15.3 million of stock-based compensation expense (representing one-half of the total stock-based compensation expense recorded during the year ended December 31,

50




2006 based on the employees’ compensation allocation) as a result of the adoption of Financial Accounting Standards Board (“FASB”) Statement No. 123(R), “Share Based Payment” (“SFAS 123(R)”), partially offset by lower expenses associated with reduced levels of clinical activity in 2006.

Selling, General and Administrative Expenses—Selling, general and administrative expenses increased $231.7 million, or 52%, for the year ended December 31, 2006 as compared to the year ended December 31, 2005. Approximately $138.6 million of the increase was due to higher selling and marketing costs in the United States resulting from the expansion of our sales force, increased promotional spending on PROVIGIL, VIVITROL and FENTORA and expenses under our agreements with Takeda and Watson. The increase was also due to the inclusion of Zeneus selling, general and administrative expenses (approximately $51.5 million) for the year ended December 31, 2006. In addition, we recognized $15.3 million of stock-based compensation expense (representing one-half of the total stock-based compensation expense recorded during the year ended December 31, 2006 based on the employees’ compensation allocation) as a result of the adoption of SFAS 123(R).

Depreciation and Amortization Expenses—Depreciation and amortization expenses increased $32.2 million, or 38%, for the year ended December 31, 2006, primarily as a result of additional amortization expense resulting from intangible assets acquired during the last quarter of 2005 and during 2006, and the inclusion of Zeneus depreciation and amortization expenses (approximately $14.8 million) for the year ended December 31, 2006.

Impairment charges—In June 2006, we announced that data from our Phase 3 clinical program evaluating GABITRIL for the treatment of generalized anxiety disorder (“GAD”) did not reach statistical significance on the primary study endpoints. We have no plans to continue further study of GABITRIL for the treatment of GAD. As a result, we performed a test of impairment on the carrying value of our investment in GABITRIL product rights and recorded an impairment charge of $12.4 million in the second quarter of 2006 related to our European rights. For the year ended December 31, 2005, we recorded an impairment charge of $20.8 million for the write-off of an intangible asset resulting from the termination of a distribution agreement in the United Kingdom.

Acquired in-process research and development—For the year ended December 31, 2005, we recorded acquired in-process research and development expense of $71.2 million for Zeneus, $130.1 million for Salmedix and $160.0 million for VIVITROL.

 

 

Year Ended December 31,

 

 

 

 

 

 

 

2006

 

2005

 

Change

 

% Change

 

Other income (expense):

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

25,438

 

$

26,171

 

$

(733

)

 

(3

)%

 

Interest expense

 

(18,922

)

(25,235

)

6,313

 

 

25

%

 

Debt exchange expense

 

(48,122

)

 

(48,122

)

 

(100

)%

 

Write-off of deferred debt issuance costs

 

(13,105

)

(27,109

)

14,004

 

 

52

%

 

Gain on early extinguishment of debt

 

 

2,085

 

(2,085

)

 

(100

)%

 

Other income (expense), net

 

(1,172

)

1,928

 

(3,100

)

 

(161

)%

 

 

 

$

(55,883

)

$

(22,160

)

$

(33,723

)

 

(152

)%

 

 

Other Income (Expense)—Other income (expense), net decreased $33.7 million, or 152%, for the year ended December 31, 2006 as compared to the year ended December 31, 2005. The decrease was attributable to the following factors:

·       a decrease in interest income for the year ended December 31, 2006 due to lower average investment balances, partially offset by higher investment returns.

51




·       A decrease in interest expense for the year ended December 31, 2006 due primarily to the repurchase of substantially all of our 2.5% convertible subordinated notes in July 2005 and to the write-off of deferred debt issuance costs related to our 2.0% Notes in December 2005 and our Zero Coupon Notes in January 2006. This decrease was partially offset by a full year of interest expense on our 2.0% Notes, which were issued in June 2005.

·       A $48.1 million charge resulting from the exchange of $336.9 million of Zero Coupon Notes and $100.0 million of 2.0% Notes in December 2006.

·       A $13.1 million write-off in 2006 of deferred debt issuance costs related to our Zero Coupon Notes, as compared to a $27.1 million write-off in 2005 of deferred debt issuance costs related to our 2.0% Notes.

·       A $2.1 million net gain on early extinguishment of debt in 2005 related to the 2.5% convertible subordinated notes.

·       A $3.1 million decrease in other income (expense), net primarily due to fluctuations in foreign currency gains and losses in the comparable periods.

 

 

Year Ended December 31,

 

 

 

 

 

 

 

2006

 

2005

 

Change

 

% Change

 

Income tax expense (benefit)

 

$

93,438

 

$

(70,164

)

$

163,602

 

 

233

%

 

 

Income Taxes—For the year ended December 31, 2006, we recognized $93.4 million of income tax expense on income before income taxes of $238.3 million, resulting in an overall effective tax rate of 39.2 percent. This compared to income tax benefit for the year ended December 31, 2005 of $70.2 million on loss before income taxes of $245.1 million, resulting in an effective tax rate of (28.6) percent. The 2006 effective tax rate was impacted by an increase in the valuation allowance. The 2005 effective tax rate was impacted by non-deductible acquired in-process research and development charges related to the Salmedix and Zeneus acquisitions for which no tax benefit was recorded, offset by a decrease in the valuation allowance. See Note 14 to our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for a reconciliation of the United States Federal statutory rate to our effective tax rate.

