Edgar Filing: VIROPHARMA INC

Viropharma Inc--Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2006

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

Commission File Number: 0-21699

VIROPHARMA INCORPORATED

(Exact Name of Registrant as Specified in its Charter)

Delaware

23-2789550

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

397 Eagleview Boulevard

Exton, Pennsylvania 19341

(Address of Principal Executive Offices and Zip Code)

610-458-7300

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):


Large Accelerated Filer ¨		Accelerated Filer x		Non-accelerated filer ¨

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

Number of shares outstanding of the issuer’s Common Stock, par value $.002 per share, as of May 2, 2006: 68,587,608 shares.

VIROPHARMA INCORPORATED

INDEX


		Page

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements:

Consolidated Balance Sheets (unaudited) at March 31, 2006 and December 31, 2005		3

Consolidated Statements of Operations (unaudited) for the three months ended March 31, 2006 and 2005		4

Consolidated Statements of Stockholders’ Equity (Deficit) for the three months ended March 31, 2006		5

Consolidated Statements of Cash Flows (unaudited) for the three months ended March 31, 2006 and 2005		6

Notes to the Consolidated Financial Statements (unaudited)		7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		15

Item 3. Quantitative and Qualitative Disclosures About Market Risk		27

Item 4. Controls and Procedures		27

PART II. OTHER INFORMATION

Item 1a. Risk Factors		28

Item 6. Exhibits		47

Signatures		48

ViroPharma Incorporated

Consolidated Balance Sheet

(unaudited)


(in thousands, except share and per share data)	March 31, 2006			December 31, 2005
Assets
Current assets:
Cash and cash equivalents	$	85,846		$	232,195
Short-term investments		70,917			1,218
Accounts receivable, net		13,710			14,887
Inventory		10,267			10,996
Income taxes receivable		732			1,977
Deferred income taxes		11,410			11,644
Other current assets		2,615			1,912

Total current assets		195,497			274,829
Intangible assets, net		120,416			121,691
Equipment and leasehold improvements, net		2,719			1,555
Deferred income taxes		34,877			36,875
Debt issue costs, net		—			526
Other assets		49			49

Total assets	$	353,558		$	435,525

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	3,759		$	9,256
Accrued expenses and other current liabilities		10,666			19,423
Income taxes payable		1,636			—
Current portion of long-term debt		—			78,920
Deferred revenue – current		423			564

Total current liabilities		16,484			108,163
Other liabilities		566			385

Total liabilities		17,050			108,548

Commitments and Contingencies

Stockholders’ equity:
Preferred stock, par value $0.001 per share. 5,000,000 shares authorized; Series A convertible participating preferred stock; no shares issued and outstanding		—			—
Series A junior participating preferred stock, par value $0.001 per share. 200,000 shares designated; no shares issued and outstanding		—			—
Common stock, par value $0.002 per share. 100,000,000 shares authorized; issued and outstanding 68,587,608 shares at March 31, 2006 and 68,563,879 shares at December 31, 2005		137			137
Additional paid-in capital		491,622			490,593
Deferred compensation		—			(3	)
Accumulated other comprehensive (loss)		(39	)		(350	)
Accumulated deficit		(155,212	)		(163,400	)

Total stockholders’ equity		336,508			326,977

Total liabilities and stockholders’ equity	$	353,558		$	435,525

See accompanying notes to unaudited consolidated financial statements.

ViroPharma Incorporated

Consolidated Statements of Operations

(unaudited)


	Three months ended March 31,
(in thousands, except per share data)	2006			2005
Revenues:
Net product sales	$	29,233		$	21,055
License fee and milestone revenue		141			6,141

Total revenues		29,374			27,196

Costs and Expenses:
Cost of sales		5,674			3,614
Research and development		4,074			2,761
Marketing, general and administrative		4,906			2,265
Intangible amortization and acquisition of technology rights		1,275			1,170

Total costs and expenses		15,929			9,810

Operating income		13,445			17,386

Other Income (Expense):
Change in fair value of derivative liability		—			3,558
Loss on bond redemption		(1,127	)		—
Interest income		2,222			208
Interest expense		(865	)		(3,778	)

Income before income tax expense		13,675			17,374
Income tax expense		5,487			—

Net income	$	8,188		$	17,374

Net income per share:
Basic	$	0.12		$	0.64
Diluted	$	0.12		$	0.36

Shares used in computing net income per share:
Basic		68,565			27,137
Diluted		70,268			51,997

See accompanying notes to unaudited consolidated financial statements.

ViroPharma Incorporated

Consolidated Statements of Stockholders’ Equity

(unaudited)



(in thousands)	Number of shares	Amount		Number of shares	Amount		Additional paid-in capital			Deferred comp			Accumulated other comprehensive (loss)			Accumulated deficit			Total stockholders’ equity
Balance, December 31, 2005	—	$	—	68,564	$	137	$	490,593		$	(3	)	$	(350	)	$	(163,400	)	$	326,977
Exercise of common stock options	—		—	24		—		69			—			—			—			69
Issuance costs of common stock	—		—	—		—		(63	)		—			—			—			(63	)
Share-based compensation	—		—	—		—		975			3			—			—			978
Record liability classified share-based obligations	—		—	—		—		(116	)		—			—			—			(116	)
Unrealized gain on available for sale securities	—		—	—		—		—			—			311			—			311
Stock option tax benefits	—		—	—		—		164			—			—			—			164
Net income	—		—	—		—		—			—			—			8,188			8,188

Balance, March 31, 2006	—	$	—	68,588	$	137	$	491,622		$	—		$	(39	)	$	(155,212	)	$	336,508

ViroPharma Incorporated

Consolidated Statements of Cash Flows

(unaudited)


	Three months ended March 31,
(in thousands)	2006			2005
Cash flows from operating activities:
Net income	$	8,188		$	17,374
Adjustments to reconcile net income to net cash provided by operating activities:
Non-cash gain on derivative liability		—			(3,558	)
Loss on bond redemption		1,127			—
Non-cash share-based compensation expense		929			2
Non-cash interest expense		75			824
Deferred tax provision		2,232			—
Depreciation and amortization expense		1,388			1,253
Changes in assets and liabilities:
Accounts receivable		1,177			410
Inventory		729			(1,920	)
Other current assets		(703	)		504
Accounts payable		(5,497	)		1,111
Accrued expenses and other current liabilities		(8,825	)		(2,598	)
Deferred revenue		(141	)		(140	)
Derivative liability		—			(585	)
Income taxes receivable/payable		2,881			—
Other liabilities		181			(9	)

Net cash provided by operating activities		3,741			12,668

Cash flows from investing activities:
Purchase of equipment and leasehold improvements		(1,277	)		(56	)
Purchase of Vancocin assets		—			(21	)
Release of restricted investments		—			9,033
Purchases of short-term investments		(401,176	)		(55,554	)
Maturities of short-term investments		331,789			55,492

Net cash provided by (used in) investing activities		(70,664	)		8,894

Cash flows from financing activities:
Redemption of subordinated convertible notes		(79,596	)		—
Net proceeds from issuance of common stock		6			83
Excess tax benefits from share-based payment arrangements		164			—
Issuance costs related to the convertible senior notes		—			(20	)

Net cash provided by (used in) financing activities		(79,426	)		63

Net increase (decrease) in cash and cash equivalents		(146,349	)		21,625

Cash and cash equivalents at beginning of period		232,195			22,993

Cash and cash equivalents at end of period	$	85,846		$	44,618

See accompanying notes to unaudited consolidated financial statements.

ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements

Note 1. Organization and Business Activities

ViroPharma Incorporated and subsidiaries (“ViroPharma” or “the Company”) is a biopharmaceutical company dedicated to the development and commercialization of products that address serious diseases. The Company has a core expertise in the area of infectious diseases and is committed to focusing its commercialization and development programs on products used by physician specialists or in hospital settings. ViroPharma has one marketed product and multiple product candidates in clinical development. The Company intends to grow through sales of its marketed product, Vancocin^{^®} HCl Capsules, the oral capsule formulation of vancomycin hydrochloride, and continued development of its product pipeline and potential acquisition of products or companies.

ViroPharma markets and sells Vancocin in the U.S. and its territories. Vancocin is a potent antibiotic approved by the U.S. Food and Drug Administration, or FDA, to treat antibiotic-associated pseudomembranous colitis caused by Clostridium difficile, or C. difficile, and enterocolitis caused by Staphylococcus aureus, including methicillin-resistant strains.

ViroPharma is developing maribavir for the treatment of cytomegalovirus, or CMV, infection and HCV-796 for the treatment of hepatitis C virus, or HCV, infection. The Company has licensed the U.S. and Canadian rights for a third product candidate, an intranasal formulation of pleconaril, to Schering-Plough for the treatment of picornavirus infections.

Basis of Presentation

The consolidated financial information at March 31, 2006 and for the three months ended March 31, 2006 and 2005, is unaudited but includes all adjustments (consisting only of normal recurring adjustments) which, in the opinion of management, are necessary to state fairly the consolidated financial information set forth therein in accordance with accounting principles generally accepted in the United States of America. The interim results are not necessarily indicative of results to be expected for the full fiscal year. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2005 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission.

In December 2004, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 123R, Share-Based Payment, (SFAS 123R). This statement replaces SFAS 123 and supersedes APB No. 25. This statement establishes standards for the accounting for which an entity exchanges its equity instruments for goods or services. This statement also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. SFAS 123R requires the Company to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost shall be recognized over the period during which an employee is required to provide service in exchange for the award – the requisite service period (vesting period). The grant-date fair value of employee share options will be estimated using Black-Scholes option-pricing model adjusted for the unique characteristics of those instruments. The Company adopted SFAS 123R using the modified prospective approach effective January 1, 2006, which resulted in a material impact on our consolidated financial statements for the quarter ended March 31, 2006. See Note 5 for the disclosures related to SFAS 123R.

In November 2005, the FASB issued FASB Staff Position (“FSP”) SFAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-based Payment Awards, that provides an elective alternative transition method of calculating the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS 123R (the “APIC Pool”) to the method otherwise required by paragraph 81 of SFAS 123R. We may take up to one year from the effective date of the FSP to evaluate our available alternatives and make our one-time election. We are currently evaluating the alternative methods in connection with our adoption of SFAS 123R.

In November 2005, the FASB issued FSP SFAS 115-1, The Meaning of Other-than-Temporary Impairment and Its Application to Certain Investments (FSP 115-1). This statement supersedes EITF Issue No. 03-1 and EITF Abstracts Topic No. D-44. This statement summarizes the accounting and disclosure guidance on other-than-temporary impairments of securities. The Company adopted FSP 115-1 on January 1, 2006 with no impact on our unaudited consolidated financial statements for the quarter ended March 31, 2006.

Reclassification

Certain prior year amounts have been reclassified to conform to the current year presentation.

ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements

Note 2. Inventory

Inventory is related to Vancocin and is stated at the lower of cost or market using the first-in first-out method. The following represents the components of the inventory at March 31, 2006 and December 31, 2005:


(in thousands)	March 31, 2006		December 31, 2005
Raw Materials	$	2,108	$	2,108
Finished Goods		8,159		8,888

Total	$	10,267	$	10,996

Note 3. Intangible Assets

The following represents the balance of the intangible assets at March 31, 2006:


(in thousands)	Gross Intangible Assets		Accumulated Amortization		Net Intangible Assets
Trademarks	$	11,412	$	634	$	10,778
Know-how		79,880		4,438		75,442
Customer relationship		36,207		2,011		34,196

Total	$	127,499	$	7,083	$	120,416

The following represents the balance of the intangible assets at December 31, 2005:


(in thousands)	Gross Intangible Assets		Accumulated Amortization		Net Intangible Assets
Trademarks	$	11,412	$	520	$	10,892
Know-how		79,880		3,639		76,241
Customer relationship		36,207		1,649		34,558

Total	$	127,499	$	5,808	$	121,691

In March 2006, the Company learned that the Office of Generic Drugs (“OGD”), Center for Drug Evaluation and Research of the Federal Drug Administration (“FDA”) had changed its approach regarding the conditions that must be met in order for a generic drug applicant to request a waiver of in-vivo bioequivalence testing for vancomycin hydrochloride capsules. A change in regulation is a defined triggering event in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Therefore, since this change in regulation could potentially impact the recoverability or useful life of the Vancocin-related intangible assets, the Company assessed the intangible assets for potential impairment or change in useful life. As such, the Company determined that no impairment charge was appropriate at this time as management believes undiscounted cash flows will be sufficient to recover the carrying value of the asset and there has been no change to fair value, which exceeds book value. In addition, management believes there are no indicators that would require a change in useful life at this time.

In the event the OGD’s revised approach for Vancocin remains in effect, the time period in which a generic competitor may enter the market could be reduced. This could result in a reduction to the useful life of the Vancocin-related intangible assets. A reduction in the useful life, as well as the timing and number of generics, will impact our cash flow assumptions and estimate of fair value, perhaps to a level that could result in an impairment charge. The Company will continue to monitor the actions of the OGD and consider the effects of our opposition actions and the announcements by generic competitors or other adverse events for additional impairment indicators and will reevaluate the expected cash flows and fair value of our Vancocin-related assets at such time.

The Company is obligated to pay Eli Lilly and Company (“Lilly”) additional purchase price consideration based on net sales of Vancocin within a calendar year. The additional purchase price consideration is determined by the annual net sales of Vancocin and is paid quarterly and is due each year through 2011. The net sales of Vancocin for the first quarter of 2006 were below the contracted range for which we would be obligated to additional purchase price consideration for 2006.

ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements

Therefore, additional purchase price consideration was not recorded in the first quarter of 2006.

The Company is obligated to pay Lilly additional amounts based on annual net sales of Vancocin as set forth below:


2006		35% payment on net sales between $46-65 million
2007		35% payment on net sales between $48-65 million
2008 through 2011		35% payment on net sales between $45-65 million

No additional payments are due to Lilly on net sales of Vancocin below or above the net sales levels reflected in the above table.

The Company accounts for these additional payments as additional purchase price in accordance with SFAS No. 141, Business Combinations, which requires that the additional purchase price consideration is recorded as an increase to the intangible assets of Vancocin, is allocated over the asset classifications described above and is amortized over the remaining estimated useful life of the intangible assets. In addition, at the time of recording the additional intangible assets, a cumulative adjustment is recorded to accumulated intangible amortization, in addition to ordinary amortization expense, in order to reflect amortization as if the additional purchase price had been paid in November 2004.

Amortization expense for the three months ended March 31, 2006 and 2005 was $1.3 million and $1.2 million, respectively. The estimated aggregated amortization expense for each of the next five years will be approximately $5.1 million, excluding any future increases related to additional purchase price consideration that may be payable to Lilly.

