ViroPharma, Inc. -- Form 10-Q
Table of Contents

 

 

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 September 30, 2011

or

 

¨ 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.)

730 Stockton Drive

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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

Large Accelerated Filer  x        Accelerated Filer  ¨        Non-accelerated Filer  ¨        Smaller Reporting Company  ¨

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 October 18, 2011: 70,542,868 shares.

 

 

 


Table of Contents

VIROPHARMA INCORPORATED

INDEX

 

         Page  

PART I

  FINANCIAL INFORMATION   

Item 1.

  Financial Statements   
 

Condensed Consolidated Balance Sheets (unaudited) at September 30, 2011 and December 31, 2010

     3   
 

Consolidated Statements of Operations (unaudited) for the three and nine months ended September 30, 2011 and 2010

     4   
 

Consolidated Statement of Stockholders’ Equity (unaudited) for the nine months ended September 30, 2011

     5   
 

Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2011 and 2010

     6   
 

Notes to the Consolidated Financial Statements (unaudited)

     7   

Item 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      22   

Item 3.

  Quantitative and Qualitative Disclosures About Market Risk      38   

Item 4.

  Controls and Procedures      39   

PART II

  OTHER INFORMATION   

Item 1.

  Legal Proceedings      40   

Item 1A.

  Risk Factors      41   

Item 2.

  Unregistered Sales of Equity Securities and Use of Proceeds      43   

Item 6.

  Exhibits      44   

SIGNATURES

     45   

 

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Table of Contents

ViroPharma Incorporated

Condensed Consolidated Balance Sheets

(unaudited)

 

(in thousands, except share and per share data)    September 30,     December 31,  
   2011     2010  

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 340,553      $ 426,732   

Short-term investments

     119,806        78,439   

Accounts receivable, net

     69,368        43,879   

Inventory

     64,387        54,388   

Prepaid expenses and other current assets

     12,648        13,959   

Prepaid income taxes

     3,606        2,000   

Deferred income taxes

     10,066        13,744   
  

 

 

   

 

 

 

Total current assets

     620,434        633,141   

Intangible assets, net

     595,321        619,712   

Property, equipment and building improvements, net

     12,597        11,468   

Goodwill

     6,290        6,228   

Debt issue costs, net

     3,723        2,397   

Deferred income taxes

     11,659        4,252   

Other assets

     4,724        10,376   
  

 

 

   

 

 

 

Total assets

   $ 1,254,748      $ 1,287,574   
  

 

 

   

 

 

 

Liabilities and Stockholders’ Equity

    

Current liabilities:

    

Accounts payable

   $ 12,673      $ 10,215   

Contingent consideration

     —          10,973   

Accrued expenses and other current liabilities

     72,713        48,990   

Income taxes payable

     3,469        1,944   
  

 

 

   

 

 

 

Total current liabilities

     88,855        72,122   

Other non-current liabilities

     2,066        2,463   

Deferred tax liability

     166,889        176,111   

Long-term debt

     151,456        145,743   
  

 

 

   

 

 

 

Total liabilities

     409,266        396,439   
  

 

 

   

 

 

 

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

     —          —     

Common stock, par value $0.002 per share. 175,000,000 shares authorized; issued and outstanding 70,542,125 shares at September 30, 2011 and 78,141,491 shares at December 31, 2010

     157        156   

Treasury shares, at cost. 8,151,583 shares at September 30, 2011 and 0 shares at December 31, 2010

     (148,884     —     

Additional paid-in capital

     733,761        717,375   

Accumulated other comprehensive loss

     (895     (258

Retained earnings

     261,343        173,862   
  

 

 

   

 

 

 

Total stockholders’ equity

     845,482        891,135   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 1,254,748      $ 1,287,574   
  

 

 

   

 

 

 

See accompanying notes to unaudited consolidated financial statements.

 

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ViroPharma Incorporated

Consolidated Statements of Operations

(unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
(in thousands, except per share data)    2011     2010     2011     2010  

Revenues:

        

Net product sales

   $ 142,956      $ 117,781      $ 398,792      $ 317,389   

Costs and Expenses:

        

Cost of sales (excluding amortization of product rights)

     20,115        15,755        60,293        43,354   

Research and development

     22,927        10,188        53,770        29,153   

Selling, general and administrative

     31,353        24,991        91,729        71,333   

Intangible amortization

     7,208        7,079        23,261        22,273   

Other operating expenses

     10,863        532        16,889        532   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total costs and expenses

     92,466        58,545        245,942        166,645   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating income

     50,490        59,236        152,850        150,744   

Other Income (Expense):

        

Interest income

     121        113        515        232   

Interest expense

     (3,142     (2,915     (9,165     (8,656

Other (expense) income, net

     (2,949     5,138        410        1,336   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income before income tax expense

     44,520        61,572        144,610        143,656   

Income tax expense

     16,281        23,233        57,129        55,515   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 28,239      $ 38,339      $ 87,481      $ 88,141   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income per share:

        

Basic

   $ 0.38      $ 0.49      $ 1.15      $ 1.13   

Diluted

   $ 0.35      $ 0.45      $ 1.04      $ 1.04   

Shares used in computing net income per share:

        

Basic

     73,808        77,895        75,871        77,744   

Diluted

     87,278        90,081        89,242        89,911   

See accompanying notes to unaudited consolidated financial statements.

 

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ViroPharma Incorporated

Consolidated Statements of Stockholders’ Equity

(unaudited)

 

     Preferred Stock      Common Stock      Treasury Shares     Additional
paid-in
capital
     Accumulated
other
comprehensive
income (loss)
    Retained
Earnings
     Total
stockholders’
equity
 
(in thousands)    Number
of
shares
     Amount      Number
of
shares
    Amount      Number
of
shares
     Amount            

Balance, December 31, 2010

     —         $ —           78,141      $ 156         —         $ —        $ 717,375       $ (258   $ 173,862       $ 891,135   

Exercise of common stock options

     —           —           514        1         —           —          3,847         —          —           3,848   

Employee stock purchase plan

     —           —           38        —           —           —          452         —          —           452   

Share-based compensation

     —           —           —          —           —           —          10,871         —          —           10,871   

Unrealized gains on available for sale securities, net

     —           —           —          —           —           —          —           12        —           12   

Cumulative translation adjustment, net

     —           —           —          —           —           —          —           (649     —           (649

Repurchase of shares

     —           —           (8,151     —           8,151         (148,884     —           —          —           (148,884

Stock option tax benefits

     —           —           —          —           —           —          1,216         —          —           1,216   

Net income

     —           —           —          —           —           —          —           —          87,481         87,481   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Balance, September 30, 2011

     —         $ —           70,542      $ 157         8,151       $ (148,884   $ 733,761       $ (895   $ 261,343       $ 845,482   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

See accompanying notes to unaudited consolidated financial statements.

 

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ViroPharma Incorporated

Consolidated Statements of Cash Flows

(unaudited)

 

     Nine Months Ended
September 30,
 
(in thousands)    2011     2010  

Cash flows from operating activities:

    

Net income

   $ 87,481      $ 88,141   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Non-cash share-based compensation expense

     10,871        8,359   

Non-cash interest expense

     6,036        5,573   

Non-cash charge for contingent consideration

     4,663        532   

Deferred tax provision

     (13,132     11,204   

Depreciation and amortization expense

     25,058        23,687   

Impairment charge

     8,496     

Other, net

     3,457        (1,371

Changes in assets and liabilities:

    

Accounts receivable

     (25,467     (12,105

Inventory

     (9,954     (4,814

Prepaid expenses and other current assets

     (1,335     (2,282

Prepaid income taxes and taxes payable

     (84     11,218   

Other assets

     5,921        (4,200

Accounts payable

     2,184        3,275   

Accrued expenses and other current liabilities

     23,790        10,577   

Payment of contingent consideration

     (6,019     —     

Other non-current liabilities

     (399     (367
  

 

 

   

 

 

 

Net cash provided by operating activities

     121,567        137,427   

Cash flows from investing activities:

    

Purchase of Auralis, net of cash acquired

     —          (13,152

Purchase of Vancocin assets

     (7,000     (7,000

Purchase of property, equipment and building improvements

     (2,943     (2,082

Purchase of short-term investments

     (118,328     (64,761

Maturities of short-term investments

     76,058        —     
  

 

 

   

 

 

 

Net cash used in investing activities

     (52,213     (86,995

Cash flows from financing activities:

    

Payment for treasury shares acquired

     (148,884     —     

Repayment of debt

     —          (1,575

Payment of financing costs

     (1,591     —     

Payment of contingent consideration

     (9,809     —     

Net proceeds from issuance of common stock

     4,300        2,053   

Excess tax benefits from share-based payment arrangements

     1,216        1,237   
  

 

 

   

 

 

 

Net cash (used in) provided by financing activities

     (154,768     1,715   

Effect of exchange rate changes on cash

     (765     142   

Net (decrease) increase in cash and cash equivalents

     (86,179     52,289   

Cash and cash equivalents at beginning of period

     426,732        331,672   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 340,553      $ 383,961   
  

 

 

   

 

 

 

See accompanying notes to unaudited consolidated financial statements.

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements

Note 1. Organization and Business Activities

ViroPharma Incorporated and subsidiaries is a global biotechnology company dedicated to the development and commercialization of products that address serious diseases, with a focus on products used by physician specialists or in hospital settings. We intend to grow through sales of our marketed products, through continued development of our product pipeline, expansion of sales into additional territories outside the United States and through potential acquisition or licensing of products or acquisition of companies. We expect future growth to be driven by sales of Cinryze, both domestically and internationally, sales of Buccolam in Europe, and by our primary development programs, including C1 esterase inhibitor and a non-toxigenic strain of C. difficile (VP20621).

We market and sell Cinryze in the United States for routine prophylaxis against angioedema attacks in adolescent and adult patients with hereditary angioedema (HAE). Cinryze is a C1 esterase inhibitor therapy for routine prophylaxis against HAE, also known as C1 inhibitor (C1-INH) deficiency, a rare, severely debilitating, life-threatening genetic disorder. Cinryze was acquired in October 2008 and in January 2010, we acquired expanded rights to commercialize Cinryze and future C1-INH derived products in certain European countries and other territories throughout the world as well as rights to develop future C1-INH derived products for additional indications. In June 2011, the European Commission granted us Centralized Marketing Authorization for Cinryze® in adults and adolescents with HAE for routine prevention, pre-procedure prevention and acute treatment of angioedema attacks. The approval also includes a self administration option for appropriately trained patients. We have begun to commercialize Cinryze in Europe and continue to evaluate our commercialization plans in countries where we have distribution rights.

We also 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 infection (CDI), or C. difficile, and enterocolitis caused by Staphylococcus aureus, including methicillin-resistant strains.

In May 2010, we acquired Auralis Limited, a UK based specialty pharmaceutical company. The acquisition of Auralis provides us with the opportunity to accelerate our European commercial systems for potential future product launches and additional business development acquisitions. In connection with the Auralis acquisition, we acquired Buccolam® (Oromucosal Solution, Midazolam [as hydrochloride]). In September of 2011, the European Commission granted a Centralized Pediatric Use Marketing Authorization (PUMA) for Buccolam, for treatment of prolonged, acute, convulsive seizures in infants, toddlers, children and adolescents, from 3 months to less than 18 years of age. We intend to begin commercialization of Buccolam during the fourth quarter of 2011. The acquisition also provides us revenue from sales of Diamorphine (Diamorphine Hydrochloride BP Injection) for palliative care and acute pain relief in the United Kingdom.

Our product development portfolio is primarily focused on three programs, C1 esterase inhibitor [human], VP20621 and OX1.