Year ended December 31, 2005 compared to year ended December 31, 2004:

 

Year Ended December 31,

 

 

 

 

 

 

 

 

 

2005

 

2004

 

% Increase (Decrease)

 

 

 

United
States

 

Europe

 

Total

 

United
States

 

Europe

 

Total

 

United
States

 

Europe

 

Total

 

Sales:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

PROVIGIL

 

$

475,557

 

$

37,248

 

$

512,805

 

$

406,238

 

$

33,429

 

$

439,667

 

 

17

%

 

 

11

%

 

 

17

%

 

GABITRIL

 

66,517

 

5,741

 

72,258

 

87,349

 

6,815

 

94,164

 

 

(24

)%

 

 

(16

)%

 

 

(23

)%

 

CNS

 

542,074

 

42,989

 

585,063

 

493,587

 

40,244

 

533,831

 

 

10

%

 

 

7

%

 

 

10

%

 

Pain

 

394,676

 

17,102

 

411,778

 

337,072

 

7,925

 

344,997

 

 

17

%

 

 

116

%

 

 

19

%

 

Other

 

49,695

 

109,982

 

159,677

 

13,270

 

88,277

 

101,547

 

 

274

%

 

 

25

%

 

 

57

%

 

Total Sales

 

986,445

 

170,073

 

1,156,518

 

843,929

 

136,446

 

980,375

 

 

17

%

 

 

25

%

 

 

18

%

 

Other Revenues

 

47,587

 

7,787

 

55,374

 

28,749

 

6,301

 

35,050

 

 

66

%

 

 

24

%

 

 

58

%

 

Total Revenues

 

$

1,034,032

 

$

177,860

 

$

1,211,892

 

$

872,678

 

$

142,747

 

$

1,015,425

 

 

18

%

 

 

25

%

 

 

19

%

 

p

52




Sales—In the United States, we sell our products to pharmaceutical wholesalers, the largest three of which accounted for 75% of our total consolidated gross sales for the year ended December 31, 2005. Decisions made by these wholesalers regarding the levels of inventory they hold (and thus the amount of product they purchase from us) can materially affect the level of our sales in any particular period and thus may not necessarily correlate to the number of prescriptions written for our products as reported by IMS Health. We believe that speculative buying of product, particularly in anticipation of possible price increases, has been the historic practice of many pharmaceutical wholesalers. In past years, we attempted to minimize these fluctuations both by providing, from time to time, discounts to our customers to stock normal amounts of inventory (which we had historically defined as approximately one month’s supply at our current sales level) and by canceling orders if we believe a particular customer is speculatively buying inventory in anticipation of possible price increases.

In 2004 and 2005, our wholesaler customers, as well as others in the industry, began modifying their business models from arrangements where they derive profits from the management of various discounts and rebates, to arrangements where they charge a fee for their services. In connection with this new wholesaler business model, we finalized distribution service agreements in the third quarter of 2005 with our major wholesaler customers. These agreements obligate the wholesalers to provide us with periodic retail demand information and current inventory levels for our products held at their warehouse locations; additionally, the wholesalers have agreed to manage the variability of their purchases and inventory levels within specified limits based on product demand.

As of December 31, 2005, we received information from our three largest U.S. wholesaler customers about the levels of inventory they held for our products. Based on this information, which we have not independently verified, we believe that total inventory held at these wholesalers is approximately two weeks supply at our current sales levels.

For the year ended December 31, 2005, total sales increased by 18% over the prior year. This change was impacted by changes in the relative levels of the number of units of inventory held at wholesalers and retailers and by changes in the product sales allowances deducted from gross sales. The other key factors that contributed to the increase in sales are summarized by product as follows:

·       In CNS Disorders, sales of PROVIGIL increased 17 percent. Demand for PROVIGIL increased as evidenced by an increase in U.S. prescriptions for PROVIGIL of 16%, according to IMS Health. For the year ended December 31, 2005, sales of PROVIGIL also were impacted by domestic price increases of approximately 21% from period to period.

·       Sales of GABITRIL decreased 23 percent. U.S. prescriptions for GABITRIL decreased 19% according to IMS Health. This decrease was driven primarily by our decision to reduce our sales and marketing efforts following an update in February 2005 to the label information for GABITRIL. For the year ended December 31, 2005, sales of GABITRIL also were impacted by domestic price increases of approximately 32% from period to period.

·       In Pain, sales increased 19 percent. Demand for ACTIQ increased as evidenced by an increase in U.S. prescriptions for ACTIQ of 8%, according to IMS Health. For the year ended December 31, 2005, sales of ACTIQ also were impacted by an increase in domestic prices of approximately 18% from period to period.

·       Other sales, which consist primarily of sales of other products and certain third party products, increased 57 percent. The most significant increases in this category are sales of products manufactured and sold to pharmaceutical partners by CIMA LABS, which we acquired in August 2004, sales of NAXY® (clarithromycin), which we acquired in December 2004 and sales of TRISENOX® which we acquired in July 2005.

53




Other Revenues—The increase of 58% from period to period is primarily due to the inclusion of product development and licensing fees and royalties attributable to CIMA LABS of $33.8 million for the year ended December 31