Note 4. Long-Term Debt

On March 31, 2006, the Company had no long-term debt outstanding. On December 31, 2005, the Company’s long-term indebtedness included $78.9 million of subordinated convertible notes, which was reported as current since, as of December 31, 2005, it was the Company’s intent to redeem these notes in the first quarter of 2006. On March 1, 2006, the Company redeemed the remaining $78.9 million principal amount of subordinated convertible notes for $79.6 million. This eliminated the Company’s long-term debt that was outstanding at December 31, 2005. The Company recognized a charge of $1.1 million related to this payment, which includes a $0.7 million premium and the write-off of the remaining $0.4 million of deferred financing costs at March 1, 2006.

Note 5. Shared-based Compensation

The Company adopted SFAS 123R as of January 1, 2006 using the modified prospective method. SFAS 123R primarily resulted in a change in the Company’s method of measuring and recognizing the cost of grants under the Employee Stock Option plans and Employee Stock Purchase Plan to a fair value method and estimating forfeitures for all unvested awards. Results for prior periods have not been restated. In connection with the adoption of SFAS 123R, the deferred compensation at December 31, 2005 of $3,000 related to previous grants of non-employee stock option was offset against additional paid-in capital. Prior to the adoption of SFAS 123R, the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows. SFAS 123R requires the cash flows resulting from gross tax benefits in excess of the compensation cost recognized for those options (excess tax benefits) be classified as financing cash flows.

In accordance with Staff Accounting Bulletin No. 107 (“SAB 107”) issued in March 2005, share-based payment expense has been included in both research and development expense and marketing, general and administrative expense. Share-based plans expense consisted of the following:


(in thousands)	Three months ended March 31, 2006
Plan	Research and Development			Marketing, general and administrative		Total
Employee Stock Option Plans	$	256		$	706	$	962
Employee Stock Purchase Plan		6			7		13
Non-employee Stock Options		(46	)		—		(46	)

Total	$	216		$	713	$	929

No amounts of share-based compensation cost have been capitalized into inventory or other assets during the quarter ended March 31, 2006.

As a result of adopting SFAS 123R, the Company’s income before income taxes and net income for the three months ended March 31, 2006 were $0.9 million and $0.7 million lower, respectively, than if it had continued to account for share-based compensation under APB No. 25. Basic and diluted earnings per share for the three months ended March 31, 2006 would have been $0.13 per share if the Company had not adopted SFAS 123R, compared to reported basic and diluted earnings per share of $0.12 per share.

ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements

Employee Stock Option Plans

The Company currently has three option plans in place: a 1995 Stock Option and Restricted Share Plan (“1995 Plan”), a 2001 Equity Incentive Plan (“2001 Plan”) and a 2005 Stock Option and Restricted Share Plan (“2005 Plan”) (collectively, the “Plans”). In September 2005, the 1995 Plan expired and no additional grants will be issued from this plan. The Plans were adopted by the Company’s board of directors to provide eligible individuals with an opportunity to acquire or increase an equity interest in the Company and to encourage such individuals to continue in the employment of the Company.

Stock options granted under the 2005 Plan must be granted at an exercise price not less than the fair value of the Company’s common stock on the date of grant. Stock options granted under the 2001 Plan can be granted at an exercise price that is less than the fair value of the Company’s common stock at the time of grant. Stock options granted under the 1995 Plan were granted at an exercise price not less than the fair value of the Company’s common stock on the date of grant. Stock options granted from the Plans are exercisable for a period not to exceed ten years from the date of grant. Vesting schedules for the stock options vary, but generally vest 25% per year, over four years. Shares issued under the Plans are new shares. The Plans provide for the delegation of certain administrative powers to a committee comprised of company officers.

Options granted during the first quarter of 2006 and 2005 had weighted average fair values of $16.77 and $2.85 per option. The fair value of each option grant was estimated throughout the periods using the Black-Scholes option-pricing model using the following assumptions for the Plans:


	2006		2005
Expected dividend yield	—		—
Range of risk free interest rate	4.29% - 5.09	%	4.33%
Weighted-average volatility	110.35	%	140.00%
Range of volatility	98.8% - 112.1	%	140.00%
Range of expected option life (in years)	4.08 - 6.25		5.77

Risk free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. Volatility is based on the Company’s stock price over the expected term of the grant. Expected term is based upon the short-cut method permitted under SAB 107. The range of weighted-average volatility as of March 31, 2005 is the same because there was only one grant date during the period.

Prior to adopting SFAS No. 123R, if the Company determined compensation cost for options granted based on their fair value at the grant date under SFAS No. 123, the Company’s net income and net income per share would have been adjusted as indicated below (option forfeitures are accounted for as they occurred and no amounts of compensation expense have been capitalized into inventory or other assets, but instead are considered period expenses in the pro forma amounts):


(in thousands, except per share data)	For the three months ended March 31, 2005
Net income (loss):
As reported	$	17,374
Add: stock-based employee compensation expense included in net income		2
Deduct: total stock-based employee compensation expense determined under the fair-value-based method for all employee and director awards		(534	)

Pro forma under SFAS No. 123	$	16,842

Net income (loss) per share:
Basic:
As reported	$	0.64

Pro forma under SFAS No. 123	$	0.62

Diluted:
As reported	$	0.36

Pro forma under SFAS No. 123	$	0.35

ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements

As of March 31, 2006, there were 566,737 shares available for grant under the Plans. The following table lists the balances available by Plan at March 31, 2006:


	1995 Plan		2001 Plan		2005 Plan		Combined
Number of shares authorized	4,500,000		500,000		850,000		5,850,000
Number of options granted since inception	(6,997,515	)	(991,600	)	(551,500	)	(8,540,615	)
Number of options cancelled since inception	2,831,824		759,837		—		3,591,661
Number of shares expired	(334,309	)	—		—		(334,309	)

Number of shares available for grant	—		268,237		298,500		566,737

The following table lists option grant activity for the quarter ended March 31, 2006:


	Share Options		Weighted average exercise price per share
Balance at December 31, 2005	3,134,205		$	8.00
Granted	509,500			19.75
Exercised	(23,724	)		2.92
Forfeited	—			—
Expired	—			—

Balance at March 31, 2006	3,619,981		$	9.69

The total intrinsic value of share options exercised during the quarters ended March 31, 2006 and 2005 was $0.4 million and approximately $87,600, respectively.

The Company has 3,619,981 million option grants outstanding at March 31, 2006 with exercise prices ranging from $0.99 per share to $38.70 per share and a weighted average remaining contractual life of 7.59 years. The following table lists the outstanding and exercisable option grants as of March 31, 2006:


	Number of options	Weighted-Average Exercise Price		Weighted Average Remaining Contractual Term (years)	Aggregate Intrinsic Value (in thousands)
Outstanding	3,619,981	$	9.69	7.59	$	21,063
Exercisable	1,716,412		10.72	6.13		9,627

As of March 31, 2006, there was $12.6 million of total unrecognized compensation cost related to un-vested share-based payments (including share options) granted under the Plans. That cost is expected to be recognized over a weighted-average period of 3.5 years. The total fair value of shares vested in the quarter ended March 31, 2006 and 2005 was $1.4 million and $0.9 million, respectively.

Employee Stock Purchase Plan

In 2000, the stockholders of the Company approved an employee stock purchase plan. A total of 300,000 shares originally were available under this plan. Since inception of the plan, the stockholders of the Company approved an amendment to the plan to increase the number of shares available for issuance under the plan by 300,000 shares. As of March 31, 2006 there are approximately 307,575 shares remaining under this plan.

Under this plan, employees may purchase common stock through payroll deductions in semi-annual offerings at a price equal to the lower of 85% of the closing price on the applicable offering commencement date or 85% of the closing price on the applicable offering termination date. Since the total payroll deductions from the plan period are used to purchase shares at the end of the offering period, the number of shares ultimately purchased by the participants is variable based upon the purchase price. Shares issued under the employee stock purchase plan are new shares.

ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements

During the first quarter of 2006, the Company received approximately $26,000 related to the employee stock purchase plan. However, employees have the option to cancel their enrollment and have these funds reimbursed any time prior to purchase of the shares.

The fair value of the share-based payments associated with the semi-annual enrollment beginning January 1, 2006 was approximately $24,000. As such, the Company recorded approximately $12,000 of compensation expense related to the first the first quarter of 2006. The fair value was estimated using the Type B model provided by SFAS 123R, with the following assumptions:


	2006
Expected dividend yield:	—
Risk free interest rate:	4.40	%
Volatility:	84.2	%
Expected option life (in years):	0.50

Under this plan, no shares were sold to employees during the first quarter of 2006 or 2005. Based on the stock price of $19.12 per share on the commencement date of January 1, 2006, there are approximately 3,200 nonvested shares related to the employee stock purchase plan as of March 31, 2006. The actual number of shares purchased will be higher if the stock price on the date of issuance is lower than stock price on the commencement date.

The plan qualifies under Section 423 of the Internal Revenue Code.

Non-employee Stock Options

In connection with the adoption of SFAS 123R on January 1, 2006, the Company reclassified approximately $116,000 from additional paid-in capital to a current liability for 9,000 shares related to outstanding stock options issued to non-employees in accordance with EITF Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock. As required by SFAS 123R, the Company remeasured the fair value of these options to approximately $67,000 as of March 31, 2006, which reduced compensation expense by approximately $49,000 in the first quarter of 2006. At the time of grant, these options had been recorded as expense and an increase in additional paid-in capital in accordance with APB Opinion No. 25.

The fair value of the non-employee share options was estimated using the Black-Scholes option-pricing model using the following range of assumptions:


	March 31, 2006	January 1, 2006
Expected dividend yield:	—	—
Risk free interest rate:	4.82% - 4.83%	4.35% - 4.41%
Volatility:	83.1% - 103.2%	78.1% - 112.6%
Expected option life (in years):	1.31 - 5.76	1.55 - 6.01

There were no non-employee share options vested or exercised during the quarters ended March 31, 2006 or 2005. Shares issued to non-employees upon exercise of stock options are new shares.

ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements

Note 6. Comprehensive Income (Loss)

In the Company’s annual consolidated financial statements, comprehensive income (loss) is presented as a separate financial statement. For interim consolidated financial statements, the Company is permitted to disclose the information in the footnotes to the consolidated financial statements. The disclosures are required for comparative purposes. The only comprehensive income (loss) item the Company has is unrealized gains and losses on available for sale securities. The following reconciles net income (loss) to comprehensive income (loss) for the three months ended March 31, 2006 and 2005:


	Three months ended March 31,
(in thousands)	2006		2005
Net income	$	8,188	$	17,374
Other comprehensive (loss):
Unrealized gains (losses) on available for sale securities		311		(266	)

Comprehensive income	$	8,499	$	17,108

The unrealized gain for the three months ended March 31, 2006 is reported net of federal and state income taxes.

Note 7. Earnings per share


	Three months ended March 31,
(in thousands, except per share data)	2006		2005
Basic Earnings Per Share
Net income	$	8,188	$	17,374
Common stock outstanding		68,565		27,137

Basic net income per share	$	0.12	$	0.64

Diluted Earnings Per Share
Net income	$	8,188	$	17,374
Add interest expense on senior convertible notes		—		1,170

Diluted net income	$	8,188	$	18,544

Common stock outstanding		68,565		27,137
Add shares from senior convertible notes		—		24,515
Add “in-the-money” stock options		1,703		345

Common stock assuming conversion and stock option exercises		70,268		51,997

Diluted net income per share	$	0.12	$	0.36

The following common shares that are associated with stock options were excluded from the calculations as their effect would be anti-dilutive:


	Three months ended March 31,
(in thousands)	2006	2005
Common Shares Excluded	1,905	2,208

ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements

Note 8. Supplemental Cash Flow Information


	Three months ended March 31,
(in thousands)	2006			2005
Supplemental disclosure of non-cash transactions:
Unrealized gains (losses) on available for sale securities	$	311		$	(266	)
Initial recognition of liability classified share-based awards		116			—
Liability classified share-based compensation benefit		(49	)		—
Non-cash conversion of senior notes to senior convertible notes		—			62,500
Non-cash debt discount on senior convertible notes		—			7,914
Non-cash conversion on senior convertible notes, net of associated costs of $561		—			2,689
Deferred compensation		—			2
Supplemental disclosure of cash flow information:
Cash paid for interest	$	2,368		$	4,688
Cash paid for taxes		374			—

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

We are a biopharmaceutical company dedicated to the development and commercialization of products that address serious diseases. We have a core expertise in the area of infectious diseases and are committed to focusing our commercialization and development programs on products used by physician specialists or in hospital settings. We intend to grow through sales of our marketed product, Vancocin^{^®} HCl Capsules, and through the continued development of our product pipeline and potential acquisition of products or companies.

We have one marketed product and multiple product candidates in clinical development. We market and sell Vancocin^{^®} HCl Capsules, the oral capsule formulation of vancomycin hydrochloride, in the U.S. and its territories. Vancocin is a potent antibiotic approved by the U.S. Food and Drug Administration, or FDA, to treat antibiotic-associated pseudomembranous colitis caused by Clostridium difficile, or C. difficile, and enterocolitis caused by S. aureus, including methicillin-resistant strains. We are developing maribavir for the treatment of cytomegalovirus, or CMV, infection, and HCV-796 for the treatment of hepatitis C virus, or HCV, infection. We have licensed the U.S. and Canadian rights for a third product candidate, an intranasal formulation of pleconaril, to Schering-Plough for the treatment of picornavirus infections.

We intend to continue to evaluate in-licensing or other means of acquiring products in clinical development, and marketed products, in order to expand our current portfolio. Such products may be intended to treat, or are currently used to treat, the patient populations treated by physician specialists or in hospital settings.

On March 1, 2006, we redeemed the remaining $78.9 million principal amount of subordinated convertible notes, which eliminated all long-term debt that was outstanding at December 31, 2005. We have working capital of $179.0 million at March 31, 2006.

Executive Summary

During the first quarter of 2006, we experienced the following:

Business Activities

Vancocin:

•

Finalized the qualifications of OSG Norwich to manufacture Vancocin finished product.

•

Learned of change by Office of Generic Drugs, Center for Drug Evaluation and Research (“OGD”) on the approach regarding the conditions that must be met in order for a generic drug applicant to request a waiver of in vivo bioequivalence testing for vancomycin hydrochloride capsules. We began opposing this attempt by the OGD to change the approach towards making vancomycin hydrochloride capsules bioequivalence decisions.

CMV:

•

Announced positive preliminary results from a phase 2 study with maribavir.

•

Continued planning phase 3 studies.

HCV (with our partner Wyeth):

•

Continued our clinical development efforts to study HCV-796 in combination with pegylated interferon.

Operating Results

•

Increased net sales as compared to the first quarter of 2005, primarily resulting from 2005 price increases.

•

A reduction in what we estimate to be the level of Vancocin inventory at wholesalers, resulting in lower net sales as compared to the fourth quarter of 2005.