We are working on developing further therapeutic uses, potential additional indications in other C1 mediated diseases, and alternative modes of administration for C1 esterase inhibitor. We are currently undertaking studies on the viability of subcutaneous administration of Cinryze. We intend to conduct ViroPharma sponsored studies and investigator-initiated studies (IIS) to identify further therapeutic uses and potentially expand the labeled indication for Cinryze to include other C1 mediated diseases, such as Antibody-Mediated Rejection (AMR) and Delayed Graft Function (DGF). Additionally, in May 2011, Halozyme Therapeutics (Halozyme) granted us an exclusive worldwide license to use Halozyme’s proprietary Enhanze™ technology, a proprietary drug delivery platform using Halozyme’s recombinant human hyaluronidase enzyme (rHuPH20) technology in combination with a C1 esterase inhibitor. We intend to apply rHuPH20 initially to develop an alternative subcutaneous formulation of Cinryze for routine prophylaxis against attacks of HAE. In September 2011, we initiated a Phase 2 study to evaluate the safety, and pharmacokinetics and pharmacodynamics of subcutaneous administration of Cinryze in combination with rHuPH20.

We are also developing VP20621 for the treatment and prevention of CDI. In May 2011, we initiated a Phase 2 dose-ranging clinical study to evaluate the safety, tolerability, and efficacy of VP 20621 for prevention of recurrence of CDI in adults previously treated for CDI.

On September 30, 2011, entered into a license agreement for the worldwide rights of Intellect Neurosciences, Inc. (INS) to its clinical stage drug candidate, OX1, which we expect to develop for the treatment of Friedreich’s Ataxia (FA), a rare, hereditary, progressive neurodegenerative disease. OX1, or indole-3-propionic acid (IPA), is a naturally occurring, small molecule that has potent anti-oxidant properties that can protect against neurodegenerative disease. In a recent Phase 1 safety and tolerability study conducted in the Netherlands, OX1 was demonstrated to be safe and well tolerated at all dose levels tested. We expect to initiate a phase 2 study within 12 to 18 months of the date of this agreement, after completion of longer-term toxicology studies. We intend to file for Orphan Drug Designation upon review of the phase 2 proof of concept data.

Under the terms of the agreement, we have exclusive worldwide rights to develop and commercialize OX1 for the treatment, management or prevention of any disease or condition covered by Intellect’s patents. We paid INS a $6.5 million up-front licensing fee

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

and may pay additional milestones up to $120 million based upon defined events. We will also pay a tiered royalty of up to a maximum percentage of low teens, based on annual net sales.

In addition to these programs, we have several other assets that we may make additional investments in. These investments will be limited and dependent on our assessment of the potential future commercial success of or benefits from the asset. These assets include maribavir for CMV and other compounds.

Basis of Presentation

The consolidated financial information at September 30, 2011 and for the three and nine months ended September 30, 2011 and 2010, 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, 2010 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Use of Estimates

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

Subsequent Events

We have evaluated all subsequent events through the date the financial statements were issued, and have not identified any such events.

Adoption of Standards

In September 2009, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. This ASU amends certain disclosure requirements of Topic 820 to provide for additional disclosures for transfers in and out of Levels 1 and 2 and for activity in Level 3. The ASU also clarifies certain other disclosure requirements including level of disaggregation and disclosures around inputs and valuation techniques. We adopted this ASU on January 1, 2010. The new disclosures about the purchases, sales, issuances and settlements in the roll forward activity for Level 3 fair value measurements are effective for fiscal years beginning after December 15, 2010 and we adopted this provision on January 1, 2011. The adoption of this disclosure provision did not have a material impact on our results of operations, cash flows, and financial position.

In October 2009, the FASB issued ASU No. 2009-13, Multiple-Deliverable Revenue Arrangements, or ASU 2009-13, formerly EITF Issue No. 08-1. ASU 2009-13, which amends existing revenue recognition accounting pronouncements that are currently within the scope of FASB ASC Topic 605 and provides accounting principles and application guidance on how the arrangement should be separated, and the consideration allocated. This guidance changes how to determine the fair value of undelivered products and services for separate revenue recognition. Allocation of consideration is now based on management’s estimate of the selling price for an undelivered item where there is no other means to determine the fair value of that undelivered item. This new approach is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. We adopted this ASU January 1, 2011. The adoption of the provisions of this guidance did not have a material impact on our results of operations, cash flows, and financial position.

In March 2010, the FASB ratified EITF Issue No. 08-9, Milestone Method of Revenue Recognition, and as a result of this ratification the FASB issued ASU 2010-17 in April 2010, which states that the milestone method is a valid application of the proportional performance model for revenue recognition if the milestones are substantive and there is substantive uncertainty about whether the milestones will be achieved. The Task Force agreed that whether a milestone is substantive is a judgment that should be made at the inception of the arrangement. To meet the definition of a substantive milestone, the consideration earned by achieving the milestone (1) would have to be commensurate with either the level of effort required to achieve the milestone or the enhancement in the value of the item delivered, (2) would have to relate solely to past performance, and (3) should be reasonable relative to all deliverables and payment terms in the arrangement. No bifurcation of an individual milestone is allowed and there can be more than one milestone in an arrangement. The new guidance is effective for interim and annual periods beginning on or after June 15, 2010. We adopted this ASU January 1, 2011. The adoption of this guidance did not have a material impact on our results of operations, cash flows, and financial position.

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

In December 2010, the FASB issued ASU 2010-27, Fees Paid to the Federal Government by Pharmaceutical Manufactures (EITF Issue 10-D; ASC 720), which addresses how pharmaceutical manufacturers should recognize and classify in the income statement fees mandated by the Patient Protection and Affordable Care Act as amended by the Health Care Education Reconciliation Act. The ASU specifies that the liability for the fee be estimated and recorded in full upon the first qualifying sale with a corresponding deferred cost that is amortized to operating expense using a straight-line method of allocation unless another method better allocates the fee over the calendar year. The new guidance is effective for calendar years beginning after December 31, 2010. We adopted this ASU January 1, 2011. The adoption of this guidance does not have a material impact on our results of operations, cash flows, and financial position.

In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, and the IASB issued IFRS 13, Fair Value Measurement. The new guidance results in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between U.S. GAAP and IFRS. The ASU is effective for interim and annual periods beginning on or after December 15, 2011, with early adoption prohibited. The new guidance changes certain fair value measurement principles and disclosure requirements. We do not expect the amendment to U.S. GAAP to have a material impact on our results of operations, cash flows, and financial position.

In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income (Topic 220). This standard eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. The standard is intended to enhance comparability between entities that report under US GAAP and those that report under IFRS, and to provide a more consistent method of presenting non-owner transactions that affect an entity’s equity. Under the ASU, an entity can elect to present items of net income and other comprehensive income in one continuous statement, referred to as the statement of comprehensive income, or in two separate, but consecutive, statements. Each component of net income and each component of other comprehensive income, together with totals for comprehensive income and its two parts, net income and other comprehensive income, would need to be displayed under either alternative. The statement(s) would need to be presented with equal prominence as the other primary financial statements. This ASU does not change items that constitute net income and other comprehensive income, when an item of other comprehensive income must be reclassified to net income or the earnings-per-share computation (which will continue to be based on net income). The new US GAAP requirements are effective for public entities as of the beginning of a fiscal year that begins after December 15, 2011 and interim and annual periods thereafter. Early adoption is permitted, but full retrospective application is required under the accounting standard. We do not expect the amendment to U.S. GAAP to have a material impact on our results of operations, cash flows, and financial position.

In September 2011, the FASB issued ASU 2011-08, Testing Goodwill for Impairment (the revised standard) (Topic 350). The objective of this Update is to simplify how entities test goodwill for impairment. The amendments in the Update provide the option to first assess qualitative factors to determine whether it is necessary to perform the current two-step test. If an entity believes, as a result of its qualitative assessment, that it is more-likely-than-not (a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. The revised standard includes examples of events and circumstances that might indicate that a reporting unit’s fair value is less than its carrying amount. These include macro-economic conditions such as deterioration in the entity’s operating environment, entity-specific events such as declining financial performance, and other events such as an expectation that a reporting unit will be sold. An entity should also consider in its qualitative assessment the “cushion” between a reporting unit’s fair value and carrying amount if determined in a recent fair value calculation. The revised standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, if a company has not yet issued financial statements for the most recent annual or interim period, provided that the entity has not yet performed its 2011 annual impairment test. We do not expect the adoption of this guidance to have a material impact on our results of operations, cash flows, and financial position.

Note 2. Short-Term Investments

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

Short-term investments consist of fixed income securities with remaining maturities of greater than three months at the date of purchase, debt securities and equity securities. At September 30, 2011, all of our short-term investments are classified as available for sale investments and measured as level 1 instruments of the fair value measurements standard.

The following summarizes the Company’s available for sale investments at September 30, 2011:

 

(in thousands)    Cost      Gross
unrealized
gains
     Gross
unrealized
losses
     Fair value  

September 30, 2011

           

Debt securities:

           

U.S. Treasury

   $ 73,470       $ 37       $ 16       $ 73,491   

Corporate

     46,315         19         19         46,315   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 119,785       $ 56       $ 35       $ 119,806   
  

 

 

    

 

 

    

 

 

    

 

 

 

Maturities of investments were as follows:

           

Less than one year

     91,634         55         13         91,676   

Greater than one year

     28,151         1         22         28,130   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 119,785       $ 56       $ 35       $ 119,806   
  

 

 

    

 

 

    

 

 

    

 

 

 

Note 3. Inventory

Inventory is stated at the lower of cost or market using actual cost.

 

(in thousands)    September 30,
2011
     December 31,
2010
 

Raw Materials

   $ 54,614       $ 37,994   

Work In Process

     4,793         10,570   

Finished Goods

     4,980         5,824   
  

 

 

    

 

 

 

Total

   $ 64,387       $ 54,388   
  

 

 

    

 

 

 

Note 4. Intangible Assets

The following represents the balance of the intangible assets at September 30, 2011:

 

(in thousands)    Gross
Intangible
Assets
     Accumulated
Amortization
     Net
Intangible
Assets
 

Cinryze Product rights

   $ 521,000       $ 61,344       $ 459,656   

Vancocin Intangibles

     168,099         46,399         121,700   

Buccolam Product rights

     6,352         53         6,299   

Auralis Contract rights

     9,054         1,388         7,666   
  

 

 

    

 

 

    

 

 

 

Total

   $ 704,505       $ 109,184       $ 595,321   
  

 

 

    

 

 

    

 

 

 

 

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

The following represents the balance of the intangible assets at December 31, 2010:

 

(in thousands)    Gross
Intangible
Assets
     Accumulated
Amortization
     Net
Intangible
Assets
 

Cinryze Product rights

   $ 521,000       $ 45,714       $ 475,286   

Vancocin Intangibles

     161,099         39,629         121,470   

Auralis Contract rights

     12,365         601         11,764   

Auralis IPR&D (1)

     11,192         —           11,192   
  

 

 

    

 

 

    

 

 

 

Total

   $ 705,656       $ 85,944       $ 619,712   
  

 

 

    

 

 

    

 

 

 

 

  (1) non-amortizing

In December 2008, FDA changed its 2006 bioequivalence recommendation, which we have opposed since its original proposal in March 2006, by issuing draft guidance for establishing bioequivalence to Vancocin which would require generic products that have the same inactive ingredients in the same quantities as Vancocin (“Q1 and Q2 the same”) to demonstrate bioequivalence through comparative in-vitro dissolution testing. Under this latest proposed method, any generic product that is not Q1 and Q2 the same as Vancocin would need to conduct an in-vivo study with clinical endpoints to demonstrate bioequivalence with Vancocin.

On August 4, 2009 the FDA’s Pharmaceutical Science and Clinical Pharmacology Advisory Committee voted in favor of the component of OGD’s 2008 draft guidance on bioequivalence for Vancocin that permits bioequivalence to be demonstrated through comparable in vitro dissolution for potential vancomycin HCl capsule generic products that contain the same active and inactive ingredients in the same amounts as Vancocin, among other requirements. If FDA’s proposed bioequivalence method for Vancocin becomes effective, the time period in which a generic competitor could be approved would be reduced and multiple generics may enter the market, which would materially impact our operating results, cash flows and possibly intangible asset valuations. This could also result in a reduction to the useful life of the Vancocin-related intangible assets. Management currently believes there are no indicators that would require a change in useful life as management believes that Vancocin will continue to be utilized along with generics that may enter the market, and the number of generics and the timing of their market entry is unknown.

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. We will continue to monitor the actions of the FDA and consider the effects of our opposition actions and the announcements by generic competitors or other adverse events for additional impairment indicators. We will reevaluate the expected cash flows and fair value of our Vancocin-related assets at such time as a triggering event occurs.

We were obligated to pay Eli Lilly and Company (Lilly) additional purchase price consideration based on net sales of Vancocin within a calendar year through 2011. We accounted for these additional payments as additional purchase price which requires that the additional purchase price consideration is recorded as an increase to the intangible asset of Vancocin and is amortized over the remaining estimated useful life of the intangible asset. 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.

As of September 30, 2011, we have paid an aggregate of $51.1 million to Lilly in additional purchase price consideration, as our net sales of Vancocin surpassed the maximum obligation level of $65 million in 2005 through 2011. In June 30, 2011, we satisfied our obligations to Lilly to make additional purchase price consideration payments under the purchase agreement.

On May 28, 2010 we acquired Auralis Limited, a UK based specialty pharmaceutical company. With the acquisition of Auralis we added one marketed product and several development assets to our portfolio. We recognized an intangible asset related to certain supply agreements for the marketed product and one of the development assets. Additionally, we have recognized in-process research and development (IPR&D) assets related to the development assets which are currently not approved. We determined that these assets meet the criterion for separate recognition as intangible assets and the fair value of these assets have been determined based upon discounted cash flow models. The supply agreements will be amortized over their useful life of 12 years. The IPR&D assets used in research and development activities are classified as indefinite-lived and will be subject to periodic impairment testing. The IPR&D assets will remain as indefinite-lived intangible assets until the projects are completed or abandoned. Upon completion of the projects, we will make a separate determination of the useful life of the asset and begin amortization.

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

In September of 2011, the European Commission granted a Centralized Pediatric Use Marketing Authorization (PUMA) for Buccolam, for treatment of prolonged, acute, convulsive seizures in infants, toddlers, children and adolescents, from 3 months to less than 18 years of age. This asset was previously classified as an IPR&D asset. As a result of this approval we will begin to amortize this asset over its estimated useful life of 10 years.

Due to the approval and the pending launch of Buccolam, coupled with the approval and launch of Cinryze in Europe, we have decided to alter our development and commercialization plans for the remaining Auralis IPR&D asset. The decision resulted in the impairment of the IPR&D asset and the Auralis Contract rights. Accordingly, we recorded a charge of approximately £5.4 million (approximately $8.5 million) during the quarter ended September 30, 2011.

Note 5. Debt

Long-term debt as of September 30, 2011 and December 31, 2010 is summarized in the following table:

 

(in thousands)    September 30,
2011
     December 31,
2010
 

Senior convertible notes

   $ 151,456       $ 145,743   

less: current portion

     —           —     
  

 

 

    

 

 

 

Total debt principal

   $ 151,456       $ 145,743   
  

 

 

    

 

 

 

Convertible Notes

As of September 30, 2011 senior convertible notes representing $205.0 million of principal debt are outstanding with a carrying value of $151.5 million.

On March 26, 2007, we issued $250.0 million of 2% senior convertible notes due March 2017 (senior convertible notes) in a public offering. Net proceeds from the issuance of the senior convertible notes were $241.8 million. The senior convertible notes are unsecured unsubordinated obligations and rank equally with any other unsecured and unsubordinated indebtedness. The senior convertible notes bear interest at a rate of 2% per annum, payable semi-annually in arrears on March 15 and September 15 of each year commencing on September 15, 2007.

The debt and equity components of our senior convertible debt securities are bifurcated and accounted for separately based on the value and related interest rate of a non-convertible debt security with the same terms. The fair value of a non-convertible debt instrument at the original issuance date was determined to be $148.1 million. The equity (conversion options) component of our convertible debt securities is included in Additional paid-in capital on our Condensed Consolidated Balance Sheets and, accordingly, the initial carrying value of the debt securities was reduced by $101.9 million. Our net income for financial reporting purposes is reduced by recognizing the accretion of the reduced carrying values of our convertible debt securities to their face amount of $250.0 million as additional non-cash interest expense. Accordingly, the senior convertible debt securities will recognize interest expense at effective rates of 8.0% as they are accreted to par value.

On March 24, 2009 we repurchased, in a privately negotiated transaction, $45.0 million in principal amount of our senior convertible notes due March 2017 for total consideration of approximately $21.2 million. The repurchase represented 18% of our then outstanding debt and was executed at a price equal to 47% of par value. Additionally, in negotiated transactions, we sold approximately 2.38 million call options for approximately $1.8 million and repurchased approximately 2.38 million warrants for approximately $1.5 million which terminated the call options and warrants that were previously entered into by us in March 2007. We recognized a $9.1 million gain in the first quarter of 2009 as a result of this debt extinguishment. For tax purposes, the gain qualifies for deferral until 2014 in accordance with the provisions of the American Recovery and Reinvestment Act.

As of September 30, 2011, we have accrued $0.2 million in interest payable to holders of the senior convertible notes. Debt issuance costs of $4.8 million have been capitalized and are being amortized over the term of the senior convertible notes, with the balance to be amortized as of September 30, 2011 being $2.1 million.

The senior convertible notes are convertible into shares of our common stock at an initial conversion price of $18.87 per share. The senior convertible notes may only be converted: (i) anytime after December 15, 2016; (ii) during the five business-day period after any five consecutive trading day period (the “measurement period”) in which the price per note for each trading day of that measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such day; (iii) during any calendar quarter (and only during such quarter) after the calendar quarter ending June 30, 2007, if the last reported sale price of our common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

immediately preceding calendar quarter exceeds 130% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; or (iv) upon the occurrence of specified corporate events. Upon conversion, holders of the senior convertible notes will receive shares of common stock, subject to ViroPharma’s option to irrevocably elect to settle all future conversions in cash up to the principal amount of the senior convertible notes, and shares for any excess. We can irrevocably elect this option at any time on or prior to the 35th scheduled trading day prior to the maturity date of the senior convertible notes. The senior convertible notes may be required to be repaid on the occurrence of certain fundamental changes, as defined in the senior convertible notes. As of September 30, 2011, the fair value of the principal of the $205.0 million convertible senior notes outstanding was approximately $248.1 million, based on the level 2 valuation hierarchy of the fair value measurements standard.

Concurrent with the issuance of the senior convertible notes, we entered into privately-negotiated transactions, comprised of purchased call options and warrants sold, to reduce the potential dilution of our common stock upon conversion of the senior convertible notes. The transactions, taken together, have the effect of increasing the initial conversion price to $24.92 per share. The net cost of the transactions was $23.3 million.

The call options allow ViroPharma to receive up to approximately 13.25 million shares of its common stock at $18.87 per share from the call option holders, equal to the number of shares of common stock that ViroPharma would issue to the holders of the senior convertible notes upon conversion. These call options will terminate upon the earlier of the maturity dates of the related senior convertible notes or the first day all of the related senior convertible notes are no longer outstanding due to conversion or otherwise. Concurrently, we sold warrants to the warrant holders to receive shares of its common stock at an exercise price of $24.92 per share. These warrants expire ratably over a 60-day trading period beginning on June 13, 2017 and will be net-share settled.

The purchased call options are expected to reduce the potential dilution upon conversion of the senior convertible notes in the event that the market value per share of ViroPharma common stock at the time of exercise is greater than $18.87, which corresponds to the initial conversion price of the senior convertible notes, but less than $24.92 (the warrant exercise price). The warrant exercise price is 75.0% higher than the price per share of $14.24 of our price on the pricing date. If the market price per share of ViroPharma common stock at the time of conversion of any senior convertible notes is above the strike price of the purchased call options ($18.87), the purchased call options will entitle us to receive from the counterparties in the aggregate the same number of shares of our common stock as we would be required to issue to the holder of the converted senior convertible notes. Additionally, if the market price of ViroPharma common stock at the time of exercise of the sold warrants exceeds the strike price of the sold warrants ($24.92), we will owe the counterparties an aggregate of approximately 13.25 million shares of ViroPharma common stock. If we have insufficient shares of common stock available for settlement of the warrants, we may issue shares of a newly created series of preferred stock in lieu of our obligation to deliver common stock. Any such preferred stock would be convertible into 10% more shares of our common stock than the amount of common stock we would otherwise have been obligated to deliver under the warrants. We are entitled to receive approximately 10.87 million shares of its common stock at $18.87 from the call option holders and if the market price of ViroPharma common stock at the time of exercise of the sold warrants exceeds the strike price of the sold warrants ($24.92), will owe the counterparties an aggregate of approximately 10.87 million shares of ViroPharma common stock.

The purchased call options and sold warrants are separate transactions entered into by us with the counterparties, are not part of the terms of the senior convertible notes, and will not affect the holders’ rights under the senior convertible notes. Holders of the senior convertible notes will not have any rights with respect to the purchased call options or the sold warrants. The purchased call options and sold warrants meet the definition of derivatives. These instruments have been determined to be indexed to our own stock and have been recorded in stockholders’ equity in our Condensed Consolidated Balance Sheets. As long as the instruments are classified in stockholders’ equity they are not subject to the mark to market provisions.

Credit Facility

On September 9, 2011, we entered into a $200 million, three-year senior secured revolving credit facility (the “Credit Facility”), the terms of which are set forth in a Credit Agreement dated as of September 9, 2011 (the “Credit Agreement”) with JPMorgan Chase Bank, N.A., as administrative agent, BMO Harris Financing Inc., TD Bank, N.A. and Morgan Stanley Bank, NA as co-syndication agents and certain other lenders.

The Credit Facility is available for working capital and general corporate purposes, including acquisitions which comply with the terms of the Credit Agreement. The Credit Agreement provides separate sub-limits for letters of credit up to $20 million and swing line loans up to $10 million.

The Credit Agreement requires us to maintain (i) a maximum senior secured leverage ratio of less than 2.00 to 1.00, (ii) a maximum total leverage ratio of less than 3.50 to 1.00, (iii) a minimum interest coverage ratio of greater than 3.50 to 1.00 and (iv) minimum liquidity equal to or greater than the sum of $100,000,000 plus the aggregate amount of certain contingent consideration payments resulting from business acquisitions payable by us within a specified time period. The Credit Agreement also contains certain other

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

usual and customary affirmative and negative covenants, including but not limited to, limitations on capital expenditures, asset sales, mergers and acquisitions, indebtedness, liens, dividends, investments and transactions with affiliates.