•

Utilized of a portion of Vancocin finished goods manufactured pursuant to the November 2005 amendment to our manufacturing agreement with Lilly, resulting in a lower gross product margin.

•

Recorded income tax expense of $5.5 million.

Liquidity

•

Eliminated debt principal of $78.9 million through redemption of the last of our subordinated convertible notes.

•

Generated net cash from operating activities of $3.7 million.

During 2006 and going forward, we expect to face a number of challenges, which include the following:

The commercial sale of approved pharmaceutical products is subject to risks and uncertainties. There can be no assurance that future Vancocin sales will meet or exceed the historical rate of sales for the product, for reasons that include, but are not limited to, generic and non-generic competition for Vancocin and/or changes in prescribing habits. Additionally, period over period fluctuations in net product sales are expected to occur as a result of wholesaler buying decisions.

We cannot assure you that generic competitors will not take advantage of the absence of patent protection for Vancocin to attempt to develop a competing product. We are not able to predict the time period in which a generic drug may enter the market. On March 17, 2006, we learned that the OGD, changed its approach regarding the conditions that must be met in order for a generic drug applicant to request a waiver of in-vivo bioequivalence testing for vancomycin hydrochloride capsules. We are opposing this attempt. However, in the event this change in approach remains in effect, the time period in which a generic competitor may enter the market could be reduced and multiple generics may enter the market.

We will face intense competition in acquiring additional products to expand further our product portfolio. Many of the companies and institutions that we will compete with in acquiring additional products to expand further our product portfolio have substantially greater capital resources, research and development staffs and facilities than we have, and substantially greater experience in conducting business development activities. We may need additional financing in order to acquire new products in connection with our plans as described in this report.

We cannot be certain that we will be successful in developing and ultimately commercializing any of our product candidates in the timeframes that we expect, or at all.

We can not assure you that cash flows from Vancocin sales will be sufficient to fund all of our ongoing development and operational costs over the next several years, that planned clinical trials can be initiated, or that planned or ongoing clinical trials can be successfully concluded or concluded in accordance with our anticipated schedule and costs. Moreover, the results of our business development efforts could require considerable investments.

Our actual results could differ materially from those results expressed in, or implied by, our expectations and assumptions described in this Quarterly Report on Form 10-Q. Please also see our discussion of the “Risk Factors” in Item 1A of Part II, which describe other important matters relating our business.

Results of Operations

Quarters ended March 31, 2006 and 2005


	For the quarters ended March 31,
(in thousands)	2006		2005
Net product sales	$	29,233	$	21,055
Total revenues	$	29,374	$	27,196
Gross margin	$	23,559	$	17,441
Operating income	$	13,445	$	17,386
Net income	$	8,188	$	17,374
Net income per share:
Basic	$	0.12	$	0.64
Diluted	$	0.12	$	0.36

The decrease in net income of $9.2 million was due to various factors, including:

•

Gross margin (net product sales less cost of sales) provided by Vancocin net product sales increased by $6.1 million.

•

In the first quarter of 2005, we sold inventory related to intranasal pleconaril to Schering-Plough for $6.0 million. We had no comparable revenue in 2006.

•

We recorded $5.5 million of income tax expense in the first quarter of 2006, with no comparable amount in 2005.

•

Other operating expenses increased $4.1 million to support Vancocin and our CMV and HCV development programs, which includes $0.9 million related to share-based compensation expense.

Revenues

Revenues consisted of the following:


	For the quarters ended March 31,
(in thousands)	2006		2005
Net product sales	$	29,233	$	21,055
License fees and milestones revenues		141		6,141

Total revenues	$	29,374	$	27,196

Revenue—Vancocin product sales

Our net product sales are solely related to Vancocin. We sell Vancocin only to wholesalers who then distribute the product to pharmacies, hospitals and long-term care facilities, among others. Our sales of Vancocin are influenced by wholesaler forecasts of prescription demand, wholesaler buying decisions related to their desired inventory levels, and, ultimately, end user prescriptions, all of which could be at different levels from period to period.

During the quarter ended March 31, 2006, net sales of Vancocin increased 38.8% compared to the same period in 2005 due to the impact of price increases, partially offset by lower unit sales. We believe, based upon data reported by IMS Health Incorporated, that prescriptions in the 2006 period exceeded prescriptions in the 2005 period by 39%. Since we do not acquire precise inventory data from wholesalers, we are required to estimate the inventory at wholesalers. We believe our lower unit sales reflect a decrease in wholesalers’ inventory levels during in the first quarter of 2006 compared to an increase in wholesalers’ inventory levels during the first quarter of 2005.

As of March 31, 2006, we have reviewed net sales under our revenue recognition policy and no deferrals are necessary.

Revenue—License fee and milestone revenues

License fee and milestone revenue primarily includes the following:

•

In 2005, the sale of inventory for $6.0 million pursuant to the terms of our license agreement with Schering-Plough for intranasal pleconaril.

•

In both 2006 and 2005, amortization of payments received under our agreement with Wyeth of approximately $141,000.

Our license fee and milestone revenues result from existing or future collaborations of development-stage product and currently vary greatly from period to period. See “Liquidity, Operating Cash Inflows” for additional information.

Cost of sales and gross product margin


	For the quarters ended March 31,
(in thousands)	2006		2005
Net product sales	$	29,233	$	21,055
Cost of sales		5,674		3,614

Gross product margin	$	23,559	$	17,441

Vancocin cost of sales includes the cost of materials and distribution costs. Our gross product margin rate (net product sales less cost of sales as a percent of net product sales) for Vancocin decreased in the first quarter of 2006 to 80.6% from 82.8% in the first quarter of 2005, which is primarily the result of sales of units carrying an increased inventory cost as they were manufactured pursuant to the November 2005 amendment to our manufacturing agreement with Lilly, partially offset by the effects of price increases.

As part of our November 2005 amendment of our manufacturing agreement with Lilly, we increased the amount of Vancocin that Lilly supplied to us, which resulted in additional costs for finished goods at December 31, 2005 of $4.4 million. This additional cost increases our cost of sales in the first quarter of 2006 by $2.3 million and will continue to increase our cost of sales as these specific units are sold. We currently expect to sell the remaining units manufactured pursuant to this amendment in the second quarter of 2006, which will result in the remaining $2.1 million being recorded to cost of sales.

Lilly will continue to manufacture finished product for us through September 30, 2006. We also expect to begin purchasing finished product from our third party supply chain during the second quarter of 2006. Thus, while we expect our gross product margin to begin to improve during the second half of 2006 over the second half of 2005, our actual margins will be impacted by the actual volume of finished product we order from each of Lilly and OSG Norwich. Moreover, we expect a decrease in the overall cost of finished products upon transition to OSG Norwich. We may, however, experience fluctuations in quarterly manufacturing yields and if this occurs, we would expect the cost of product sales of Vancocin, and accordingly, gross product margin percentage, to fluctuate from quarter to quarter during 2006. Additionally, if we enter into fee-for-service or similar agreements with wholesalers in future periods, the fees would negatively impact our gross product margins.

Research and development expenses

For each of our research and development programs, we incur both direct and indirect expenses. Direct expenses include third party costs related to these programs such as contract research, consulting, cost sharing payments or receipts, and preclinical and development costs. Indirect expenses include personnel, facility, and other overhead costs.

Research and development expenses were divided between our research and development programs in the following manner:


	For the quarters ended March 31,
(in thousands)	2006		2005
*Direct—Core programs*
CMV	$	1,571	$	1,542
HCV		—		13
Vancocin / C. difficile		427		—
*Indirect*
Development		2,076		1,206

Total	$	4,074	$	2,761

Direct Expenses—Core Development Programs

Related to our CMV program, during the first quarter of 2006 we concluded a preliminary analysis of data from our phase 2 clinical trial with maribavir and announced positive preliminary results demonstrating that maribavir significantly reduces CMV reactivation in patients who had undergone allogeneic stem cell transplantation. We are currently finalizing our plans for our phase 3 development program and will seek concurrence with FDA prior to initiating this program. In the same period of 2005, we were recruiting patients into our phase 2 study and were conducting or analyzing data from several phase 1 clinical trials with maribavir (to evaluate the potential for drug interactions, pharmacokinetics in subjects with renal or hepatic impairment, and the evaluation of different tablet formulations).

Related to our HCV program, the first quarter of 2006 costs included payments to Wyeth made in accordance with our cost-sharing arrangement. During the first quarter of 2006, we initiated a phase 1b clinical trial of HCV-796 in combination with pegylated interferon. During the same period in 2005, we initiated phase 1 clinical trials with our HCV compound, HCV-796. Wyeth pays a substantial portion of the collaboration’s predevelopment and development expenses. In addition, during the quarter ended March 31, 2005, we halted development on our former HCV lead product candidate, HCV-086.

During the first quarter of 2006, we incurred costs for research and development activities related to Vancocin and C. difficile.

Indirect Expenses

These costs primarily relate to the compensation of and overhead attributable to our development team, including our regional medical scientists, who account for a majority of the increase in costs from the first quarter of 2005.

Marketing, general and administrative expenses

Marketing, general and administrative (MG&A) expenses of $4.9 million for the quarter ended March 31, 2006 increased $2.6 million from $2.3 million for the same period in 2005. The $2.6 million increase was primarily due to commercial and other personnel related expenses, share-based compensation expense, and increased legal and consulting costs. Legal and consulting costs include $0.4 million of which related to our opposition to the attempt by the OGD to change the approach towards making vancomycin hydrochloride capsules bioequivalence decisions, as more fully described in “Risk Factors”. We anticipate that these additional legal and consulting costs will continue at this level, or higher, in future periods as we continue this opposition.

Intangible amortization and acquisition of technology rights

Intangible amortization is the result of the Vancocin product rights acquisition in the fourth quarter of 2004.

Intangible amortization was $1.3 million for the first quarter of 2006 and $1.2 million for the first quarter of 2005. To the extent that we incur an obligation to Lilly for additional payments on Vancocin sales, as described in our agreement with Lilly, we will account for any future payment to Lilly as a contingent consideration and record an adjustment to the carrying amount of the related intangible asset and a cumulative adjustment to the intangible amortization upon achievement of the related sales milestones. Contingent consideration and Lilly related additional payments are more fully described in Note 3 of the Unaudited Consolidated Financial Statements.

On an ongoing periodic basis, we evaluate the useful life of these intangible assets and determine if any economic, governmental or regulatory event has impaired the value of the assets or modified their estimated useful lives. As a result of the FDA change in regulation relating to generic guidelines, we reviewed the value of the intangible asset and, as of March 31, 2006, we have concluded that there was no impairment of the carrying value of the intangible assets or change to the useful lives as estimated at the acquisition date.

Other Income (Expense)

Change in fair value of derivative liability

The change in fair value of derivative liability related to the senior convertible notes that were outstanding during 2005, all of which were converted by July 2005. Therefore, there is no impact in 2006.

As it relates to 2005, based upon relevant information available, we estimated the fair value of the make-whole provision contained within our senior notes using a Monte Carlo simulation model to be $8.6 million, which included $7.9 million at the time of conversion of the senior notes into senior convertible notes in January 2005 and $0.7 million upon exercise of the initial investors’ purchase option in April 2005. This fair value of the make-whole provision, which was recorded as a derivative liability, was adjusted quarterly for changes in fair value during the periods that the senior convertible notes were outstanding, with the corresponding charge or credit to change in fair value of derivative liability. These adjustments resulted in a gain on the change in fair value of derivative liability of $3.6 million for the quarter ended March 31, 2005.

Loss on bond redemption

On March 1, 2006, the Company redeemed the remaining $78.9 million principal amount of subordinated convertible notes for $79.6 million. This eliminated our long-term debt that was outstanding at December 31, 2005. The charge of $1.1 million related to this payment in the first quarter of 2006, represents a premium of $0.7 million and the write-off of deferred finance costs of $0.4 million at March 1, 2006.

Interest Income

Interest income for quarters ended March 31, 2006 and 2005 was $2.2 million and $0.2 million, respectively. Interest income increased due to an increase in investments related to the cash received from the issuance of common stock in our December 2005 public offering and higher rates of return.

Interest Expense


	For the quarters ended March 31,
(in thousands)	2006		2005
Interest expense on 6% subordinated converible notes	$	790	$	1,919
Interest expense on 10% senior notes		—		330
Interest expense on 6% senior convertible notes		—		711
Amortization of finance costs		75		474
Amortization of debt discount		—		338
Other interest		—		6

Total interest expense	$	865	$	3,778

Interest expense on notes includes interest on all our notes outstanding and decreased over 2005 due to varying principal amounts outstanding during the periods. Amortization of finance costs and debt discount in 2005 relates primarily to the senior convertible notes issued in January and April 2005, which were fully converted to common stock during the year.

Income Tax Expense

Our effective income tax rate was 40.1% for the quarter ended March 31, 2006. Our income tax expense of $5.5 million for the quarter ended March 31, 2006 includes federal and state income tax at statutory rates, current impact of adjustments to prior state apportionment rates, and the effects of various permanent differences. We expect our annual effective income tax rate will be 38.2% for the year ended December 31, 2006.

Liquidity

We expect that our near term sources of revenue will arise from Vancocin product sales and milestone and license fee payments that we may receive from Wyeth and Schering-Plough if agreed upon events under our agreements with each of these companies are achieved. However, we cannot predict what the actual sales of Vancocin will be in the future, and there are no assurances that the events that require payments to us under the Wyeth and Schering-Plough arrangements will be achieved. In addition, there are no assurances that demand for Vancocin will continue at historical or current levels.

Our ability to generate positive cash flow is also impacted by the timing of anticipated events in our CMV and HCV programs, including results from clinical trials, the results of our product development efforts, and variations from our estimate of future direct and indirect expenses.

While we anticipate that cash flows from Vancocin, as well as our current cash, cash equivalents and short term investments, should allow us to fund substantially all of our ongoing development and other operating costs, we may need additional financing in order to expand our product portfolio. At March 31, 2006, we had cash, cash equivalents and short-term investments of $156.8 million. At March 31, 2006, the annualized weighted average nominal interest rate on our short-term investments was 4.5%.

Overall Cash Flows

During the quarter ended March 31, 2006, we generated $3.7 million of net cash from operating activities, primarily from the cash contribution of Vancocin, our first commercial product, which includes the effects of net income, as well as decreases in accounts receivable and inventory, partially offset by decreases in accounts payable and accrued expenses. We also used $70.7 million in investing activities, as we purchased short-term investments. Our net cash used by financing activities for the quarter ended March 31, 2006 was $79.4 million, primarily from the redemption of the subordinated convertible notes for $79.6 million.