Our obligations under the Credit Facility are guaranteed by certain of our domestic subsidiaries (the “Subsidiary Guarantors”) and are secured by substantially all of our assets and the assets of the Subsidiary Guarantors. Borrowings under the Credit Facility will bear interest at an amount equal to a rate calculated based on the type of borrowing and our senior secured leverage ratio (as defined in the Credit Agreement) from time to time. For loans (other than swing line loans), we may elect to pay interest based on adjusted LIBOR plus between 2.25% and 2.75% or an Alternate Base Rate (as defined in the Credit Agreement) plus between 1.25% and 1.75%. We will also pay a commitment fee of between 35 to 45 basis points, payable quarterly, on the average daily unused amount of the Credit Facility based on our senior secured leverage ratio from time to time.

As of the date of this filing, we have not drawn any amounts under the Credit Facility.

As of September 30, 2011, we have accrued $0.0 million in interest expense for the revolver. Financing costs of approximately $1.6 million incurred to establish the Credit Facility were deferred and are being amortized to interest expense over the life of the Credit Facility, with an unamortized balance of $1.6 million as of September 30, 2011.

Note 6. Stockholder’s Equity

Preferred Stock

The Company’s Board of Directors has the authority, without action by the holders of common stock, to issue up to 5,000,000 shares of preferred stock from time to time in such series and with such preference and rights as it may designate.

Share Repurchase Program

On March 9, 2011, our Board of Directors authorized the use of up to $150 million to repurchase shares of our common stock and/or our 2% Senior Convertible Notes due 2017. Purchases may be made by means of open market transactions, block transactions, privately negotiated purchase transactions or other techniques from time to time.

On March 14, 2011, we entered into a three month accelerated share repurchase (ASR) agreement with a large financial institution to repurchase $50.0 million of our common stock on an accelerated basis. We paid $50.0 million to the financial institution and received approximately 2.7 million shares under this arrangement at an average purchase price of $18.74 per share.

During the third quarter of 2011, we reacquired approximately 5.5 million shares at a cost of approximately $98.9 million or an average price of $18.04 per share. These purchases effectively completed the repurchase program authorized by our board on March 9, 2011.

On September 14, 2011, our Board of Directors authorized the use of up to an additional $200 million to repurchase shares of our common stock and/or our 2% Senior Convertible Notes due 2017. Purchases may be made by means of open market transactions, block transactions, privately negotiated purchase transactions or other techniques from time to time.

Note 7. Share-based Compensation

Beginning in 2011, our stock-based compensation program consisted of a combination of: time vesting stock options with graduated vesting over a four year period; performance and market vesting common stock units, or PSUs, tied to the achievement of pre-established company performance metrics and market based goals over a three-year performance period; and, time vesting restricted stock awards, or RSUs, granted to our non-employee directors vesting over a one year period. Grants under our former stock based compensation program consisted only of time vesting stock options.

The fair values of our share-based awards are determined as follows:

 

   

Stock option grants are estimated as of the date of grant using a Black-Scholes option valuation model and compensation expense is recognized over the applicable vesting period;

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

   

PSUs subject to company specific performance metrics, which include both performance and service conditions, are based on the market value of our stock on the date of grant. Compensation expense is based upon the number of shares expected to vest after assessing the probability that the performance criteria will be met. Compensation expense is recognized over the vesting period, adjusted for any changes in our probability assessment;

 

   

PSUs subject to our total shareholder return, or TSR, market metric relative to a peer group of companies, which includes both market and service conditions, are estimated using a Monte Carlo simulation. Compensation expense is based upon the number and value of shares expected to vest. Compensation expense is recognized over the applicable vesting period. All compensation cost for the award will be recognized if the requisite service period is fulfilled, even if the market condition is never satisfied; and,

 

   

Time vesting RSUs are based on the market value of our stock on the date of grant. Compensation expense for time vesting RSUs is recognized over the vesting period.

The vesting period for our stock awards is the requisite service period associated with each grant.

Our share-based compensation expense is comprised of the following:

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
(in thousands)    2011      2010      2011      2010  

Stock options

   $ 3,268       $ 2,916       $ 9,302       $ 8,264   

Performance shares

     285         —           1,171         —     

Restricted shares

     117         —           283         —     

Employee Stock Purchase Plan

     38         35         115         95   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 3,708       $ 2,951       $ 10,871       $ 8,359   
  

 

 

    

 

 

    

 

 

    

 

 

 

Our share-based compensation expense is recorded as follows:

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
(in thousands)    2011      2010      2011      2010  

Research and development

   $ 904       $ 866       $ 2,890       $ 2,504   

Selling, general and administrative

     2,804         2,085         7,981         5,855   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 3,708       $ 2,951       $ 10,871       $ 8,359   
  

 

 

    

 

 

    

 

 

    

 

 

 

We currently have three shared-based award 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”).

The following table lists information about these equity plans at September 30, 2011:

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

     1995 Plan      2001 Plan      2005 Plan      Combined  

Shares authorized for issuance

     4,500,000         500,000         12,850,000         17,850,000   

Shares outstanding

     4,500,000         434,854         8,713,683         13,648,537   
  

 

 

    

 

 

    

 

 

    

 

 

 

Shares available for grant

     —           65,146         4,136,317         4,201,463   
  

 

 

    

 

 

    

 

 

    

 

 

 

Employee Stock Option Plans

We issued 1,778,278 stock options during the nine months ended September 30, 2011. The weighted average fair value of the grants was estimated at $ 11.37 per share using the Black-Scholes option-pricing model using the following assumptions:

 

Expected dividend yield

   -   

Range of risk free interest rate

     1.35%     -         2.87

Weighted-average volatility

   67.99%   

Range of volatility

   64.64%     -         69.32

Range of expected option life (in years)

   5.50     -         6.25   

We have 9,548,737 option grants outstanding at September 30, 2011 with exercise prices ranging from $0.99 per share to $25.90 per share and a weighted average remaining contractual life of 6.77 years. The following table lists the outstanding and exercisable option grants as of September 30, 2011:

 

     Number of
options
     Weighted
average exercise
price
     Weighted average
remaining
contractual term
(years)
     Aggregate intrinsic
value
 
              (in thousands)  

Outstanding

     9,548,737       $ 11.77         6.77       $ 61,248   

Exercisable

     5,345,422       $ 10.51         5.35       $ 41,387   

The following tables summarizes information regarding our stock option awards at September 30, 2011:

 

     Shares Under
Option
    Weighted Average
Exercise Price
 

Balance at December 31, 2010

     8,553,332      $ 10.45   

Granted

     1,778,278      $ 17.96   

Exercised

     (513,911   $ 7.49   

Forfeited and cancelled

     (268,962   $ 18.72   
  

 

 

   

Balance at September 30, 2011

     9,548,737      $ 11.77   
  

 

 

   

As of September 30, 2011, there was $28.9 million of total unrecognized compensation cost related to unvested share-based payments (including share options) granted under the Plans. That cost is expected to be recognized over a weighted-average period of 2.81 years.

Performance Awards

Beginning in 2011, employees receive annual grants of performance award units, or PSUs, in addition to stock options which give the recipient the right to receive common stock that is contingent upon achievement of specified pre-established company performance goals over a three year performance period. The performance goals for the PSUs granted in January 2011, which are accounted for as equity awards, are based upon the following performance measures: (i) our revenue growth over the performance period, (ii) our adjusted net income as a percent of sales at the end of the performance period, and (iii) our relative total shareholder return, or TSR, compared to a peer group of companies at the end of the performance period. Depending on the outcome of these performance goals, a

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

recipient may ultimately earn a number of shares greater or less than their target number of shares granted, ranging from 0% to 200% of the PSUs granted. Shares of our common stock are issued on a one-for-one basis for each PSU earned. Participants vest in their PSUs at the end of the performance period.

The fair value of the market condition PSUs was determined using a Monte Carlo simulation and utilized the following inputs and assumptions:

 

     Nine Months Ended
September 30,
 
(in thousands)    2011  

Closing stock price on grant date

   $ 17.84   

Performance period starting price

   $ 16.85   

Term of award (in years)

     2.99   

Volatility

     69.75

Risk-free interest rate

     1.19

Expected dividend yield

     0.00

Fair value per TSR PSU

   $ 24.38   

The performance period starting price is measured as the average closing price over the last 30 trading days prior to the performance period start. The Monte Carlo simulation model also assumed correlations of returns of the prices of our common stock and the common stocks of the comparator group of companies and stock price volatilities of the comparator group of companies.

At September 30, 2011, for the purposes of determining stock based compensation we assumed 253,721 and 16,928 performance condition PSUs and TSR based PSUs outstanding, respectively, with weighted-average grant date fair values of $ 17.84 and $ 24.38, respectively.

At September 30, 2011, there was approximately $ 3.7 million of unrecognized compensation cost related to all PSUs that is expected to be recognized over a weighted-average period of approximately 2.27 years.

The following table summarizes select information regarding our PSUs as of September 30, 2011:

 

     Share Units
(in thousands)
    Weighted-
average grant
date fair value
 

Balance at December 31, 2010

     —        $ —     

Granted

     173,107      $ 18.50   

Vested

     —        $ —     

Forfeited

     (4,250   $ 18.49   
  

 

 

   

Balance at September 30, 2011

     168,857      $ 18.50   
  

 

 

   

Restricted Stock Awards

Beginning in 2011, we also grant our non-employee directors restricted stock awards that vest after one year of service. The fair value of a restricted stock award is equal to the closing price of our common stock on the grant date. The following summarizes select information regarding our restricted stock awards as of September 30, 2011:

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

     Share Units
(in thousands)
     Weighted-
average grant
date fair value
 

Balance at December 31, 2010

     —         $ —     

Granted

     27,000       $ 17.30   

Vested

     —         $ —     

Forfeited

     —         $ —     
  

 

 

    

Balance at September 30, 2011

     27,000       $ 17.30   
  

 

 

    

As of September 30, 2011, there was approximately $ 0.18 million of unrecognized compensation cost related to RSUs that is expected to be recognized over a weighted average period of 0.39 years.

Employee Stock Purchase Plan

During the first nine months of 2011, 16,991 shares were sold to employees. During the year ended December 31, 2010, 48,909 shares were sold to employees. As of September 30, 2011 there are approximately 413,069 shares available for issuance under this plan.

Under this plan, there are two plan periods: January 1 through June 30 (Plan Period One) and July 1 through December 31 (Plan Period Two). For Plan Period One in 2011, the fair value of approximately $77,000 was estimated using the Type B model with a risk free interest rate of 0.19%, volatility of 37.8% and an expected option life of 0.5 years. This fair value is being amortized over the six month period ending June 30, 2011.

Note 8. Income Tax Expense

Our income tax expense was $16.3 million and $23.2 million for the quarters ended September 30, 2011 and 2010, respectively and $57.1 million and $55.5 million for the nine months ended September 30, 2011 and September 30, 2010, respectively. Our income tax expense includes federal, state and foreign income taxes at statutory rates and the effects of various permanent differences.

Our effective tax rates for the quarters ended September 30, 2011 and 2010 were 36.6% and 37.7%, respectively. For the nine months ended September 30, 2011 and September 30, 2010, our effective tax rates were 39.5% and 38.6%, respectively. Our effective tax rate is higher than the statutory U.S. tax rate in all periods primarily due to state income taxes and certain share-based compensation that is not tax deductible. In addition, the effective tax rates for the quarter and nine months ended September 30, 2011 are higher than the statutory U.S. tax rate due to an increase in the fair value of contingent consideration that is not deductible for tax purposes. The increase in the effective tax rate during 2011 caused by the above referenced items is partially offset by the recognition during the third quarter of 2011 of the tax benefit associated with domestic manufacturing tax deductions claimed.

During the nine months ended September 30, 2011, we had no material changes to our liability for uncertain tax positions. The examination of our 2008 U.S. income tax return concluded during the quarter ended March 31, 2011 with no material adjustments. Various state income tax returns are currently under examination. At this time, we do not believe that the results of these examinations will have a material impact on our financial statements.

Note 9. Comprehensive Income

The following table reconciles net income to comprehensive income for the three and nine months ended September 30, 2011 and 2010:

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
(in thousands)    2011     2010     2011     2010  

Net income

   $ 28,239      $ 38,339      $ 87,481      $ 88,141   

Other comprehensive:

        

Unrealized (loss) gains on available for sale securities, net (1)

     (35     27        13        31   

Currency translation adjustments, net

     (1,601     (77     (649     (776
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income

   $ 26,603      $ 38,289      $ 86,844      $ 87,396   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

  (1) Net of federal and state income taxes

Note 10. Earnings per share

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
(in thousands, except per share data)    2011      2010      2011      2010  

Basic Earnings Per Share

           

Net income

   $ 28,239       $ 38,339       $ 87,481       $ 88,141   

Common stock outstanding (weighted average)

     73,808         77,895         75,871         77,744   
  

 

 

    

 

 

    

 

 

    

 

 

 

Basic net income per share

   $ 0.38       $ 0.49       $ 1.15       $ 1.13   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted Earnings Per Share

           
           

Net income

   $ 28,239       $ 38,339       $ 87,481       $ 88,141   

Add interest expense on senior convertible notes, net of income tax

     1,936         1,802         5,663         5,357   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted net income

   $ 30,175       $ 40,141       $ 93,144       $ 93,498   

Common stock outstanding (weighted average)

     73,808         77,895         75,871         77,744   

Add shares from senior convertible notes

     10,864         10,864         10,864         10,864   

Add “in-the-money” stock options and stock awards

     2,606         1,322         2,507         1,303   
  

 

 

    

 

 

    

 

 

    

 

 

 

Common stock equivalents

     87,278         90,081         89,242         89,911   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted net income per share

   $ 0.35       $ 0.45       $ 1.04       $ 1.04   
  

 

 

    

 

 

    

 

 

    

 

 

 

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
September 30,
     Nine Months Ended
September 30,
 
(in thousands)    2011      2010      2011      2010  

“Out-of-the-money” stock options

     2,266         5,827         1,825         5,685   

Note 11. Fair Value Measurement

Valuation Hierarchy—GAAP establishes a valuation hierarchy for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

financial instrument. Level 3 inputs are unobservable inputs based on our own assumptions used to measure assets and liabilities at fair value. A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement.

The following table provides the assets and liabilities carried at fair value measured on a recurring basis as of September 30, 2011:

 

            Fair Value Measurements at September 30, 2011  

(in thousands)

   Total Carrying
Value at
September 30, 2011
     (Level 1)      (Level 2)      (Level 3)  

Cash and cash equivalents

   $ 340,553       $ 340,553       $ —         $ —     

Short term investments

   $ 119,806       $ 119,806       $ —         $ —     

Valuation Techniques—Cash, cash equivalents and short-term investments are measured at fair value using quoted market prices and are classified within Level 1 of the valuation hierarchy. There were no changes in valuation techniques during the quarter ended September 30, 2011.

There were no transfers into or out of Levels 1 and 2. The contingent consideration liability previously disclosed in Level 3 was settled during the third quarter of 2011. At June 30, 2011 this liability had a fair value of approximately $13.9 million. During the quarter, we recorded an additional charge to income of approximately $2.1 million, prior to the settlement of this liability.

We believe that the fair values of our current assets and current liabilities approximate their reported carrying amounts.

Note 12. Acquisitions

Auralis

On May 28, 2010 we acquired a 100% ownership interest in Auralis Limited, a UK based specialty pharmaceutical company for approximately $14.5 million in upfront consideration for the acquisition of the company and its existing pharmaceutical licenses and products. We also agreed to pay an additional payment of £10 million Pounds Sterling upon the first regulatory approval of Buccolam.

The acquisition provides us with the opportunity to accelerate our European commercial systems, which will be utilized in the commercial launch of Cinryze™ (C1 esterase inhibitor [human]) in Europe, for future product launches and potential additional business development acquisitions. The acquisition also provides immediate revenue from sales of a marketed product in the UK.

In September of 2011, the European Commission granted a Centralized Pediatric Use Marketing Authorization (PUMA) for Buccolam, and accordingly the additional consideration was paid. The U.S. dollar equivalent of the payment was approximately $15.8 million. The fair value of the contingent consideration recognized on the acquisition date ($9.0 million) was estimated by applying a discount rate based on an implied rate of return from the acquisition to the risk probability weighted asset cash flows and the expected approval date. This fair value was based on significant inputs not observable in the market, which are referred to in the guidance as Level 3 inputs. The contingent consideration was classified as a liability and was subject to the recognition of subsequent changes in fair value.

The results of Auralis’s operations have been included in the Consolidated Statement of Operations beginning June 1, 2010.

 

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ViroPharma Incorporated

Notes to the Unaudited Consolidated Financial Statements—(Continued)

 

$0.5 million as a result of the acquisition. As of the date of this filing, we have not received valuations from our independent valuation specialist, including the determination of the fair value of the contingent consideration given.

Note 13. Supplemental Cash Flow Information

 

     Nine Months Ended
September 30,
 
(in thousands)    2011      2010  

Supplemental disclosure of non-cash transactions:

     

Employee share-based compensation

   $ 10,871       $ 8,359   

Unrealized gains on available for sale securities, net

     12         31   

Supplemental disclosure of cash flow information:

     

Cash paid for income taxes

   $ 69,930       $ 31,742   

Cash paid for interest

     4,141         4,100   

Cash received for stock option exercises

     3,848         1,850   

Cash received for employee stock purchase plan

     368         271   

 

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

ViroPharma Incorporated and subsidiaries is a global biotechnology company dedicated to the development and commercialization of products that address serious diseases, with a focus on products used by physician specialists or in hospital settings. We intend to grow through sales of our marketed products, through continued development of our product pipeline, expansion of sales into additional territories outside the United States and through potential acquisition or licensing of products or acquisition of companies. We expect future growth to be driven by sales of Cinryze, both domestically and internationally, sales of Buccolam in Europe, and by our primary development programs, including C1 esterase inhibitor and a non-toxigenic strain of C. difficile (VP20621).

We market and sell Cinryze in the United States for routine prophylaxis against angioedema attacks in adolescent and adult patients with hereditary angioedema (HAE). Cinryze is a C1 esterase inhibitor therapy for routine prophylaxis against HAE, also known as C1 inhibitor (C1-INH) deficiency, a rare, severely debilitating, life-threatening genetic disorder. Cinryze was acquired in October 2008 and in January 2010, we acquired expanded rights to commercialize Cinryze and future C1-INH derived products in certain European countries and other territories throughout the world as well as rights to develop future C1-INH derived products for additional indications. In June 2011, the European Commission granted us Centralized Marketing Authorization for Cinryze® in adults and adolescents with HAE for routine prevention, pre-procedure prevention and acute treatment of angioedema attacks. The approval also includes a self administration option for appropriately trained patients. We have begun to commercialize Cinryze in Europe and continue to evaluate our commercialization plans in countries where we have distribution rights.

We also 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 infection (CDI), or C. difficile, and enterocolitis caused by Staphylococcus aureus, including methicillin-resistant strains.

In May 2010, we acquired Auralis Limited, a UK based specialty pharmaceutical company. The acquisition of Auralis provides us with the opportunity to accelerate our European commercial systems for potential future product launches and additional business development acquisitions. In connection with the Auralis acquisition, we acquired Buccolam® (Oromucosal Solution, Midazolam [as hydrochloride]). In September of 2011, the European Commission granted a Centralized Pediatric Use Marketing Authorization (PUMA) for Buccolam, for treatment of prolonged, acute, convulsive seizures in infants, toddlers, children and adolescents, from 3 months to less than 18 years of age. We intend to begin commercialization of Buccolam during the fourth quarter of 2011. The acquisition also provides us revenue from sales of Diamorphine (Diamorphine Hydrochloride BP Injection) for palliative care and acute pain relief in the United Kingdom.

Our product development portfolio is primarily focused on three programs, C1 esterase inhibitor [human], VP20621 and OX1.

We are working on developing further therapeutic uses, potential additional indications in other C1 mediated diseases, and alternative modes of administration for C1 esterase inhibitor. We are currently undertaking studies on the viability of subcutaneous administration of Cinryze. We intend to conduct ViroPharma sponsored studies and investigator-initiated studies (IIS) to identify further therapeutic uses and potentially expand the labeled indication for Cinryze to include other C1 mediated diseases, such as Antibody-Mediated Rejection (AMR) and Delayed Graft Function (DGF). Additionally, in May 2011, Halozyme Therapeutics (Halozyme) granted us an exclusive worldwide license to use Halozyme’s proprietary Enhanze™ technology, a proprietary drug delivery platform using Halozyme’s recombinant human hyaluronidase enzyme (rHuPH20) technology in combination with a C1 esterase inhibitor. We intend to apply rHuPH20 initially to develop an alternative subcutaneous formulation of Cinryze for routine prophylaxis against attacks of HAE. In September 2011, we initiated a Phase 2 study to evaluate the safety, and pharmacokinetics and pharmacodynamics of subcutaneous administration of Cinryze in combination with rHuPH20.

We are also developing VP20621 for the treatment and prevention of CDI. In May 2011, we initiated a Phase 2 dose-ranging clinical study to evaluate the safety, tolerability, and efficacy of VP 20621 for prevention of recurrence of CDI in adults previously treated for CDI.

On September 30, 2011, we entered into a license agreement for the worldwide rights of Intellect Neurosciences, Inc. (INS) to its clinical stage drug candidate, OX1, which we expect to develop for the treatment of Friedreich’s Ataxia (FA), a rare, hereditary, progressive neurodegenerative disease. OX1, or indole-3-propionic acid (IPA), is a naturally occurring, small molecule that has potent anti-oxidant properties that can protect against neurodegenerative disease. In a recent Phase 1 safety and tolerability study conducted in the Netherlands, OX1 was demonstrated to be safe and well tolerated at all dose levels tested. We expect to initiate a phase 2 study within 12 to 18 months of the date of this agreement, after completion of longer-term toxicology studies. We intend to file for Orphan Drug Designation upon review of the phase 2 proof of concept data.

 

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Under the terms of the agreement, we have exclusive worldwide rights to develop and commercialize OX1 for the treatment, management or prevention of any disease or condition covered by Intellect’s patents. We paid INS a $6.5 million up-front licensing fee and may pay additional milestones up to $120 million based upon defined events. We will also pay a tiered royalty of up to a maximum percentage of low teens, based on annual net sales.

In addition to these programs, we have several other assets that we may make additional investments in. These investments will be limited and dependent on our assessment of the potential future commercial success of or benefits from the asset. These assets include maribavir for CMV and other compounds.

Duocort Pharma AB

On October 26, 2011, we entered into an agreement to acquire a 100% ownership interest in Duocort Pharma AB (Duocort), a Swedish based specialty pharmaceutical company for approximately 220 million SEK (approximately $33 million) in cash. We have also agreed to pay future additional consideration upon the achievement of certain events. This additional consideration may range from 240 million SEK to 860 million SEK (approximately $37 million to $131 million). The closing of the transaction is subject to the prior satisfaction of certain conditions, which we anticipate will occur prior to year-end. Duocorts primary drug candidate, currently in development, is Plenadren, a once-daily duel-release hydrocortisone replacement therapy for patients with chronic adrenal insufficiency.