Operating Cash Inflows

We began to receive cash inflows from the sale of Vancocin in January 2005. We cannot reasonably estimate the period in which we will begin to receive material net cash inflows from our product candidates currently under development. Cash inflows from development-stage products are dependent on several factors, including the achievement of milestones and regulatory approvals. We may not receive milestone payments from any existing or future collaborations if a development-stage product fails to meet technical or performance targets or fails to obtain the required regulatory approvals. Further, our revenues from collaborations will be affected by efforts of our collaborative partners. Even if we achieve technical success in developing drug candidates, our collaborative partners may not devote the resources necessary to complete development and commence marketing of these products, when and if approved, or they may not successfully market these products.

Operating Cash Outflows

The cash flows we have used in operations historically have been applied to research and development activities, marketing and business development efforts, general and administrative expenses, servicing our debt, and income tax payments. Bringing drugs from the preclinical research and development stage through phase 1, phase 2, and phase 3 clinical trials and FDA approval is a time consuming and expensive process. Because our product candidates are currently in the clinical stage of development, there are a variety of events that could occur during the development process that will dictate the course we must take with our drug development efforts and the cost of these efforts. As a result, we cannot reasonably estimate the costs that we will incur through the commercialization of any product candidate. The most significant uses of our near-term operating development cash outflows are as described below.

For each of our development programs, we incur both direct and indirect expenses. Direct expenses include third party costs related to these programs such as contract research, consulting, cost sharing payments or receipts, and preclinical and clinical development costs. Indirect expenses include personnel, facility and other overhead costs.

Direct Expenses—Core Development Programs

CMV program—From the date we in-licensed maribavir through March 31, 2006, we incurred $13.2 million of direct costs in connection with this program, including the acquisition fee of $3.5 million paid to GSK for the rights to maribavir in September 2003.

During the remainder of 2006, we expect maribavir-related activities to include costs to plan and initiate the phase 3 clinical development program, which we currently anticipate will include phase 3 studies in patients undergoing allogeneic stem cell transplant and patients who have received solid organ transplant. Therefore, we expect our expenses in 2006 for this program to be substantially higher than in 2005. In addition, discussions with the FDA regarding these future studies may impact the timing, nature and cost of future planned studies. We are solely responsible for the cost of developing our CMV product candidate.

Should we achieve certain product development events, we are obligated to make certain milestone payments to GSK, the licensor of maribavir, one of which could occur as early as the middle of 2006.

HCV program—From the date that we commenced predevelopment activities for compounds in this program that are currently active through March 31, 2006, we incurred $2.0 million in direct expenses for the predevelopment and development activities relating to such compounds. These costs are net of contractual cost sharing arrangements between Wyeth and us. Wyeth pays a substantial portion of the collaboration’s predevelopment and development expenses.

During 2006, the planned activities include phase 1 testing of our HCV product candidate, HCV-796, in combination with pegylated interferon. If these data are supportive, we and Wyeth anticipate initiation of phase 2 in 2006. The results of the planned studies, along with other predevelopment activities performed during the year, will significantly impact the timing and amount of expenses we will incur related to this program in future periods. In addition, discussions with the FDA regarding these future studies may impact the timing, nature and cost of future planned studies.

Should we achieve certain product development events, Wyeth is required to pay us certain cash milestones and to purchase, in cash, our common stock pursuant to terms of our collaboration agreement. Based on the activities planned by Wyeth and us, there is the potential to achieve certain of these milestones in 2006. However, there can be no assurances that we will be successful in achieving any milestones during this timeframe, or at all.

Vancocin and C. difficile related – We acquired Vancocin in November 2004 and have spent approximately $0.6 million in direct research and development costs related to Vancocin or on related C. difficile activities since acquisition. Included in this amount is the license of the intellectual property related to non-toxigenic C. difficile.

During 2006, we expect our research and development activities in the field of C. difficile to increase and we expect this increase to result in additional direct costs above 2005 levels.

Direct Expenses—Non-Core Development Programs

Common Cold—From the date that we commenced predevelopment activities for the intranasal formulation of pleconaril through March 31, 2006, we incurred $1.9 million in direct expenses. We did not incur any significant direct expenses in connection with this program in 2006 or 2005, nor will we in the future, as Schering-Plough has assumed responsibility for all future development and commercialization of pleconaril.

In November 2004, we entered into a license agreement with Schering-Plough under which Schering-Plough has assumed responsibility for all future development and commercialization of pleconaril. Schering-Plough paid us an initial license fee of $10.0 million in December 2004 and purchased our existing inventory of bulk drug substance for an additional $6.0 million in January 2005. We will also be eligible to receive up to an additional $65.0 million in milestone payments upon achievement of certain targeted regulatory and commercial events, as well as royalties on Schering-Plough’s sales of intranasal pleconaril in the licensed territories.

Business development activities

Through March 31, 2006, we paid an acquisition price of $116.0 million, paid $10.5 million related to additional purchase price consideration tied to product sales (see Note 3 of the Unaudited Consolidated Financial Statements) and incurred $2.0 million of fees and expenses in connection with the Vancocin acquisition. We also paid an acquisition fee of $3.5 million paid to GSK in 2003 for the rights to maribavir.

In addition, we intend to seek to acquire additional products or product candidates. The costs associated with acquiring any additional product or product candidate can vary substantially based upon market size of the product, the commercial effort required for the product, the product’s current stage of development, and actual and potential generic and non-generic competition for the product, among other factors. Due to the variability of the cost of acquiring a product candidate, it is not feasible to predict what our actual acquisition costs would be, if any, however, the costs could be substantial.

Debt service requirements

Subordinated Convertible Notes

On March 1, 2006, we redeemed the remaining $78.9 million principal amount of subordinated convertible notes for $79.6 million. This eliminated all long-term debt that was outstanding at December 31, 2005.

Contractual Obligations

Future contractual obligations and commercial commitments at March 31, 2006 are as follows:


(in thousands) Contractual Obligations⁽¹⁾	Total		1 year or less		2-3 years		4-5 years		More than 5 years
Minimum purchase requirements (2)	$	2,191	$	2,191	$	—	$	—	$	—
Operating leases (3)		8,052		677		1,330		1,339		4,706

Total	$	10,243	$	2,868	$	1,330	$	1,339	$	4,706

(1)

This table does not include any milestone payments under our agreement with GSK in relation to our in-licensed technology, as the timing and likelihood of such payments are not known. Similarly, it does not include any additional payments due to Lilly in connection with the Vancocin acquisition, as the amount and timing of future additional payments are not determinable. Under the terms of the agreement with Lilly, Lilly is entitled to additional payments on net sales of Vancocin through 2011. The additional payments to be paid to Lilly are calculated as follows:


2006		35% payment on net sales between $46-65 million
2007		35% payment on net sales between $48-65 million
2008 through 2011		35% payment on net sales between $45-65 million

No additional payments are due to Lilly on sales of Vancocin below or above the sales levels reflected in the above table. We will account for the future payments as contingent consideration and will record an adjustment to the carrying amount of the related intangible asset and a cumulative adjustment to the intangible amortization upon achievement of the related sales milestones. Assuming the maximum threshold is met at the end of each year, the cumulative amortization adjustment would be $0.6 million, $0.7 million and $1.2 million in the years ended December 31, 2006, 2007 and 2008, respectively.

In the event we develop any product line extensions, revive discontinued vancomycin product lines (injectable or oral solution), make improvements of existing products, or expand the label to cover new indications, Lilly would receive an additional royalty on net sales on these additional products for a predetermined time period.

(2)

Represents contractual commitment at March 31, 2006. As part of our manufacturing agreement with Lilly, as amended, we have certain minimum purchase requirements of Vancocin for a period of time less than one year, on a rolling basis. We are not contractually obligated to any amount of purchases past this time period, and cannot reasonably estimate the amount for which we may be obligated in the future.

This table does not include various agreements that we have entered into for services with third party vendors, including agreements to conduct clinical trials, to manufacture product candidates, and for consulting and other contracted services due to the cancelable nature of the services. We accrue the costs of these agreements based on estimates of work completed to date. We estimate that approximately $5.0 million will be payable in future periods under arrangements in place at March 31, 2006. Of this amount, approximately $0.9 million has been accrued for work estimated to have been completed as of March 31, 2006 and approximately $4.1 million relates to future performance under these arrangements.

(3)	We currently lease 33,000 square feet in a facility located in Exton, Pennsylvania for our marketing, development and corporate activities under an operating lease expiring in 2017 with $8.0 million in future rental obligations.

Operating leases also includes equipment leases of $0.1 million.

Capital Resources

While we anticipate that cash flows from Vancocin, as well as our current cash, cash equivalents and short-term investments, should allow us to fund substantially all of our ongoing development and other operating costs, we may need additional financing in order to expand our product portfolio. Should we need financing, we would seek to access the public or private equity or debt markets, enter into additional arrangements with corporate collaborators to whom we may issue equity or debt securities or enter into other alternative financing arrangements that may become available to us.

Financing

We have an effective Form S-3 universal shelf registration statement filed with the Securities and Exchange Commission for the potential additional issuance of up to approximately $39 million of our securities. The registration statement provides us with the flexibility to determine the type of security we choose to sell, including common stock, preferred stock, warrants and debt securities, as well as the ability to time such sales when market conditions are favorable.

If we raise additional capital by issuing equity securities, the terms and prices for these financings may be much more favorable to the new investors than the terms obtained by our existing stockholders. These financings also may significantly dilute the ownership of existing stockholders.

Additionally, Wyeth is required to purchase our common stock at the time of successful completion of certain product development events pursuant to the terms of our collaboration agreement. However, in the event we are not able to successfully achieve the product development events, this additional financing would not be available to us.

If we raise additional capital by accessing debt markets, the terms and pricing for these financings may be much more favorable to the new lenders than the terms obtained from our prior lenders. These financings also may require liens on certain of our assets that may limit our flexibility.

Additional equity or debt financing, however, may not be available on acceptable terms from any source as a result of, among other factors, our operating results, our inability to achieve regulatory approval of any of our product candidates, our inability to generate revenue through our existing collaborative agreements, and our inability to file, prosecute, defend and enforce patent claims and or other intellectual property rights. If sufficient additional financing is not available, we may need to delay, reduce or eliminate current development programs, or reduce or eliminate other aspects of our business.

Critical Accounting Policies

Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. Preparing consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and contingent assets and liabilities. Actual results could differ from such estimates. These estimates and assumptions are affected by the application of our accounting policies. Critical policies and practices are both most important to the portrayal of a company’s financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.

Our summary of significant accounting policies is described in Note 2 to our Consolidated Financial Statements included in our December 31, 2005 Form 10-K. However, we consider the following policies and estimates to be the most critical in understanding the more complex judgments that are involved in preparing our consolidated financial statements and that could impact our results of operations, financial position, and cash flows:

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Product Sales—Product revenue is recorded upon delivery to the wholesaler, when title has passed. Product demand from wholesalers during a given period may not correlate with prescription demand for the product in that period. As a result, we periodically estimate and evaluate the wholesalers’ inventory position. If we believe these levels are too high based on prescription demand and that there may be excess channel inventory for our product, we may not process wholesaler orders until these levels are reduced. We analyze our estimated channel inventory, utilizing our revenue recognition policy, derived from the criteria of SEC Staff Accounting Bulletin No. 104, and we may defer recognition of revenue on product that has been delivered. From acquisition in November 2004 through March 31, 2006, we have not deferred any product sales.

We establish provisions for sales discounts, chargebacks, product returns and rebates. These provisions are primarily based upon the history of Vancocin, including both Lilly and our ownership periods. We currently have no contracts with private third party payors, such as HMO’s. We do have contractual arrangements with governmental agencies, including Medicaid. In the first quarter of 2006, we adjusted our monthly provisions due to recent changes in Medicaid and Medicare laws, which had an immaterial impact on our results of operations. We establish provisions for chargebacks and rebates related to these contracts based upon historical experience of government agencies’ market share and governmental contractual prices. Product return accruals are estimated based on Vancocin’s history of damage and product expiration returns. Since actual experience could vary significantly from expectations, we periodically analyze estimated channel inventory, historical governmental usage, potential expiration of unused product and quality assurance indicators to confirm our monthly provisions appear reasonable and within an acceptable range. Although from acquisition to date, we have not had a material adjustment to our sales related accruals, changes in usage of Vancocin could result in material impacts on future periods.

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Impairment of Long-lived Assets—We review our fixed and intangible assets for possible impairment whenever events occur or circumstances indicate that the carrying amount of an asset may not be recoverable. Assumptions and estimates used in the evaluation of impairment may affect the carrying value of long-lived assets, which could result in impairment charges in future periods. Such assumptions include, for example, projections of future cash flows and the timing and number of generic/competitive entries into the market, in determining the current fair value of the asset and whether an impairment exists. These assumptions are subjective and could result in a material impact on operating results in the period of impairment. While we reviewed our intangible assets as of March 31, 2006 in light of the actions taken by the OGD, we did not recognize any impairment charges during the quarter ended March 31, 2006. See Note 3 of the Unaudited Consolidated Financial Statements for further information. We will continue to monitor the actions of the OGD and consider the effects of our opposition actions and the announcements by generic competitors or other adverse events for additional impairment indicators and we will reevaluate the expected cash flows and fair value of our Vancocin-related assets at such time.

On an ongoing periodic basis, we evaluate the useful life of intangible assets and determine if any economic, governmental or regulatory event has impaired the value of the assets or modified their estimated useful lives. While we reviewed the useful life of our intangible assets as of March 31, 2006 in light of the actions taken by the OGD, we did not change the useful life of our intangible assets during the quarter ended March 31, 2006. See Note 3 of the Unaudited Consolidated Financial Statements for further information.

We review our short-term investments on a periodic basis for other-than-temporary impairments. This review is subjective as it requires management to evaluate whether an event or change in circumstances has occurred in that period that may have a significant adverse effect on the fair value of the investment. As of March 31, 2006, we have minimal unrealized losses, all of which we have deemed not to be other-than-temporary.

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Share Based Employee Compensation—We adopted Statement of Financial Accounting Standards No. 123R, “Share-based Payment,” as amended (SFAS 123) effective January 1, 2006. The calculation of this expense includes judgment related to the period of time used in calculating the volatility of our common stock and our estimate of the exercising habits of our employees, which is also influenced by our Insider Trading Policy. Changes in the volatility of our common stock or the habits of our employees could result in variability in the fair value of awards granted.

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Income Taxes—Our annual effective tax rate is based on expected pre-tax earnings, existing statutory tax rates, limitations on the use of tax credits and net operating loss carryforwards and tax planning opportunities available in the jurisdictions in which we operate. Significant judgment is required in determining our annual effective tax rate and in evaluating our tax position.

On a periodic basis, we evaluate the realizability of our deferred tax assets and liabilities and will adjust such amounts in light of changing facts and circumstances, including but not limited to future projections of taxable income, tax legislation, rulings by relevant tax authorities, tax planning strategies and the progress of ongoing tax audits. Settlement of filing positions that may be challenged by tax authorities could impact the income tax position in the year of resolution. Our current tax liability is presented in the consolidated balance sheet within income taxes payable.