Executive Summary

Since June 30, 2011, we experienced the following:

Business Activities

Cinryze:

 

   

Shipped approximately 17,000 doses of Cinryze to specialty pharmacy/specialty distributors (SP/SD’s);

 

   

Initiated a Phase 2 study to evaluate the safety, and pharmacokinetics and pharmacodynamics of subcutaneous administration of Cinryze in combination with rHuPH20; and,

 

   

Began commercial sales of Cinryze in Europe;

Buccolam:

 

   

The European Commission granted a PUMA for Buccolam, we anticipate a product launch in the fourth quarter;

C. difficile infection (CDI):

 

   

Vancocin scripts decreased 0.9% in the third quarter of 2011 as compared to the third quarter of 2010; and,

 

   

Volume increased 7% compared to the third quarter of 2010;

Business Development:

 

   

Entered into the INS license agreement; and,

 

   

After the end of the quarter, entered into an agreement to acquire Duocort, which we anticipate will occur prior to year end;

Financial Results

 

   

Increased net sales of Cinryze to $65.4 million as compared to $49.1 million in the third quarter of 2010, or 33.2%;

 

   

Net sales of Vancocin increased to $76.6 million from $67.6 million in the third quarter of 2010, or 13.1%; and,

 

   

Reported net income of $28.2 million in the third quarter of 2011 compared to $38.3 million in the same quarter of 2010;

Liquidity

 

   

Generated net cash from operations of $121.6 million;

 

   

Entered into $200 million revolving credit facility;

 

   

Ended the third quarter of 2011 with working capital of $531.6 million, which includes cash and cash equivalents and short-term investments of $460.4 million; and

 

   

Repurchased an additional 5.5 million shares of our common stock at a cost of approximately $98.9 million that substantially completed the $150 million securities repurchase program previously announced, and we announced an additional $200 million buyback program.

 

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During the remainder of 2011 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 or disease incidence.

The FDA convened a meeting of its Advisory Committee for Pharmaceutical Science and Clinical Pharmacology to discuss bioequivalence recommendations for oral vancomycin hydrochloride capsule drug products on August 4, 2009. The Advisory Committee was asked if the proposed guidelines are sufficient for establishing bioequivalence for generic vancomycin oral capsules. The Advisory Committee voted unanimously in favor of the component of the proposed OGD recommendation that requires bioequivalence to be demonstrated through comparable dissolution in media of pH 1.2, 4.5 and 6.8 for potential vancomycin HCl capsule generic products that (a) contain the same active and inactive ingredients in the same amounts as Vancocin HCl capsules; (b) meet currently accepted standards for assay, potency, purity, and stability (equivalent to those in place for Vancocin HCl capsules); and (c) are manufactured according to cGMP. We have opposed both the substance of the FDA’s bioequivalence method and the manner in which it was developed. In the event the OGD’s revised bioequivalence recommendation for Vancocin remains in effect, the time period in which a generic competitor may enter the market would be reduced. There can be no assurance that the FDA will agree with the positions stated in our Vancocin related submissions or that our efforts to oppose the OGD’s March 2006 and December 2008 recommendation to determine bioequivalence to Vancocin through in-vitro dissolution testing will be successful. We cannot predict the timeframe in which the FDA will make a decision regarding either our citizen petition for Vancocin or the approval of generic versions of Vancocin. If we are unable to change the recommendation set forth by the OGD in March 2006 as revised in December 2008 and voted upon by the Advisory Committee for Pharmaceutical Science and Clinical Pharmacology, the threat of generic competition will be high.

The FDA approved Cinryze for routine prophylaxis against angioedema attacks in adolescent and adult patients with hereditary angioedema on October 10, 2008. Cinryze became commercially available for routine prophylaxis against HAE in December 2008. The commercial success of Cinryze depends on several factors, including: the number of patients with HAE that may be treated with Cinryze; manufacturing or supply interruptions and capacity which could impair our ability to acquire an adequate supply of Cinryze to meet demand for the product; and our ability to achieve expansion of manufacturing capabilities in the capacities and timeframes currently anticipated acceptance by physicians and patients of Cinryze as a safe and effective treatment; our ability to effectively market and distribute Cinryze in the United States; cost effectiveness of HAE treatment using Cinryze; relative convenience and ease of administration of Cinryze; potential advantages of Cinryze over alternative treatments; the timing of the approval of competitive products including another C1 esterase inhibitor for the acute treatment of HAE; the market acceptance of competing approved products such as Berinert; patients’ ability to obtain sufficient coverage or reimbursement by third-party payors; variations in dosing arising from physician preferences and patient compliance; sufficient supply and reasonable pricing of raw materials necessary to manufacture Cinryze; In addition, our ability to develop life cycle management plans for Cinryze, including designing and commencing clinical studies for additional indications and pursuing regulatory approvals in additional indications or territories will impact our ability to generate future revenues from Cinryze. In Europe, the European Commission has granted us Centralized Marketing Authorization for Cinryze in adults and adolescents with HAE for routine prevention, pre-procedure prevention and acute treatment of angioedema attacks. The approval also includes a self administration option for appropriately trained patients. In addition, the European Commission has granted us a PUMA for Buccolam. The commercial success of each of these products in Europe will depend on a number of factors, including the impact of the loss of orphan designation on Cinryze, market acceptance of each of the products and our ability to manufacture sufficient quantities of product to meet patient needs.

In March 2010, President Obama signed into law the Patient Protection and Affordable Care Act (PPACA), which was amended by the Health Care and Education Reconciliation Act of 2010. PPACA, as amended, is a sweeping measure intended to expand healthcare coverage within the United States, primarily through the imposition of health insurance mandates on employers and individuals and expansion of the Medicaid program. Several provisions of the new law, which have varying effective dates, will affect us. These include new requirements on private insurance companies that prohibit coverage denials because of a pre-existing condition; prohibit the application of annual and lifetime benefits limits on health insurance policies; and prohibit coverage rescissions (except for fraud) and health-based insurance rating. In addition, PPACA, as amended, funds an interim high risk pool that states can draw on; following the expiration of this high risk pool funding, it provides for the creation of state-run “exchanges” that will allow people without employer-provided coverage, or who cannot afford their employer’s plan, to buy health insurance; and provides federal subsidies to those who cannot afford premiums. Collectively, these factors may increase the availability of reimbursement for patients seeking the products that ViroPharma commercializes. However, the Act, as amended, will likely increase certain of our costs as well. For example, an increase in the Medicaid rebate rate from 15.1% to 23.1% was effective as of January 1, 2010, and the volume of rebated drugs has been expanded to include beneficiaries in Medicaid managed care organizations, effective as of March 23, 2010. In 2011, PPACA also imposes a manufacturer’s fee on the sale of branded Pharmaceuticals (excluding orphan drugs) to specified government programs, expands the 340B drug discount program (excluding orphan drugs), and includes a 50% discount on

 

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brand name drugs for Medicare Part D participants in the coverage gap, or “doughnut hole”. We have determined that the manufacturing fee is immaterial relative to our anticipated 2011 operating income and cash flow. We have also estimated that our incremental cost associated with the Medicare Part D coverage gap will be approximately $8.2 million during 2011. Our evaluation of PPACA, as amended, will continue to enable us to determine not only the immediate effects on our business, but also the trends and changes that may be encouraged by the legislation that may potentially impact on our business over time.

We will face intense competition in acquiring additional products to further expand our product portfolio. Many of the companies and institutions that we will compete with in acquiring additional products to further expand our product portfolio have substantially greater capital resources, research and development staffs and facilities than we have, and greater resources to conduct business development activities. We may need additional financing in order to acquire new products in connection with our plans as described in this report. Upon completion of business development transactions, we will face risks related to the integration of the acquired assets or business which could result in delays in development timelines, increased expenses or assumptions of undisclosed liabilities, and disruption from the transaction making it more difficult to maintain relationships with manufactures, employees or other suppliers.

The outcome of our clinical development programs is subject to considerable uncertainties. We are currently undertaking studies on the viability of subcutaneous administration of Cinryze, either alone or in combination with Halozyme’s recombinant human hyaluronidase enzyme (rHuPH20) technology, and to identify further therapeutic uses and potentially expand the labeled indication for Cinryze to include other C1 mediated diseases, such as AMR and DGF. In addition, we are also developing VP20621 for the treatment and prevention of CDI and in May 2011 we initiated a Phase 2 dose-ranging clinical study. We anticipate that we will commence pre-clinical and clinical studies with OX1 for the treatment of Friedreich’s Atoxia. There can be no assurance that that our clinical programs with Cinryze, VP20621 and OX1 will yield positive results or support further development. We cannot be certain that we will be successful in developing and ultimately commercializing any of our product candidates, that the FDA or other regulatory authorities will not require additional or unanticipated studies or clinical trial outcomes before granting regulatory approval, or that we will be successful in obtaining regulatory approval of any of our product candidates in the timeframes that we expect, or at all.

We cannot assure you that our current cash and cash equivalents and investments or cash flows from product sales will be sufficient to fund all of our ongoing development and operational costs, as well as the interest payable on our outstanding senior convertible notes, 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. The risks described in this report, our Form 10-Q for the quarter ended September 30, 2011, are not the only risks facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results. Please also see our discussion of the “Risk Factors” as described in our Form 10-K for the year ended December 31, 2010 in Item 1A and in our Form 10-Q for the quarters ended March 31, 2011 and June 30, 2011, which describe other important matters relating to our business.

Results of Operations

Three and Nine Months Ended September 30, 2011 and 2010

 

     For the three months ended
September 30,
     For the nine months ended
September 30,
 
(in thousands, except per share data)    2011      2010      2011      2010  

Net product sales

   $ 142,956       $ 117,781       $ 398,792       $ 317,389   

Cost of sales (excluding amortization of product rights)

   $ 20,115       $ 15,755       $ 60,293       $ 43,354   

Operating income

   $ 50,490       $ 59,236       $ 152,850       $ 150,744   

Net income

   $ 28,239       $ 38,339       $ 87,481       $ 88,141   

Net income per share:

           

Basic

   $ 0.38       $ 0.49       $ 1.15       $ 1.13   

Diluted

   $ 0.35       $ 0.45       $ 1.04       $ 1.04   

 

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The $50.5 million in operating income for the three month period ended September 30, 2011 decreased $8.7 million as compared to the same period in 2010 as the increase in overall net sales of $25.2 million have been offset by the following: increased cost of sales of approximately $4.4 million due to the higher mix of Cinryze volume; a $3.0 million charge related to the achievement of a development milestone under our license arrangement with Halozyme; a $6.5 million upfront fee related to our license agreement with Intellect Neurosciences, Inc. (INS); increased selling, general and administrative expenses of $6.4 million primarily related to our European expansion efforts and our Cinryze marketing programs; an impairment charge of approximately $8.5 million related to certain assets acquired from Auralis; and, a charge of approximately $2.1 million related to the change in the fair value of the Auralis contingent consideration liability, compared to $0.5 million in the third quarter of 2010.

The $152.9 million in operating income for the nine months ended September 30, 2011 increased $2.1 million compared to the same period in 2010. The primary drivers of this increase are higher net sales of $81.4 million. Partly offsetting the increased sales are: an increase of $16.9 million in cost of sales due to increased Cinryze volume; a $9.0 million upfront fee and a $3.0 million charge related to the achievement of a development milestone related to our license arrangement with Halozyme; a $6.5 million upfront fee related to our license agreement with Intellect Neurosciences, Inc. (INS); an increase of $20.4 million in selling, general and administrative expenses primarily related to our European expansion efforts and our Cinryze marketing programs; an impairment charge of approximately $8.5 million related to certain assets acquired from Auralis; and, a charge of approximately $4.6 million related to the changes in the fair value of the Auralis contingent consideration liability, compared to $0.5 million in the third quarter of 2010. Also included in other operating expenses for the nine month period ended September 30, 2011 is approximately $3.4 million of costs associated with the funding of Cinryze manufacturing enhancements at Sanquin.