At March 31, 2006, we had $96.7 million of gross deferred tax assets, which included the effects of federal and state net operating loss (“NOL”) carryforwards of $49.5 million, capitalized research and development costs of $36.0 million and other items of $11.2 million. These assets are offset by a $49.0 million valuation allowance as our ability to estimate long-term future taxable income with a high level of certainty is limited. In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the period in which those temporary differences becomes deductible or the NOLs and credit carryforwards can be utilized. When considering the reversal of the valuation allowance, we consider the level of past and future taxable income, the utilization of the carryforwards and other factors. Revisions to the estimated net realizable value of the deferred tax asset could cause our provision for income taxes to vary significantly from period to period. Should we further reduce the valuation allowance of deferred tax assets, a current year tax benefit will be recognized and future periods would then include income taxes at a higher rate than the effective rate in the period that the adjustment is made.

As our business evolves, we may face additional issues that will require increased levels of management estimation and complex judgments.

Recently Issued Accounting Pronouncements

In November 2005, the FASB issued FASB Staff Position SFAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-based Payment Awards, that provides an elective alternative transition method of calculating the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS 123R (the “APIC Pool”) to the method otherwise required by paragraph 81 of SFAS 123R. We may take up to one year from the effective date of the FSP to evaluate our available alternatives and make our one-time election. We are currently evaluating the alternative methods in connection with our adoption of SFAS123R.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Our holdings of financial instruments are primarily comprised of a mix of U.S. corporate debt, government securities and commercial paper. All such instruments are classified as securities available for sale. Our debt security portfolio represents funds held temporarily pending use in our business and operations. We manage these funds accordingly. Our primary investment objective is the preservation of principal, while at the same time maximizing the generation of investment income. We seek reasonable assuredness of the safety of principal and market liquidity by investing in cash equivalents (such as Treasury bills and money market funds) and fixed income securities (such as U.S. government and agency securities, municipal securities, taxable municipals, and corporate notes) while at the same time seeking to achieve a favorable rate of return. Our market risk exposure consists principally of exposure to changes in interest rates. Our holdings are also exposed to the risks of changes in the credit quality of issuers. Historically, we have typically invested in financial instruments with maturities of less than one year. The carrying amount, which approximates fair value, and the annualized weighted average nominal interest rate of our investment portfolio at March 31, 2006, was approximately $70.9 million and 4.6%, respectively. A one percent change in the interest rate would have resulted in a $0.2 million impact to interest income for the quarter ended March 31, 2006.

ITEM 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

An evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer, or CEO, and our Chief Financial Officer, or CFO, of the effectiveness of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of March 31, 2006. Based on that evaluation, our management, including our CEO and CFO, concluded that as of March 31, 2006 our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission and that such information is accumulated and communicated to the Company’s management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

During the first quarter of 2006, we began considering the required internal controls over financial reporting related to our third party manufacturing, which will begin in the second quarter of 2006. There were no other significant changes in our internal control over financial reporting identified in connection with the evaluation of such controls that occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect our internal control over financial reporting.

PART II—OTHER INFORMATION

ITEM 1a.

Risk Factors

You should carefully consider the risk factors described below and all other information contained or incorporated by reference in this Quarterly Report on Form 10-Q before you make an investment decision. If any of the following risk factors, as well as other risks and uncertainties that are not currently known to us or that we currently believe are not material, actually occur, our business, financial condition and results of operations could be materially and adversely affected. In that case, the trading price of our common stock could decline, and you may lose part or all of your investment.

We depend heavily on the continued sales of Vancocin.

If revenue from Vancocin materially declines, our financial condition and results of operations will be materially harmed because, other than potential royalties and milestone payments, sales of Vancocin may be our only source of revenue for at least the next several years.

Vancocin product sales could be adversely affected by a number of factors, including:

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the development and FDA approval of competitive generic versions of oral Vancocin, approval of products which are currently marketed for other indications by other companies or new pharmaceuticals and technological advances to treat the conditions addressed by Vancocin;

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fluctuations in wholesaler order patterns and inventory levels;

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manufacturing, supply or distribution interruptions which could impair our ability to acquire an adequate supply of Vancocin to meet demand for the product;

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changes in the prescribing or procedural practices of physicians in the areas of infectious disease, gastroenterology and internal medicine, including off-label prescribing of other products;

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regulatory action by the FDA and other government regulatory agencies;

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decreases in the rate of infections for which Vancocin is prescribed;

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decrease in the sensitivity of the relevant bacterium to Vancocin;

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changes in terms required by wholesalers, including fee-for-service contracts;

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marketing or pricing actions by one or more of our competitors;

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our ability to maintain all necessary contracts or obtain all necessary rights under applicable federal and state rules and regulations;

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the approval of legislative proposals that would authorize re-importation of Vancocin into the U.S. from other countries;

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changes in the reimbursement or substitution policies of third-party payors or retail pharmacies; and

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product liability claims.

We cannot assure you that revenues from the sale of Vancocin will remain at or above current levels or achieve the level of net product sales that we expect. A decrease in sales of Vancocin could result in our inability to maintain profitability and could have a material adverse effect on our business, financial condition and results of operations.

Core patent protection for Vancocin has expired, which could result in significant competition from generic products and lead to a significant reduction in sales of Vancocin.

The last core patent protecting Vancocin expired in 1996. As a result, there is a potential for significant competition from generic products that treat the same conditions addressed by Vancocin. Such competition could result in a significant reduction in sales of Vancocin. We believe that regulatory hurdles (notwithstanding the recent actions taken by the Office of Generic Drugs, Center for Drug Evaluation and Research (“OGD”), which we describe in more detail below and which we are vigorously opposing), as well as product manufacturing trade secrets, know-how and related non-patent intellectual property, may present barriers to market entry of generic competition. However, there can be no assurance that these barriers will actually delay or prevent generic competition. The effectiveness of these non-patent-related barriers to competition will depend primarily upon:

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the nature of the market which Vancocin serves and the position of Vancocin in the market from time to time;

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the growth of the market which Vancocin serves;

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our ability to protect Vancocin know-how as a trade secret;

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the complexities of the manufacturing process for a competitive product; and

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the current or future regulatory approval requirements for any generic applicant.

We cannot assure you that generic competitors will not take advantage of the absence of patent protection for Vancocin to attempt to develop a competing product. We have become aware of information suggesting that other potential competitors are attempting to develop a competing generic product. We are not able to predict the time period in which a generic drug may enter the market, as this timing will be affected by a number of factors, including:

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the time required to develop appropriate manufacturing procedures;

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whether a method of demonstrating bioequivalence, or other in-vitro method, is available to an applicant to gain marketing approval by the FDA in lieu of performing clinical studies;

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the nature of any clinical trials which are required, if any; and

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the specific formulation of drug for which approval is being sought.

On March 17, 2006, we learned that the OGD changed its approach regarding the conditions that must be met in order for a generic drug applicant to request a waiver of in-vivo bioequivalence testing for vancomycin hydrochloride capsules. Specifically, we were informed that a generic applicant may be able to request such a waiver provided that dissolution testing demonstrates that the test product is rapidly dissolving at certain specified conditions. This deviates from our understanding of OGD’s historical practices which would require, for a poorly-absorbed, locally acting gastrointestinal drug (such as Vancocin) a demonstration of bioequivalence through clinical studies or a demonstration of bioequivalence using an appropriately validated in vitro methodology.

On March 17, 2006 we filed a Petition for Stay of Action with the FDA regarding the requirements for waivers of in-vivo bioequivalence testing for Vancocin, and we amended that petition on March 30, 2006. We expect to make additional filings in support of our opposition to any approach that does not require rigorous scientific methods to demonstrate a rate and extent of drug release to the site of action consistent with good medicine and science. In the event the OGD’s revised approach regarding the conditions that must be met in order for a generic drug applicant to request a waiver of in-vivo bioequivalence testing for Vancocin remains in effect, the time period in which a generic competitor may enter the market could be reduced.

If a generic competitor were to formulate a competing product that was approved by the FDA and that gained market acceptance, it would have a material adverse effect on our sales of Vancocin and on our business.

We do not know whether Vancocin will continue to be competitive in the markets which it serves.

We currently generate revenues from sales of Vancocin in the U.S. for the treatment of antibiotic-associated pseudomembranous colitis caused by Clostridium difficile, or C. difficile, and enterocolitis caused by S. aureus, including methicillin-resistant strains. Vancocin sales for treatment of antibiotic-associated pseudomembranous colitis caused by C. difficile have increased over the past 12 months; however, Vancocin’s share of the U.S. market for this indication may decrease due to competitive forces and market dynamics. Metronidazole, a generic product, is regularly prescribed to treat CDAD at costs which are substantially lower than for Vancocin. In addition, products which are currently marketed for other indications by other companies may also be prescribed to treat this indication. Other drugs that are still in development by our competitors, including Genzyme Corporation, Oscient Pharmaceuticals, and Optimer Pharmaceuticals, could be found to have competitive advantages over Vancocin. Approval of new products, or expanded use of currently available products, to treat CDAD, and particularly severe disease caused by C. difficile infection, could materially and adversely affect our sales of Vancocin.

We rely on a single third party to perform the distribution and logistics services for Vancocin.

We rely on a single third party to provide all necessary distribution and logistics services with respect to our sales of Vancocin, including warehousing of finished product, accounts receivable management, billing, collection and recordkeeping. If our third party ceases to be able to provide us with these services, or does not provide these services in a timely or professional manner, it could significantly disrupt our commercial operations, and may result in our not achieving the sales of Vancocin that we expect. Additionally, any interruption to these services could cause a delay in delivering product to our customers, which could have a material adverse effect on our business.

The third party service provider stores and distributes our products from a single warehouse located in the central U.S. A disaster occurring at or near this facility, including but not limited to tornados or other natural disasters, could materially and adversely impact our ability to supply Vancocin to our wholesalers which would result in a reduction in revenues from sales of Vancocin.

Our sales are mainly to a limited number of pharmaceutical wholesalers, and changes in terms required by these wholesalers or disruptions in these relationships could result in us not achieving the sales of Vancocin that we expect.

Approximately 95% of our Vancocin sales are to the three largest pharmaceutical wholesalers. If any of these wholesalers ceases to purchase our product for any reason, then unless and until the remaining wholesalers increase their purchases of Vancocin or alternative distribution channels are established:

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our commercial operations could be significantly disrupted;

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the availability of Vancocin to patients could be disrupted; and

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we may not achieve the sales of Vancocin that we expect, which could decrease our revenues and potentially affect our ability to maintain profitability.

We are aware that wholesalers have, in the past, entered into fee-for-service or similar agreements with pharmaceutical companies in connection with the distribution of their products. Although we do not currently have such agreements in place with our wholesalers, our entering into such arrangements with wholesalers could result in higher costs to us and adversely affect our product margins. Additionally, we do not require collateral from our wholesalers but rather maintain credit limits and as a result we have an exposure to credit risk in our accounts receivable. The highest account receivable we have experienced from any one wholesaler was approximately $13 million and we anticipate that this amount could increase if Vancocin sales continue to increase. While we have experienced prompt payment by wholesalers and have not had any defaults on payments owed, a default by a large wholesaler could have a material adverse effect on our revenues and our earnings.

Orders for Vancocin may fluctuate depending on the inventory levels held by our major customers. Significant increases or decreases in orders from our major customers could cause our operating results to vary significantly from quarter to quarter.

Our customers for Vancocin include some of the nation’s leading wholesale pharmaceutical distributors. We attempt to monitor wholesaler inventory of our products using a combination of methods, including our data reflecting sales to wholesalers, IMS sales and prescription data, and data reflecting prescriptions filled at the pharmacy level, to determine inventory amounts sold from the wholesalers to their customers. However, our estimates of wholesaler inventories may differ significantly from their actual inventory levels as we do not acquire data regarding inventory levels from the wholesalers Significant differences between actual and estimated inventory levels may result in excessive inventory production, inadequate supplies of products in distribution channels, insufficient or excess product available at the retail level, and unexpected increases or decreases in orders from our major customers. Forward-buying by wholesalers, for example, may result in significant and unexpected changes in customer orders from quarter to quarter. These changes may cause our revenues to fluctuate significantly from quarter to quarter, and in some cases may cause our operating results for a particular quarter to be below our expectations or projections. If our financial results are below expectations for a particular period, the market price of our securities may drop significantly.

If our supplies of Vancocin finished product or any other approved products are interrupted or if we are unable to acquire adequate supplies of Vancocin or any other approved products to meet increasing demand for the products, our ability to maintain our inventory levels could suffer and future revenues may be delayed or reduced.

We will try to maintain Vancocin inventory levels to meet our current projections, plus a reasonable stock in excess of those projections. Any interruption in the supply of Vancocin finished products could hinder our ability to timely distribute Vancocin and satisfy customer demand. If we are unable to obtain adequate product supplies to satisfy our customers’ orders, we may lose those orders, our customers may cancel other orders, and they may choose instead to stock and purchase competing products. This in turn could cause a loss of our market share and negatively affect our revenues. Supply interruptions may occur and our inventory may not always be adequate. Our initial manufacturing agreement with Lilly relating to the manufacture of Vancocin capsules, required that Lilly continue to supply Vancocin capsules to us until the earlier of the qualification of a third party supply chain for Vancocin capsules or the expiration of the manufacturing agreement. As a result of increased demand for Vancocin during the first nine months of 2005, we entered into an amendment to this agreement in November 2005, which increased the amount of Vancocin that Lilly supplied to us during 2005, and ensures that Lilly will continue to supply us with Vancocin until September 30, 2006. In December 2005, we entered into agreements with OSG Norwich for the manufacture of finished product and in March 2006 we received the required regulatory approvals for the Vancocin finished product manufactured by OSG Norwich. In April 2006 we entered a supply agreement with the API manufacturer to act as our new source of Vancocin API, and we also entered into an additional manufacturing agreement with OSG Norwich relating to a scaled-up manufacturing process. We anticipate that we will commence purchasing a portion of our needs from these parties in the second quarter of 2006. However, we cannot assure you that there will be no disruption in the availability of sufficient supply to meet the demand for Vancocin.

Lilly and our third party finished product supplier, are the only manufacturers qualified by the FDA to manufacture Vancocin capsule finished product for distribution and sale in the U.S. Upon expiration of our agreement with Lilly, we will be dependent upon a single third party finished product supplier.

Numerous factors could cause interruptions in the supply of our Vancocin finished products or other approved products, including manufacturing capacity limitations, changes in our sources for manufacturing, our failure to timely locate and obtain replacement manufacturers as needed and conditions affecting the cost and availability of raw materials. Lilly experienced a supply interruption during 2002 due to changes in quality standards for Vancocin and its components and there is no assurance that we will not experience similar or dissimilar supply interruptions. In addition, any commercial dispute with any of our suppliers could result in delays in the manufacture of our product, and affect our ability to commercialize our products.

We cannot be certain that manufacturing sources will continue to be available or that we can continue to out-source the manufacturing of our products on reasonable or acceptable terms. Any loss of a manufacturer or any difficulties that could arise in the manufacturing process could significantly affect our inventories and supply of products available for sale. If we are unable to supply sufficient amounts of our products on a timely basis, our market share could decrease and, correspondingly, our revenues would decrease.

We maintain business interruption insurance which could mitigate some of our loss of income in the event of certain covered interruptions of supply. However, this insurance coverage is unlikely to completely mitigate the harm to our business from the interruption of the manufacturing of products. The loss of a manufacturer could still have a negative effect on our sales, margins and market share, as well as our overall business and financial results.

We currently depend, and will in the future continue to depend, on third parties to manufacture our products, including Vancocin and our product candidates. If these manufacturers fail to meet our requirements and the requirements of regulatory authorities, our future revenues may be materially adversely affected.

We do not have the internal capability to manufacture commercial quantities of pharmaceutical products under the FDA’s current Good Manufacturing Practice regulations, or cGMPs. In order to continue to develop products, apply for regulatory approvals and commercialize our products, we will need to contract with third parties that have, or otherwise develop, the necessary manufacturing capabilities.

There are a limited number of manufacturers that operate under cGMPs that are capable of manufacturing our products and product candidates. If we are unable to enter into supply and processing contracts with any of these manufacturers or processors for our development stage product candidates, there may be additional costs and delays in the development and commercialization of these product candidates. If we are required to find an additional or alternative source of supply, there may be additional costs and delays in the development or commercialization of our product candidates. Additionally, the FDA inspects all commercial manufacturing facilities before approving a new drug application, or NDA, for a drug manufactured at those sites. If any of our manufacturers or processors fails to pass this FDA inspection, the approval and eventual commercialization of our products and product candidates may be delayed.

All of our contract manufacturers must comply with the applicable cGMPs, which include quality control and quality assurance requirements as well as the corresponding maintenance of records and documentation. If our contract manufacturers do not comply with the applicable cGMPs and other FDA regulatory requirements, the availability of marketed products for sale could be reduced, our product commercialization could be delayed or subject to restrictions, we may be unable to meet demand for our products and may lose potential revenue and we could suffer delays in the progress of clinical trials for products under development. We do not have control over our third-party manufacturers’ compliance with these regulations and standards. Moreover, while we may choose to manufacture products in the future, we have no experience in the manufacture of pharmaceutical products for clinical trials or commercial purposes. If we decide to manufacture products, we would be subject to the regulatory requirements described above. In addition, we would require substantial additional capital and would be subject to delays or difficulties encountered in manufacturing pharmaceutical products. No matter who manufactures the product, we will be subject to continuing obligations regarding the submission of safety reports and other post-market information.

If we encounter delays or difficulties with contract manufacturers, packagers or distributors, market introduction and subsequent sales of our products could be delayed. If we change the source or location of supply or modify the manufacturing process, FDA and other regulatory authorities will require us to demonstrate that the product produced by the new source or location or from the modified process is equivalent to the product used in any clinical trials that were conducted. If we are unable to demonstrate this equivalence, we will be unable to manufacture products from the new source or location of supply, or use the modified process, we may incur substantial expenses in order to ensure equivalence, and it may harm our ability to generate revenues.

If we, or our manufacturers, are unable to obtain raw and intermediate materials needed to manufacture our products in sufficient amounts or on acceptable terms, we will incur significant costs and sales of our products would be delayed or reduced.

We, or the manufacturers with whom we contract, may not be able to maintain adequate relationships with current or future suppliers of raw or intermediate materials for use in manufacturing our products or product candidates. If our current manufacturing sources and suppliers are unable or unwilling to make these materials available to us, or our manufacturers, in required quantities or on acceptable terms, we would likely incur significant costs and delays to qualify alternative manufacturing sources and suppliers. If we are unable to identify and contract with alternative manufacturers when needed, sales of our products would be delayed or reduced and will result in significant additional costs.

Our future product revenues from sales of Vancocin could be reduced by imports from countries where Vancocin is available at lower prices.

Vancocin has been approved for sale outside of the U.S., including but not limited to Canada, Brazil and Europe, and Lilly or its licensees will continue to market Vancocin outside of the U.S. There have been cases in which pharmaceutical products were sold at steeply discounted prices in markets outside the U.S. and then imported to the United States where they could be resold at prices higher than the original discounted price, but lower than the prices commercially available in the U.S. If this happens with Vancocin our revenues would be adversely affected. Additionally, there are non-U.S., Internet-based companies supplying Vancocin directly to patients at significantly reduced prices.

In recent years, various legislative proposals have been offered in the U.S. Congress and in some state legislatures that would authorize re-importation of pharmaceutical products into the U.S. from other countries including Canada. We cannot predict the outcome of such initiatives, which if adopted, could result in increased competition for our products and lower prices.

Historically, Vancocin has been subject to limitations on the amount of payment and reimbursement available to patients from third party payors.

Historically, only a portion of the cost of Vancocin prescriptions is paid for or reimbursed by managed care organizations, government and other third-party payors. This reimbursement policy makes Vancocin less attractive, from a net-cost perspective, to patients and, to a lesser degree, prescribing physicians. For example, metronidazole, a drug frequently prescribed for CDAD, is significantly less expensive than Vancocin. If adequate reimbursement levels are not provided for Vancocin, or if reimbursement policies increasingly favor other products, our market share and gross margins could be negatively affected, as could our overall business and financial condition.

Our long-term success depends upon our ability to develop, receive regulatory approval for and commercialize drug product candidates and if we are not successful, our ability to generate revenues from the commercialization and sale of products resulting from our product candidates will be limited.

All of our drug candidates will require governmental approvals prior to commercialization. We have not completed the development of or received regulatory approval to commercialize any of our existing product candidates. Our failure to develop, receive regulatory approvals for and commercialize our development stage product candidates successfully will prevent us from generating revenues from the sale of products resulting from our product candidates. Our product candidates are at early stages of development and may not be shown to be safe or effective. We reported preliminary results of a phase 2 clinical trial on a product candidate for the prevention and treatment of CMV in March 2005 and reported preliminary results of a phase 1b clinical trial of a product candidate for the treatment of HCV in November 2005. The clinical trial results of each of these clinical trials are preliminary and full analysis of the data, and further testing including clinical studies of HCV-796 in combination with pegylated interferon, or the larger clinical trials which will be required in order to achieve regulatory approvals, may be inconsistent with the preliminary results and may not support further clinical development. Our potential therapies under development for the treatment of CMV and HCV will require significant additional development efforts and regulatory approvals prior to any commercialization. We cannot be certain that our efforts and the efforts of our partners in this regard will lead to commercially viable products. Negative, inconclusive or inconsistent clinical trial results could prevent regulatory approval, increase the cost and timing of regulatory approval, cause us to perform additional studies or to file for a narrower indication than planned. We do not know what the final cost to manufacture our CMV and HCV product candidates in commercial quantities will be, or the dose required to treat patients and, consequently, what the total cost of goods for a treatment regimen will be.

If we are unable to successfully develop our product candidates, we will not have a source of revenue other than Vancocin. Moreover, the failure of one or more of our product candidates in clinical development could harm our ability to raise additional capital.

The development of any of our product candidates is subject to many risks, including that:

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the product candidate is found to be ineffective or unsafe;

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the clinical test results for the product candidate delay or prevent regulatory approval;

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the FDA forbids us to initiate or continue testing of the product candidates in human clinical trials;

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the product candidate cannot be developed into a commercially viable product;

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the product candidate is difficult and/or costly to manufacture;

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the product candidate later is discovered to cause adverse effects that prevent widespread use, require withdrawal from the market, or serve as the basis for product liability claims;

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third party competitors hold proprietary rights that preclude us from marketing the product candidate; and

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third party competitors market a more clinically effective, safer, or more cost-effective product.

Even if we believe that the clinical data demonstrates the safety and efficacy of a product candidate, regulators may disagree with us, which could delay, limit or prevent the approval of such product candidate. As a result, we may not obtain regulatory approval, or even if a product is approved, we may not obtain the labeling claims we believe are necessary or desirable for the promotion of the product. In addition, regulatory approval may take longer than we expect as a result of a number of factors, including failure to qualify for priority review of our application. All statutes and regulations governing the approval of our product candidates are subject to change in the future. These changes may increase the time or cost of regulatory approval, limit approval, or prevent it completely.

Even if we receive regulatory approval for our product candidates, or acquire the rights to additional already approved products, the later discovery of previously unknown problems with a product, manufacturer or facility may result in adverse consequences, including withdrawal of the product from the market. Approval of a product candidate may be conditioned upon certain limitations and restrictions as to the drug’s use, or upon the conduct of further studies, and may be subject to continuous review.

The regulatory process is expensive, time consuming and uncertain and may prevent us from obtaining required approvals for the commercialization of our product candidates.

We have product candidates for the treatment of CMV and HCV in clinical development. Schering-Plough is conducting the clinical development of pleconaril. We must complete significant laboratory, animal and clinical testing on these product candidates before we submit marketing applications in the U.S. and abroad.

The rate of completion of clinical trials depends upon many factors, including the rate of enrollment of patients. For example, our enrollment of patients in our clinical trial for maribavir has been impacted by our ability to identify and successfully recruit a sufficient number of patients who have undergone allogeneic hematopoietic stem cell/bone marrow transplantation. If we are unable to accrue sufficient clinical patients who are eligible to participate in the trials during the appropriate period, we may need to delay our clinical trials and incur significant additional costs. In addition, the FDA or Institutional Review Boards may require us to delay, restrict, or discontinue our clinical trials on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk. Moreover, we may be unable to submit a NDA to the FDA for our product candidates within the timeframe we currently expect. Once a NDA is submitted, it must be approved by the FDA before we can commercialize the product described in the application. The cost of human clinical trials varies dramatically based on a number of factors, including:

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the order and timing of clinical indications pursued;

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the extent of development and financial support from corporate collaborators;

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the number of patients required for enrollment;

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the length of time required to enroll these patients;

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the costs and difficulty of obtaining clinical supplies of the product candidate; and

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the difficulty in obtaining sufficient patient populations and clinicians.

Even if we obtain positive preclinical or clinical trial results in initial studies, future clinical trial results may not be similarly positive. As a result, ongoing and contemplated clinical testing, if permitted by governmental authorities, may not demonstrate that a product candidate is safe and effective in the patient population and for the disease indications for which we believe it will be commercially advantageous to market the product. The failure of our clinical trials to demonstrate the safety and efficacy of our product candidate for the desired indications could delay the commercialization of the product.

In 2003, Congress enacted the Pediatric Research Equity Act requiring the development and submission of pediatric use data for new drug products. Our failure to obtain these data, or to obtain a deferral of, or exemption from, this requirement could adversely affect our chances of receiving regulatory approval, or could result in regulatory or legal enforcement actions.

Even after we receive regulatory approval, as with Vancocin, if we fail to comply with regulatory requirements, or if we experience unanticipated problems with our approved products, our products could be subject to restrictions or withdrawal from the market.

Vancocin is, and any other product for which we obtain marketing approval from the FDA or other regulatory authority will be, along with the manufacturing processes, post-approval clinical data collection and promotional activities for each such product, subject to continual review and periodic inspection by the FDA and other regulatory bodies. After approval of a product, we will have, and with Vancocin, we currently have, significant ongoing regulatory compliance obligations. Later discovery of previously unknown problems with our products or manufacturing processes, or failure to comply with regulatory requirements, may result in penalties or other actions, including:

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warning letters;

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fines;

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product recalls;

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withdrawal of regulatory approval;

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operating restrictions, including restrictions on such products or manufacturing processes;

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disgorgement of profits;

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injunctions; and

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criminal prosecution.

Any of these events could result in a material adverse effect on our revenues and financial condition.

There are many potential competitors with respect to our product candidates under development, who may develop products and technologies that make ours non-competitive or obsolete.

There are many entities, both public and private, including well-known, large pharmaceutical companies, chemical companies, biotechnology companies and research institutions, engaged in developing pharmaceuticals for applications similar to those targeted by our products under development.

There are products already marketed by F. Hoffman La-Roche, AstraZeneca and Gilead Sciences Inc. for the prevention and treatment of CMV and Schering-Plough and F. Hoffman La-Roche for the treatment of HCV. We are aware of a number of other companies which have compounds in various stages of clinical development for the treatment HCV. Developments by these or other entities may render our product candidates non-competitive or obsolete. Furthermore, many of our competitors are more experienced than we are in drug development and commercialization, obtaining regulatory approvals and product manufacturing and marketing. Accordingly, our competitors may succeed in obtaining regulatory approval for products more rapidly and more effectively than we do for our product candidates. Competitors may succeed in developing products that are more effective and less costly than any that we develop and also may prove to be more successful in the manufacturing and marketing of products.

Any product that we successfully develop and for which we gain regulatory approval must then compete for market acceptance and market share. Accordingly, important competitive factors, in addition to completion of clinical testing and the receipt of regulatory approval, will include product efficacy, safety, timing and scope of regulatory approvals, availability of supply, marketing and sales capacity, reimbursement coverage, pricing and patent protection. Our products could also be rendered obsolete or uneconomical by regulatory or competitive changes.

In order to continue to expand our business and sustain our revenue growth, we will need to acquire additional products in development or marketed products through in-licensing or the acquisitions of businesses that we believe are a strategic fit with us. We may not be able to in-license or acquire suitable products at an acceptable price or at all. In addition, engaging in any in-licensing or acquisitions will incur a variety of costs, and we may never realize the anticipated benefits of any such in-license or acquisition.

As part of our long-term strategy and in order to sustain our revenue growth, we intend to seek to acquire or in-license additional products to treat the patient population targeted by Vancocin and our current product candidates, or products to treat other diseases for which patients are treated by physician specialists or in hospital settings. Even if we are able to locate products or businesses that fit within our strategic focus, we cannot assure you that we will be able to negotiate agreements to acquire or in-license such additional products on acceptable terms or at all. Further, if we acquire a product or business, the process of integrating the acquired product or business may result in unforeseen operating difficulties and expenditures and may divert significant management attention from our ongoing business operations. Moreover, we may fail to realize the anticipated benefits for a variety of reasons, such as an acquired product candidate proving to not be safe or effective in later clinical trials. We may fund any future acquisition by issuing equity or debt securities, which could dilute the ownership percentages of our existing stockholders. Acquisition efforts can consume significant management attention and require substantial expenditures, which could detract from our other programs. In addition, we may devote resources to potential acquisitions that are never completed.