Revenues

Revenues consisted of the following:

 

     For the three months ended
September 30,
     For the nine months ended
September 30,
 
       
(in thousands)    2011      2010      2011      2010  

Net product sales

           

Vancocin

   $ 76,618       $ 67,644       $ 211,092       $ 191,748   

Cinryze

     65,443         49,058         184,491         124,283   

Other

     895         1,079         3,209         1,358   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total revenues

   $ 142,956       $ 117,781       $ 398,792       $ 317,389   
  

 

 

    

 

 

    

 

 

    

 

 

 

Revenue

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.

We sell Cinryze to specialty pharmacy/specialty distributors (SP/SD’s) who then distribute to physicians, hospitals and patients, among others. We continue to work to expand our manufacturing capacity to insure the availability of Cinryze to meet growing patient needs and believe our efforts will allow us to continue to meet this growing patient demand for the foreseeable future. In the second quarter of 2010, we introduced parallel chromatography produced Cinryze into the trade which increased our supply so that we were able to start new patients on Cinryze as needed without undue concern of any disruption of the availability of Cinryze to those already receiving it. In order to meet anticipated longer term demand, we submitted to the FDA a Prior Approval Supplement (PAS) in the second quarter of 2010. The PAS involves a larger scale manufacturing project to significantly increase the Cinryze production capabilities at Sanquin. In October 2010, the FDA issued a complete response letter regarding the Cinryze industrial scale manufacturing expansion activities. In the complete response letter the FDA has requested additional information related to observations from the pre-approval inspection and review of the technical processes. In October 2011, we filed a response to the complete response letter and in parallel will continue advancing additional initiatives intended to increase our capacity.

 

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During the three month period ended September 30, 2011, net sales of Vancocin increased 13.3% compared to the same period in 2010 due to volume improvements and net realized price growth period over period. During the nine months ended September 30, 2011, net sales of Vancocin increased 10.1% compared to the same period in 2010 primarily due to net realized price growth period over period. Also, during the three and nine months ended September 30, 2011 Vancocin net sales were reduced by approximately $2.2 million and $6.2 million, respectively, by the Medicare Part D coverage gap discount enacted under PPACA which did not impact net sales in 2010. Based upon data reported by IMS Health Incorporated, prescriptions during the three and nine months ended September 30, 2011 decreased from the same periods in 2010 period by 0.9% and 6.7%, respectively, which we believe is due to a decrease in the incidence of severe disease, improved aseptic technique and a suspected increase in compounding seen both in the hospital and long-term care marketplace. Our net sales of Cinryze during the three and nine months ended September 30, 2011 increased 33.4% and 48.4%, respectively, over the same periods in the prior year due to the increase in the number of patients receiving commercial drug.

Vancocin product sales are driven by demand fluctuations in trade inventories which could be at different levels from period to period. Cinryze product sales are influenced by prescriptions and the rate at which new patients are placed on Cinryze. We receive inventory data from our three largest wholesalers through our fee for service agreements and our two SP/SD’s through service agreements. We do not independently verify this data. Based on this inventory data and our estimates, we believe that as of September 30, 2011, the wholesalers and SP/SD’s did not have excess channel inventory.

Cost of sales (excluding amortization of product rights)

Cost of sales increased for the three months ended September 30, 2011 as compared to the prior year quarter by $4.4 million and increased for the nine months ended September 30, 2011 by $16.9 million compared to the prior year. These increases are primarily due to the increased Cinryze volume.

Vancocin and Cinryze cost of sales includes the cost of materials and distribution costs and excludes amortization of product rights. Since units are shipped based upon earliest expiration date, we would expect the cost of product sales of both Vancocin and Cinryze to fluctuate from quarter to quarter as we may experience fluctuations in quarterly manufacturing yields.

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 clinical and development costs. Indirect expenses include personnel, facility, stock compensation and other overhead costs. Due to advancements in our VP20621 clinical program, our Cinryze life cycle management program as well as cost associated with our efforts to advance additional initiatives intended to increase our Cinryze capacity and the cost to develop OX1 and other compounds, we expect future costs in these programs to increase from historical levels.

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

 

     For the three months
ended September 30,
     For the nine months
ended September 30,
 
(in thousands)    2011      2010      2011      2010  

Direct – Core programs

           

Non-toxigenic strains of C. difficle (VP20621)

   $ 2,017       $ 1,697       $ 6,186       $ 5,590   

Cinryze & C1 esterase inhibitor

     6,380         2,171         19,724         6,651   

Vancocin

     68         12         118         1,156   

OX1

     6,500         —           6,500         —     

Direct – Other Assets

           

CMV

     422         1,627         683         2,163   

New Initiatives

     967         —           2,148         —     

Other assets

     67         —           383         —     

Indirect

           

Development

     6,506         4,681         18,028         13,593   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 22,927       $ 10,188       $ 53,770       $ 29,153   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Direct Expenses—Core Development Programs

The increase in costs of VP20621 in the three and nine months ended September 30, 2011 over the same period in 2010 relates to timing of costs associated with our Phase 1 clinical trial and the initiation of our Phase 2 clinical trial during the second quarter of 2011.

Our costs associated with our Cinryze program increased during the three and nine months ended September 30, 2011, as we incurred costs related to the continuation of our Phase 4 clinical trial and development of our life cycle program, including initiation of a Phase 2 study of subcutaneous administration of Cinryze in combination with rHuPH20. In the same period in the prior year, we incurred costs related to the preparation of our Phase 4 clinical trial. During the second quarter of 2011, we made a $9.0 million upfront payment related to our entering into a license with Halozyme for the development of an alternative subcutaneous formulation of Cinryze for routine prophylaxis against attacks of HAE, which we will begin to develop concurrently with our existing formulation. In addition, during the third quarter of 2011 we incurred a $3 million charge related to the achievement of a development milestone under our Halozyme license arrangement.

During the quarter ended September 30, 2011, we incurred a $6.5 million upfront fee related to our license agreement with INS for the clinical stage drug candidate, OX1, which is being developed for the treatment of Friedreich’s Ataxia (FA), a rare, hereditary, progressive neurodegenerative disease.

Direct Expenses—Other Assets

Our direct expenses related to our CMV program decreased in the three and nine months ended September 30, 2011 as we wound down our stem cell and liver transplant studies during 2010. During 2011, we continue to evaluate any potential alternative development strategies for maribavir.

Our costs related to New Initiatives represent expenses associated with our evaluation of a recombinant C1-INH technology and spending under our collaboration agreement with Sanquin supporting their Early Stage Research Programs.

Anticipated fluctuations in future direct expenses are discussed under “LiquidityDevelopment Programs.

Indirect Expenses

These costs primarily relate to the compensation of and overhead attributable to our development team.

Selling, general and administrative expenses

Selling, general and administrative expenses (SG&A) increased for the three months ended September 30, 2011 by $6.4 million compared to the same period in the prior year primarily due to increases in compensation expense and employee cost of $2.6 million, marketing activities of $1.8 million and increased corporate cost of $1.2 million. For the nine months ended September 30, 2011, SG&A increased $20.4 million compared to the same period in 2010. The increase of $20.4 million for the nine month period was driven by increased compensation expense and employee cost of $8.9 million, increased marketing expenses of $5.5 million and increased corporate cost of $2.9 million.

To a large extent the overall increase in SG&A in both periods is driven by our European commercialization efforts and new Cinryze marketing programs. We anticipate that our SG&A spending will continue to increase in future periods as we continue our commercialization and expansion efforts outside the United States.

Intangible amortization and acquisition of technology rights

Intangible amortization for the three and nine months ended September 30, 2011 were $7.2 million and $23.3 million, respectively, as compared to $7.1 million and $22.3 million, respectively during the same periods in 2010. The year over year increases are primarily due to the amortization of the Auralis intangible assets acquired in May of 2010.

On an ongoing periodic basis, we evaluate the useful life of our intangible assets and determine if any economic, governmental or regulatory event has modified their estimated useful lives. This evaluation did not result in a change in the life of the intangible assets during the quarter ended September 30, 2011. We will continue to monitor the actions of the FDA surrounding the bioequivalence

 

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recommendation for Vancocin and consider the effects of our opposition efforts, any announcements by generic competitors or other adverse events for additional impairment indicators. We will reevaluate the expected cash flows and fair value of our Vancocin-related assets, as well as estimated useful lives, at such time.

Other operating expenses

The re-measurement of the fair value of the contingent consideration given for the acquisition of Auralis resulted in a charge to income of approximately $2.1 million and $4.6 million during the three and nine months ended September 30, 2011, respectively. We incurred expense of approximately $0.5 million for this item during the three and nine months ended September 30, 2010. Also included in other operating expenses for the nine month period ended September 30, 2011 is approximately $3.4 million of costs associated with the funding of Cinryze manufacturing enhancements at Sanquin.

Due to the approval and the pending launch of Buccolam, coupled with the launch of Cinryze in Europe, we have decided to alter our development and commercialization plans for the remaining Auralis IPR&D asset. The decision resulted in the impairment of the IPR&D asset and the Auralis Contract rights. Accordingly, we recorded a charge of approximately £5.4 million (approximately $8.5 million) during the quarter ended September 30, 2011.

Other Income (Expense)

Interest Income

Interest income for three and nine months ended September 30, 2011 and 2010 was $0.1 million and $0.1 million and $0.5 million and $0.2 million, respectively.

Interest Expense

 

     For the three months
ended September 30,
     For the nine months
ended September 30,
 
(in thousands)    2011      2010      2011      2010  

Interest expense on debt

   $ 1,080       $ 1,025       $ 3,129       $ 3,075   

Amortization of debt discount

     1,933         1,793         5,713         5,290   

Amortization of finance costs

     129         97         323         291   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total interest expense

   $ 3,142       $ 2,915       $ 9,165       $ 8,656   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interest expense and amortization of finance costs in 2011 and 2010 relate to the senior convertible notes issued on March 26, 2007. In future periods this caption will also include amortization of the debt issue cost associated with the $200 million credit facility entered into during the third quarter of 2011 as well as commitment fees and interest expense, depending on our utilization of this facility.

Other income (expense), net

Our other income (expense), net is primarily due to our foreign exchange gains and losses.

Income Tax Expense

Our income tax expense was $16.3 million and $23.2 million for the quarters ended September 30, 2011 and 2010, respectively, and $57.1 million and $55.5 million for the nine months ended September 30, 2011 and September 30, 2010, respectively. Our income tax expense includes federal, state and foreign income taxes at statutory rates and the effects of various permanent differences.

Our effective tax rates for the quarters ended September 30, 2011 and 2010 were 36.6% and 37.7%, respectively. For the nine months ended September 30, 2011 and September 30, 2010, our effective tax rates were 39.5% and 38.6%, respectively. Our effective tax rate is higher than the statutory U.S. tax rate in all periods primarily due to state income taxes and certain share-based compensation that is not tax deductible. In addition, the effective tax rates for the quarter and nine months ended September 30, 2011 are higher than the statutory U.S. tax rate due to an increase in the fair value of contingent consideration that is not deductible for tax purposes. The increase in the effective tax rates during 2011 caused by the above referenced items was offset by the recognition during the third quarter of 2011 of the tax benefit associated with domestic manufacturing tax deductions claimed.

 

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The examination of our 2008 U.S. income tax return concluded during the quarter ended March 31, 2011 with no material adjustments. Various state income tax returns are currently under examination. At this time, we do not believe that the results of these examinations will have a material impact on our financial statements.