We cannot assure you that an acquired product or business will have the intended effect of helping us to sustain our revenue growth. If we are unable to do so, our business could be materially adversely affected.

Any of our future products may not be accepted by the market, which would harm our business and results of operations.

Even if approved by the FDA and other regulatory authorities, our product candidates may not achieve market acceptance by patients, prescribers and third-party payors. As a result, we may not receive revenues from these products as anticipated. The degree of market acceptance will depend upon a number of factors, including:

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the receipt and timing of regulatory approvals, and the scope of marketing and promotion activities permitted by such approvals (e.g., the “label” for the product approved by the FDA);

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the availability of third-party reimbursement from payors such as government health programs and private health insurers;

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the establishment and demonstration in the medical community, such as doctors and hospital administrators, of the clinical safety, efficacy and cost-effectiveness of drug candidates, as well as their advantages over existing treatment alternatives, if any;

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the effectiveness of the sales and marketing force that may be promoting our products; and

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the effectiveness of our contract manufacturers.

If our product candidates do not achieve market acceptance by a sufficient number of patients, prescribers and third-party payors, our business will be materially adversely affected.

We have limited sales and marketing infrastructure and if we are unable to develop our own sales and marketing capability we may be unsuccessful in commercializing our products.

Under our agreement with GSK, we have the exclusive right to market and sell maribavir throughout the world, other than Japan. Under our agreement with Wyeth, we have the right to co-promote HCV products arising from our collaboration in the U.S. and Canada. Schering-Plough is solely responsible for the marketing, promotion and sale of intranasal pleconaril following its approval.

We currently have a limited marketing staff and no sales staff. As a result of our acquisition of Vancocin, we established a small group of regional medical scientists and commenced medical education programs, but do not anticipate that we will build a sales force related solely to Vancocin. The development of a marketing and sales capability for our product candidates in clinical development, or for products that we may acquire if we are successful in our business development efforts, could require significant expenditures, management resources and time. We may be unable to build a marketing and sales capability, the cost of establishing such a marketing and sales capability may exceed any product revenues, and our marketing and sales efforts may be unsuccessful. We may not be able to find a suitable sales and marketing partner for our other product candidates. If we are unable to successfully establish a sales and marketing capability in a timely manner or find suitable sales and marketing partners, our business and results of operations will be harmed. Even if we are able to develop a sales force or find a suitable marketing partner, we may not successfully penetrate the markets for any of our proposed products.

We depend on collaborations with third parties, which may reduce our product revenues or restrict our ability to commercialize products, and also ties our success to the success of our collaborators.

We have entered into, and may in the future enter into additional, sales and marketing, distribution, manufacturing, development, licensing and other strategic arrangements with third parties. For example, in November 2004, we announced that we entered into a license agreement with Schering-Plough under which Schering-Plough assumed responsibility for all future development and commercialization of pleconaril. Sanofi-Aventis also has exclusive rights to market and sell pleconaril in countries other than the U.S. and Canada for which we will receive a royalty. Schering-Plough will receive a portion of any royalty payments made to us under our license agreement with Sanofi-Aventis for rights to pleconaril.

In August 2003, we entered into a license agreement with GSK under which we acquired exclusive worldwide rights, excluding Japan, from GSK to develop and commercialize an antiviral compound, maribavir, for the prevention and treatment of CMV infections related to transplant, including solid organ and hematopoietic stem cell / bone marrow transplantation, congenital transmission, and in patients with HIV infection. GSK retained the exclusive right to market and sell products covered by these patents and patent applications in Japan.

In December 1999, we entered into an agreement with Wyeth to develop jointly products for use in treating the effects of HCV in humans. Under the agreement, we exclusively licensed to Wyeth worldwide rights under patents and know-how owned by us or created under the agreement. While we have the right to co-promote these products in the U.S. and Canada, Wyeth has the exclusive right to promote these products elsewhere in the world, for which we will receive a royalty. Wyeth also has the exclusive right to manufacture any commercial products developed under the agreement.

If any of Wyeth, Schering-Plough or Sanofi-Aventis do not successfully market and sell products in their respective territories, we will not receive revenue from royalties on their sales of products.

We are currently engaged in additional discussions relating to other arrangements. We cannot be sure that we will be able to enter into any such arrangements with third parties on terms acceptable to us or at all. Third party arrangements may require us to grant certain rights to third parties, including exclusive marketing rights to one or more products, or may have other terms that are burdensome to us.

Our ultimate success may depend upon the success of our collaborators. We have obtained from Sanofi-Aventis and GSK, and will attempt to obtain in the future, licensed rights to certain proprietary technologies and compounds from other entities, individuals and research institutions, for which we may be obligated to pay license fees, make milestone payments and pay royalties. In addition, we may in the future enter into collaborative arrangements for the marketing, sales and distribution of our product candidates, which may require us to share profits or revenues. We may be unable to enter into additional collaborative licensing or other arrangements that we need to develop and commercialize our drug candidates. Moreover, we may not realize the contemplated benefits from such collaborative licensing or other arrangements. These arrangements may place responsibility on our collaborative partners for preclinical testing, human clinical trials, the preparation and submission

of applications for regulatory approval, or for marketing, sales and distribution support for product commercialization. We cannot be certain that any of these parties will fulfill their obligations in a manner consistent with our best interests. These arrangements may also require us to transfer certain material rights or issue our equity securities to corporate partners, licensees or others. Any license or sublicense of our commercial rights may reduce our product revenue. Moreover, we may not derive any revenues or profits from these arrangements. In addition, our current strategic arrangements may not continue and we may be unable to enter into future collaborations. Collaborators may also pursue alternative technologies or drug candidates, either on their own or in collaboration with others, that are in direct competition with us.

If we fail to comply with our obligations in the agreements under which we license development or commercialization rights to products or technology from third parties, we could lose license rights that are important to our business.

Two of our current product candidates are based on intellectual property that we have licensed from Sanofi-Aventis and GSK. Another clinical development program involves a joint development program with Wyeth pursuant to which we licensed to Wyeth worldwide rights within a certain field under patents and know-how owned by us or created under the agreement. We depend, and will continue to depend, on these license agreements. All of our license agreements may be terminated if, among other events, we fail to satisfy our obligations as they relate to the development of the particular product candidate. All of our license agreements, other than the agreements with Lilly regarding Vancocin, may also be terminated if we breach that license agreement and do not cure the breach within specified time periods or in the event of our bankruptcy or liquidation. Our agreement with Lilly permits it to suspend the licenses granted to us by Lilly in the event of uncured defaults by us until such time as the default is cured or otherwise resolved.

Our license agreement with GSK imposes various obligations on us, including milestone payment requirements and royalties. If we fail to comply with these obligations, GSK has or may have the right to terminate the license, in which event we would not be able to market products covered by the license.

Disputes may arise with respect to our licensing agreements regarding manufacturing, development and commercialization of any of the particular product candidates. These disputes could lead to delays in or termination of the development, manufacture and commercialization of our product candidates or to litigation.

Many other entities seek to establish collaborative arrangements for product research and development, or otherwise acquire products, in competition with us.

We face competition from large and small companies within the pharmaceutical and biotechnology industry as well as public and private research organizations, academic institutions and governmental agencies in acquiring products and establishing collaborative arrangements for product development. 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 business development activities. These entities represent significant competition to us as we seek to expand further our pipeline through the in-license or acquisition of additional products in clinical development, or that are currently on the market. Moreover, while it is not feasible to predict the actual cost of acquiring additional product candidates, that cost could be substantial. We may need additional financing in order to acquire additional new products.

Even if we are successful in maintaining or increasing Vancocin revenues, we may be dependent upon our ability to raise financing for, and the successful development and commercialization of our product candidates in CMV and HCV.

We will need substantial funds to continue our business activities. We expect that Vancocin will generate significant cash flows for us and should allow us to substantially fund our development and other operating costs under our current business plan over the next several years. We expect to incur significant expenses over at least the next several years primarily due to our development costs from our CMV and HCV programs, business development activities seeking new opportunities to expand further our product pipeline, general and administrative expenses, and income taxes. If Vancocin revenues decrease, we may require additional capital to continue our business activities as currently planned.

In addition, the amount and timing of our actual capital requirements as well as our ability to finance such requirements will depend upon numerous factors, including:

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our actual sales of Vancocin;

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the cost of commercializing Vancocin and our product candidates;

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our ability to generate revenue and positive cash flow through our HCV collaboration agreement with Wyeth;

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whether we receive any of the additional milestone payments and royalties contemplated by our license agreement with Schering-Plough relating to development and commercialization of intranasal pleconaril;

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the cost and progress of our clinical development programs;

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the cost of milestone payments that may be due to GSK under our license agreement with them for maribavir, our product candidate to treat CMV, if pre-defined clinical and regulatory events are achieved;

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the time and cost involved in obtaining regulatory approvals;

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the cost of acquiring additional commercialized products and / or products in clinical development;

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the cost of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights;

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the effect of competing technological and market developments; and

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the effect of changes and developments in our existing collaborative, licensing and other relationships.

We may be unable to generate or raise sufficient funds to complete our development, marketing and sales activities for any of our product candidates. Potential funding sources, besides Vancocin, include:

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public and private securities offerings;

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debt financing, such as bank loans; and

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collaborative, licensing and other arrangements with third parties.

We may not be able to find sufficient debt or equity funding on acceptable terms, if at all. If we cannot, we may need to delay, reduce or eliminate development programs, as well as other aspects of our business. The sale by us of additional equity securities or the expectation that we will sell additional equity securities may have an adverse effect on the price of our common stock. In addition, collaborative arrangements may require us to grant product development programs or licenses to third parties for products that we might otherwise seek to develop or commercialize ourselves.

We have a history of losses and our continued profitability is uncertain.

Prior to 2005 we had incurred losses in each year since our inception in 1994. As of March 31, 2006, we had an accumulated deficit of approximately $155.2 million. We achieved profitability for the fourth quarter ended December 31, 2004 and have maintained profitability in each of the five following quarters. Our ability to maintain profitability is dependent on a number of factors, including continued revenues from Vancocin sales, our ability to obtain regulatory approvals for our product candidates, successfully commercializing those product candidates, generating revenues from the sale of products from existing and potential future collaborative agreements, and securing contract manufacturing, distribution and logistics services. We do not know when or if we will acquire additional products to expand further our product portfolio, complete our product development efforts, receive regulatory approval of any of our product candidates or successfully commercialize any approved products. We expect to incur significant additional expenses over several years, and Vancocin’s ability to generate substantial cash flows over this timeframe could be materially and adversely affected by the introduction of effective generic or branded competing products. As a result, we are unable to accurately predict whether we will be able to maintain profitability and if not, the extent of any future losses or the time required to regain profitability, if at all.

We have a substantial amount of intangible assets, and if we are required to write down or adjust the useful life of the intangible assets in future periods, it would increase our operating expenses in the effected periods, which in turn would materially and adversely affect our results of operations.

Approximately $120.4 million, or 34%, of our total assets as of March 31, 2006 consists of net intangible assets which were established in November 2004 with a useful life, at that time, of twenty-five years. Intangible assets principally include know-how, customer relationships and trademarks associated with our acquisition of Vancocin. Our initial valuation of the fair value and useful life of the Vancocin related intangible assets required that we makes estimates regarding the timing and number of generic competitors entering the market. SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” requires, among other things, the impairment testing of amortizable intangible assets. If at any point in the future, the remaining book value of these intangible assets exceeds their undiscounted cash flows, we may be required to record an impairment charge that could significantly adversely impact our results of operations. Additionally, even if we determine the intangible assets are not impaired, we might determine that the estimated useful life of these intangible assets is less than the remaining useful life. In which case, we would shorten the remaining usefully life prospectively, which would result in an increase in amortization expense each period. The entry of a number of generic competitors into the market sooner than our initial estimate could impact our cash flow assumptions and estimate of fair value, perhaps to a level that could result in an impairment charge. We will continue to monitor the actions of the OGD and consider the effects of our opposition actions and the announcements by generic competitors or other adverse events for additional impairment indicators and we will reevaluate the expected cash flows and fair value of our Vancocin-related assets at such time.

We have a deferred tax asset and net operating loss and credit carryforwards which may not be realizable if future projections of our revenues decrease, which in turn could result in our increasing our valuation allowance against our deferred tax asset. This would adversely affect our results of operations, through tax expense, perhaps to a material level.

At March 31, 2006, we had $96.7 million of gross deferred tax assets, which included the effects of federal and state net operating loss (“NOL”) carryforwards of $49.5 million, capitalized research and development costs of $36.0 million and other items of $11.2 million. These assets are offset by a $49.0 million valuation allowance. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the period in which those temporary differences becomes deductible or the NOLs and credit carryforwards can be utilized. We evaluate the realizability of our deferred tax asset on a periodic basis, and will adjust such amounts in light of changing facts and circumstances, including but not limited to future projections of taxable income. Generic competition for Vancocin, for example, could reduce our future revenues and taxable income which could limit our future utilization of NOLs and, possibly, result in a lower estimated net realizable value of the deferred tax asset, which would require us to reestablish all or a portion of our income tax valuation allowance. Reestablishing the valuation allowance would result in income taxes at a higher rate than the effective tax rate in the period that such adjustment is made.

Our strategic plan may not achieve the intended results.

We restructured our business in January 2004 as part of our effort to redefine our strategic direction to focus on development of later stage opportunities, to build specific franchises relating to our current development programs and to expand our product portfolio through the acquisition of complementary clinical development stage or commercial product opportunities as a means to accelerate our path toward becoming a profitable pharmaceutical company. Our restructuring efforts have placed and may continue to place a significant strain on our managerial, operational, financial and other resources. We may not be successful in executing our strategy. There are a variety of risks and uncertainties that we face in executing this strategy.

We may need additional financing in order to acquire additional new products or product candidates. We may not have sufficient resources to execute our plans, and our actual expenses over the periods described in this report may vary depending on a variety of factors, including:

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the level of revenue from sales of Vancocin actually received by us;

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our actual operating costs related to Vancocin;

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the cost of acquiring additional new product opportunities as a result of our business development efforts;

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the actual cost of conducting clinical trials;

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the outcome of clinical trials in our CMV and HCV programs;

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whether we receive any of the milestone payments and royalties contemplated by our license agreement with Schering-Plough relating to the development and commercialization of intranasal pleconaril; and

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our resulting right to receive or obligation to pay milestone payments under agreements relating to our CMV, HCV and common cold programs.

In addition to the points noted above, our ability to sustain profitability is dependent on developing and obtaining regulatory approvals for our product candidates, successfully commercializing such product candidates, which may include entering into collaborative agreements for product development and commercialization, acquiring additional products through our business development efforts, and securing contract manufacturing services and distribution and logistics services. If our sales of Vancocin are materially adversely affected because of competition or other reasons, we may need to raise substantial additional funds to continue our business activities as currently planned.

We will rely on our employees, consultants, contractors, suppliers, manufacturers and collaborators to keep our trade secrets confidential.

We rely on trade secrets, trademarks, and unpatented proprietary know-how and continuing technological innovation in developing and manufacturing our products, including Vancocin, in order to protect our significant investment in these products from the risk of discovery by generic drug manufacturers and other potential competition. We require each of our employees, consultants, advisors, contractors, suppliers, manufacturers and collaborators to enter into confidentiality agreements prohibiting them from taking our proprietary information and technology or from using or disclosing proprietary information to third parties except in specified circumstances. The agreements also provide that all inventions conceived by an employee, consultant or advisor, to the extent appropriate for the services provided during the course of the relationship, are our exclusive property, other than inventions unrelated to us and developed entirely on the individual’s own time. Nevertheless, these agreements may not provide meaningful protection of our trade secrets and proprietary know-how if they are used or disclosed. Despite all of the precautions we may take, people who are not parties to confidentiality agreements may obtain access to our trade secrets or know-how. In addition, others may independently develop similar or equivalent trade secrets or know-how.

We depend on patents and proprietary rights for our products which are in clinical development, which may offer only limited protection against potential infringement, and if we are unable to protect our patents and proprietary rights, we may lose the right to develop, manufacture, market or sell products and lose sources of revenue.

The pharmaceutical industry places considerable importance on obtaining patent and trade secret protection for new technologies, products and processes. Our success depends, in part, on our ability to develop and maintain a strong patent position for our products and technologies in clinical development, both in the U.S. and in other countries. Litigation or other legal proceedings may be necessary to defend against claims of infringement, to enforce our patents, or to protect our trade secrets, and could result in substantial cost to us and diversion of our efforts. We intend to file applications as appropriate for patents describing the composition of matter of our drug candidates, the proprietary processes for producing such compositions, and the uses of our drug candidates. We own four issued U.S. patents, two non-U.S. patents and have eleven pending U.S. patent applications, six of which we co-own with Wyeth. We also have filed international, regional and non-U.S. national patent applications in order to pursue patent protection in major foreign countries.

Many of our scientific and management personnel were previously employed by competing companies. As a result, such companies may allege trade secret violations and similar claims against us.

To facilitate development of our proprietary technology base, we may need to obtain licenses to patents or other proprietary rights from other parties. If we are unable to obtain such licenses, our product development efforts may be delayed. We may collaborate with universities and governmental research organizations which, as a result, may acquire certain rights to any inventions or technical information derived from such collaboration.

We may incur substantial costs in asserting any patent rights and in defending suits against us related to intellectual property rights, even if we are ultimately successful. If we are unsuccessful in defending a claim that we have infringed or misappropriated the intellectual property of a third party, we could be required to pay substantial damages, stop using the disputed technology, develop new non-infringing technologies, or obtain one or more licenses from third parties. If we or our licensors seek to enforce our patents, a court may determine that our patents or our licensors’ patents are invalid or unenforceable, or that the defendant’s activity is not covered by the scope of our patents or our licensors’ patents. The U.S. Patent and Trademark Office or a private party could institute an interference proceeding relating to our patents or patent applications. An opposition or revocation proceeding could be instituted in the patent offices of foreign jurisdictions. An adverse decision in any such proceeding could result in the loss of our rights to a patent or invention.

If our licensors do not protect our rights under our license agreements with them or do not reasonably consent to our sublicense of rights or if these license agreements are terminated, we may lose revenue and expend significant resources defending our rights.

We have licensed from GSK worldwide rights, excluding Japan, to an antiviral compound, maribavir, for the prevention and treatment of CMV infections related to transplant, including solid organ and hematopoietic stem cell/bone marrow transplantation, congenital transmission, and in patients with HIV infection. This compound, and a related compound, are subject to patents and patent applications in a variety of countries throughout the world. We have licensed from Sanofi-Aventis the exclusive U.S. and Canadian rights to certain antiviral agents for use in picornavirus indications, which are the subject of U.S. and Canadian patents and patent applications owned by Sanofi-Aventis, certain of which describe pleconaril and others of which describe compounds that are either related to pleconaril or have antiviral activity. We sublicensed our rights under these patents to Schering-Plough. We depend on GSK and Sanofi-Aventis to prosecute and maintain many of these patents and patent applications and protect such patent rights. Failure by GSK or Sanofi-Aventis to prosecute or maintain such patents or patent applications and protect such patent rights could lead to our loss of revenue. Under certain circumstances, our ability to sublicense our rights under these license agreements is subject to the licensor’s consent. If our license agreements with GSK and Sanofi-Aventis are terminated, our ability to manufacture, develop, market and sell products under those agreements would terminate.

Our successful commercialization of our products will depend, in part, on the availability and adequacy of third party reimbursement.

Our ability to commercialize our product candidates successfully will depend, in part, on the extent to which reimbursement for the cost of such products and related treatments will be available from government health administration authorities, such as Medicare and Medicaid in the U.S., private health insurers and other organizations. Federal and state regulations govern or influence the reimbursement to health care providers of fees in connection with medical treatment of certain patients. In the U.S., there have been, and we expect there will continue to be, a number of state and federal proposals that could limit the

amount that state or federal governments will pay to reimburse the cost of drugs. Continued significant changes in the health care system could have a material adverse effect on our business. Decisions by state regulatory agencies, including state pharmacy boards, and/or retail pharmacies may require substitution of generic for branded products, may prefer competitors’ products over our own, and may impair our pricing and thereby constrain our market share and growth. In addition, we believe the increasing emphasis on managed care in the U.S. could put pressure on the price and usage of our product candidates, which may in turn adversely impact future product sales.

Significant uncertainty exists as to the reimbursement status of newly approved health care products, particularly for indications for which there is no current effective treatment or for which medical care typically is not sought. Adequate third-party coverage may not be available to enable us to maintain price levels sufficient to realize an appropriate return on our investment in product development. If adequate coverage and reimbursement levels are not provided by government and third-party payors for use of our products, our products may fail to achieve market acceptance and we could lose anticipated revenues and experience delayed achievement of profitability.

In recent years, various legislative proposals have been offered in the U.S. Congress and in some state legislatures that include major changes in the health care system. These proposals have included price or patient reimbursement constraints on medicines and restrictions on access to certain products. We cannot predict the outcome of such initiatives, and it is difficult to predict the future impact of the broad and expanding legislative and regulatory requirements affecting us.

We depend on key personnel and may not be able to retain these employees or recruit additional qualified personnel, which would harm our ability to compete.

We are highly dependent upon qualified scientific, technical and managerial personnel, including our President and CEO, Michel de Rosen, our Vice President, Chief Operating Officer and Chief Financial Officer, Vincent J. Milano, our Vice President and Chief Scientific Officer, Colin Broom, and our Vice President and Chief Commercial Officer, Joshua Tarnoff. Our ability to grow and expand into new areas and activities will require additional expertise and the addition of new qualified personnel. There is intense competition for qualified personnel in the pharmaceutical field. Therefore, we may not be able to attract and retain the qualified personnel necessary for the development of our business. Furthermore, we have not entered into non-competition agreements or employment agreements with our key employees. The loss of the services of existing personnel, as well as the failure to recruit additional key scientific, technical and managerial personnel in a timely manner, would harm our development programs, and our ability to manage day-to-day operations, attract collaboration partners, attract and retain other employees and generate revenues. We do not maintain key man life insurance on any of our employees.

We may be subject to product liability claims, which can be expensive, difficult to defend and may result in large judgments or settlements against us.

The administration of drugs to humans, whether in clinical trials or after marketing clearance is obtained, can result in product liability claims. Product liability claims can be expensive, difficult to defend and may result in large judgments or settlements against us. In addition, third party collaborators and licensees may not protect us from product liability claims.

We currently maintain product liability insurance in connection with our clinical development programs and marketing of Vancocin. We may not be able to obtain or maintain adequate protection against potential liabilities arising from clinical development or product sales. If we are unable to obtain sufficient levels of insurance at acceptable cost or otherwise protect against potential product liability claims, we will be exposed to product liability claims. A successful product liability claim in excess of our insurance coverage could harm our financial condition, results of operations and prevent or interfere with our product commercialization efforts. In addition, any successful claim may prevent us from obtaining adequate product liability insurance in the future on commercially desirable terms. Even if a claim is not successful, defending such a claim may be time-consuming and expensive.

We previously used hazardous materials in our business and any claims relating to improper handling, storage or disposal of these materials could be time consuming and costly.

Prior to our restructuring in January 2004, we used radioactive and other materials that could be hazardous to human health, safety or the environment. In connection with our restructuring in January 2004, we decommissioned our discovery laboratories, which required the disposal of many of these materials. We are subject to stringent federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge, handling and disposal of certain materials and wastes. We stored these materials and various wastes resulting from their use at our

facility pending ultimate use and disposal. Although we believe that our safety procedures for handling and disposing of such materials comply with federal, state and local laws, rules, regulations and policies, the risk of accidental injury or contamination from these materials cannot be entirely eliminated. We may be required to incur significant costs to comply with environmental laws, rules, regulations and policies. Additionally, if an accident occurs, we could be held liable for any resulting damages, and any such liability could exceed our resources. We do not maintain a separate insurance policy for these types of risks and we do not have reserves set aside for environmental claims. Any future environmental claims could harm our financial conditions, results of operations, liquidity and prevent or interfere with our product commercialization efforts. In addition, compliance with future environmental laws, rules, regulations and policies could lead to additional costs and expenses.

The rights that have been and may in the future be granted to holders of our common or preferred stock may adversely affect the rights of other stockholders and may discourage a takeover.

Our board of directors has the authority to issue up to 4,800,000 shares of preferred stock and to determine the price, privileges and other terms of such shares. Our board of directors may exercise this authority without the approval of, or notice to, our stockholders. Accordingly, the rights of the holders of our common stock may be adversely affected by the rights of the holders of any preferred stock that may be issued in the future. In addition, the issuance of preferred stock may make it more difficult for a third party to acquire a majority of our outstanding voting stock in order to effect a change in control or replace our current management. We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. The application of Section 203 could also delay or prevent a third party or a significant stockholder of ours from acquiring control of us or replacing our current management. In general, Section 203 prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder for a period of three years following the date the person became an interested stockholder, unless the business combination or the transaction in which the person became an interested stockholder is approved in a prescribed manner. Generally, a business combination includes a merger, asset or stock sale, or other transaction resulting in a financial benefit to the interested stockholder. Under Delaware law, an interested stockholder is a person who, together with affiliates and associates, owns 15% or more of a corporation’s voting stock.

In September 1998, our board of directors adopted a plan that grants each holder of our common stock the right to purchase shares of our series A junior participating preferred stock. This plan is designed to help insure that all our stockholders receive fair value for their shares of common stock in the event of a proposed takeover of us, and to guard against the use of partial tender offers or other coercive tactics to gain control of us without offering fair value to the holders of our common stock. In addition, our charter and bylaws contain certain provisions that could discourage a hostile takeover, such as a staggered board of directors and significant notice provisions for nominations of directors and proposals. The plan and our charter and bylaws may make it more difficult for a third party to acquire a majority of our outstanding voting stock in order to effect a change in control or replace our current management.

Our stock price could continue to be volatile.

Our stock price, like the market price of the stock of other pharmaceutical companies, has been volatile. For example, during the twelve months ended March 31, 2006, the market price for our common stock fluctuated between $1.67 and $24.36 per share. The following factors, among others, could have a significant impact on the market for our common stock:

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announcements regarding potential generic competition, including the status of changes to the OGD’s approach to approval of a generic Vanocin;

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the development of competitive generic versions of oral Vancocin, approval of products which are currently marketed for other indications by other companies or new pharmaceuticals and technological advances to treat the conditions addressed by Vancocin;

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period to period fluctuations in sales of Vancocin;

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results of clinical trials with respect to our product candidates in development or those of our competitors;

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developments with our collaborators;

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announcements of technological innovations or new products by our competitors;

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litigation or public concern relating to our products or our competitors’ products;

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developments in patent or other proprietary rights of ours or our competitors (including related litigation);

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any other future announcements concerning us or our competitors;

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any announcement regarding our acquisition of product candidates or entities;

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future announcements concerning our industry;

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governmental regulation;

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actions or decisions by the SEC, the FDA or other regulatory agencies;

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changes or announcements of changes in reimbursement policies;

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period to period fluctuations in our operating results, including changes in accounting estimates;

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our cash and cash equivalents balances;

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changes in our capital structure;

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changes in estimates of our performance by securities analysts;

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market conditions applicable to our business sector; and

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general market conditions.

Future sales of our common stock in the public market could adversely affect our stock price.

We cannot predict the effect, if any, that future sales of our common stock or the availability for future sale of shares of our common stock or securities convertible into or exercisable for our common stock will have on the market price of our common stock prevailing from time to time. We have an effective registration statement on Form S-3 which allows us to sell up to $39 million of securities in one or more public offerings. The registration statement provides us with the flexibility to determine the type of security we choose to sell, including common stock, preferred stock, warrants and debt securities, as well as the ability to time such sales when market conditions are favorable. Additionally, we have another effective registration statement on Form S-3 which permits the holders of up to 33.8 million shares of our common stock received upon conversion of our senior convertible notes to resell these shares from time to time.

As of March 31, 2006 we had outstanding options to purchase 2,992,283 shares of our common stock at a weighted average exercise price of $8.05 per share (1,335,820 of which have not yet vested) issued to employees, directors and consultants pursuant to our 1995 Stock Option and Restricted Share Plan, outstanding options to purchase 551,500 shares of our common stock at a weighted average exercise price of $19.73 per share (551,500 of which have not yet vested) issued to employees, directors and consultants pursuant to our 2005 Stock Option and Restricted Share Plan and outstanding options to purchase 76,198 shares of our common stock at a weighted average exercise price of $1.43 per share (16,249 of which have not yet vested) to non-executive employees pursuant to our 2001 Equity Incentive Plan. In order to attract and retain key personnel, we may issue additional securities, including stock options, restricted stock grants and shares of common stock, in connection with our employee benefit plans, or may lower the price of existing stock options. Sale, or the availability for sale, of substantial amounts of common stock by our existing stockholders pursuant to an effective registration statement or under Rule 144, through the exercise of registration rights or the issuance of shares of common stock upon the exercise of stock options or warrants, or the perception that such sales or issuances could occur, could adversely affect the prevailing market prices for our common stock.

ITEM 6. Exhibits

List of Exhibits:


31.1		Certification by Chief Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification by Chief Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	VIROPHARMA INCORPORATED

Date: May 4, 2006	By:	/s/ Michel de Rosen
		Michel de Rosen President, Chief Executive Officer and Chairman of the Board of Directors (Principal Executive Officer)

	By:	/s/ Vincent J. Milano
		Vincent J. Milano Vice President, Chief Operating Officer, Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)