Liquidity and Capital Resources

In the near term, we expect that our sources of revenue will continue to arise from Cinryze and Vancocin product sales. We anticipate commercializing Buccolam in the later part of 2011. However, future sales of Vancocin will vary based on the number of generic competitors that could enter the market if approved by the FDA, the timing of entry into the market of those generic competitors and/or the sales we may generate from an authorized generic version of Vancocin. In addition, there are no assurances that demand for Cinryze will continue to grow or 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 Cinryze, VP20621, OX1 and other development programs, including the timing of our expansions as we have begun to commercialize Cinryze in Europe, the scope of the clinical trials required by regulatory authorities, results from clinical trials, the results of our product development efforts, and variations from our estimate of future direct and indirect expenses.

The cash flows we have used in operations historically have been applied to research and development activities, marketing and commercial efforts, business development activities, general and administrative expenses, debt service, 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 and/or EMA or regulatory approval is a time consuming and expensive process. Because we have product candidates that 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. However, our future costs may exceed current costs as we anticipate we will continue to invest in our pipeline, including our initiative to develop VP20621 (non-toxigenic strains of C. difficile), OX1, any additional studies to identify further therapeutic uses and expand the labeled indication for Cinryze to potentially include other C1 mediated diseases as well as new modes of administration for Cinryze. Also, we will incur additional costs as we intend to seek to commercialize Cinryze in Europe in countries where we have distribution rights and certain other countries beginning in 2011 as well as conduct studies to identify additional C1 mediated diseases, such as AMR and DGF, which may be of interest for further clinical development, and to evaluate new forms of administration for Cinryze. In May 2011, Halozyme Therapeutics (Halozyme) granted us an exclusive worldwide license to use Halozyme’s proprietary Enhanze™ technology, a proprietary drug delivery platform using Halozyme’s recombinant human hyaluronidase enzyme (rHuPH20) technology in combination with a C1 esterase inhibitor. We intend to apply rHuPH20 initially to develop a novel subcutaneous formulation of Cinryze for routine prophylaxis against attacks. Under the terms of the license agreement, we paid Halozyme an initial upfront payment of $9 million. In the fourth quarter of 2011, we made a milestone payment of $ 3 million related to the initiation of a Phase 2 study begun in September 2011 to evaluate the safety, and pharmacokinetics and pharmacodynamics of subcutaneous administration of Cinryze in combination with rHuPH20. Pending successful completion of an additional series of clinical and regulatory milestones, anticipated to begin during 2012, we may make further milestone payments to Halozyme which could reach up to an additional $41 million related to HAE and up to $30 million of additional milestone payments for three additional indications. Additionally, we will pay an annual maintenance fee of $1 million to Halozyme until specified events have occurred. Upon regulatory approval, Halozyme will receive up to a 10% royalty on net sales of the combination product utilizing Cinryze and rHuPH20, depending on the existence of a valid patent claim in the country of sale.

On September 30, 2011, we entered into a license agreement for the worldwide rights of Intellect Neurosciences, Inc. (INS) to its clinical stage drug candidate, OX1, being developed for the treatment of Friedreich’s Ataxia (FA), a rare, hereditary, progressive neurodegenerative disease. We expect to initiate a phase 2 study within 12 to 18 months of the date of this agreement, after completion of longer-term toxicology studies. We intend to file for Orphan Drug Designation upon review of the phase 2 proof of concept data. Under the terms of the agreement, we have exclusive worldwide rights to develop and commercialize OX1 for the treatment, management or prevention of any disease or condition covered by Intellect’s patents. We paid INS a $6.5 million up-front licensing fee and may pay additional milestones up to $120 million based upon defined events. We will also pay a tiered royalty of up to a maximum percentage of low teens, based on annual net sales.

On October 21, 2008, we completed our acquisition under which ViroPharma acquired Lev Pharmaceuticals, Inc. (Lev). Lev is a biopharmaceutical company focused on developing and commercializing therapeutic products for the treatment of inflammatory diseases. The terms of the merger agreement provided for the conversion of each share of Lev common stock into upfront consideration of $453.1 million, or $2.75 per Lev share, comprised of $2.25 per share in cash and $0.50 per share in ViroPharma

 

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common stock, and contingent consideration of up to $1.00 per share which may be paid on achievement of certain regulatory and commercial milestones. The target for the first CVR payment of $0.50 per share (or $87.5 million) will not be paid as a third party’s human C1 inhibitor product was approved for the acute treatment of HAE and granted orphan exclusivity. The second CVR payment of $0.50 per share ($87.5 million) becomes payable if Cinryze reaches at least $600 million in cumulative net product sales by October 2018. As of September 30, 2011, we have recognized approximately $458.6 million of cumulative sales of Cinryze and we anticipate achieving this milestone in 2012.

Duocort Pharma AB

On October 26, 2011, we entered into an agreement to acquire a 100% ownership interest in Duocort Pharma AB (Duocort), a Swedish based specialty pharmaceutical company for approximately 220 million SEK (approximately $33 million) in cash. We have also agreed to pay future additional consideration upon the achievement of certain events. This additional consideration may range from 240 million SEK to 860 million SEK (approximately $37 million to $131 million). The closing of the transaction is subject to the prior satisfaction of certain conditions, which we anticipate will occur prior to year-end. Duocorts primary drug candidate, currently in development, is Plenadren, a once-daily duel-release hydrocortisone replacement therapy for patients with chronic adrenal insufficiency.

The most significant of our near-term operating development cash outflows are as described under “Development Programs” as set forth below.

We are required to pay contingent consideration to Lev shareholders upon achievement of a commercial milestone related to Cinryze sales and additional consideration to Auralis shareholders upon achievement of a regulatory milestone. Additionally, our operating expenses will not decrease significantly if there is the introduction of a generic Vancocin.

In March 2010, President Obama signed into law the Patient Protection and Affordable Care Act (PPACA). The PPACA, as amended, will likely increase certain of our costs as well. For example, an increase in the Medicaid rebate rate from 15.1% to 23.1% was effective as of January 1, 2010, and the volume of rebated drugs has been expanded to include beneficiaries in Medicaid managed care organizations, effective as of March 23, 2010. In 2011, the PPACA also imposes a manufacturer’s fee on the sale of branded Pharmaceuticals (excluding orphan drugs) to specified government programs, expands the 340B drug discount program (excluding orphan drugs), and includes a 50% discount on brand name drugs for Medicare Part D participants in the coverage gap, or “donut hole”. We have determined that the manufacturing fee is immaterial relative to our anticipated 2011 operating income and cash flow. We have also estimated that our incremental cost associated with the Medicare Part D coverage gap will be approximately $7.8 million during 2011. Our evaluation of PPACA, as amended, will continue to enable us to determine not only the immediate effects on our business, but also the trends and changes that may be encouraged by the legislation that may potentially impact on our business over time.

Capital Resources

While we anticipate that cash flows from Cinryze and Vancocin, our current cash, cash equivalents and short-term investments (together, “our cash”) and revolving credit facility should allow us to fund our ongoing development and operating costs, as well our interest payments and future milestone payments or acquisition costs, we may need additional financing in order to expand our product portfolio. At September 30, 2011, we had cash, cash equivalents and short-term investments of $460.4 million. Short-term investments consist of high quality fixed income securities with remaining maturities of greater than three months at the date of purchase and high quality debt securities or obligation of departments or agencies of the United States. At September 30, 2011, the annualized weighted average nominal interest rate on our short-term investments was 0.28% and the weighted average length to maturity was 8.0 months. At September 30, 2011, we also had $200 million available under our revolving credit agreement. At September 30, 2011, approximately $187.5 million of our cash and availability under the credit agreement is subject to the minimum liquidity covenant of our credit agreement.

Financing

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.

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.

 

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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, 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.

From time to time, we may seek approval from our board of directors to evaluate additional opportunities to repurchase our common stock or convertible notes, including through open market purchases or individually negotiated transactions.

Overall Cash Flows

During the nine months ended September 30, 2011, we generated $121.6 million of net cash from operating activities, primarily from our net income after adjustments for non-cash items, including the charge for the intangible assets impairment, partly offset by our net increase in working capital and our payment of the Auralis contingent consideration. We used $52.2 million of cash from investing activities mainly in the purchase of short-term investments, net of investment maturities. Our net cash used in financing activities for the nine months ended September 30, 2011 was $154.8 million primarily attributable to the repurchase of our common stock and our payment of the Auralis contingent consideration. For the prior year period ended September 30, 2010, we generated $137.4 million of net cash from operating activities, primarily from our net income plus non-cash items. We used $87.0 million of cash from investing activities mainly in the purchase of short-term investments, as well as in the purchase of Auralis and Vancocin assets and our net cash provided by financing activities for the nine months ended September 30, 2010 was $1.7 million related to stock option exercises.

Development Programs

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. Additionally, for some of our development programs, we have cash inflows and outflows upon achieving certain milestones.

Core Development Programs

Cinryze—We acquired Cinryze in October 2008 and through September 30, 2011 have spent approximately $39.1 million in direct research and development costs related to Cinryze since acquisition. During the remainder of 2011, we continue to expect research and development costs related to Cinryze to increase as we complete our Phase 4 commitment and initiate our Phase 2 study to evaluate Cinryze for treatment of acute HAE in children. Additionally, we will incur costs related to evaluating additional indications, formulations and territories as we develop our life cycle program related to Cinryze such as our efforts on both our own and the C1 esterase inhibitor/rHuPH20 combination sub-subcutaneous formulations, AMR and DGF. We are solely responsible for the costs of Cinryze development. In September 2011, we initiated a Phase 2 study to evaluate the safety, and pharmacokinetics and pharmacodynamics of subcutaneous administration of Cinryze in combination with rHuPH20.

VP20621—We acquired VP20621 in February 2006 and through September 30, 2011 have spent approximately $30.1 million in direct research and development costs. For the remainder of 2011, we expect our research and development activities related to VP20621 to increase as we continue our development program and in May 2011 we initiated a Phase 2 dose-ranging clinical study to evaluate the safety, tolerability, and efficacy of VP 20621 for prevention of recurrence of CDI in adults previously treated for CDI. We are solely responsible for the costs of VP20621 development.

Vancocin—We acquired Vancocin in November 2004 and through September 30, 2011 have spent approximately $2.9 million in direct research and development costs related to Vancocin activities since acquisition.

OX1—On September 30, 2011, we entered into a license agreement for the worldwide rights of Intellect Neurosciences, Inc. (INS) to its clinical stage drug candidate, OX1, being developed for the treatment of Friedreich’s Ataxia (FA), a rare, hereditary, progressive neurodegenerative disease. We expect to initiate a phase 2 study within 12 to 18 months of the date of this agreement, after completion of longer-term toxicology studies. We intend to file for Orphan Drug Designation upon review of the phase 2 proof of concept data. Under the terms of the agreement, we have exclusive worldwide rights to develop and commercialize OX1 for the treatment,

 

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management or prevention of any disease or condition covered by Intellect’s patents. We paid INS a $6.5 million up-front licensing fee and may pay additional milestones up to $120 million based upon defined events. We will also pay a tiered royalty of up to a maximum percentage of low teens, based on annual net sales. We are solely responsible for the costs of OX1 development.

Other Assets

In addition to the programs described above, we have several other assets that we may make additional investments in. These investments will be dependent on our assessment of the potential future commercial success of or benefits from the asset. These assets include maribavir for CMV, and other compounds. We will continue to incur costs associated with our other development assets for direct research and development costs for medicinal products which will address unmet medical needs such as our current evaluation of a recombinant C1-INH technology which may be included in future clinical studies.

Business Development Activities

On September 30, 2011, entered into a license agreement for the worldwide rights of Intellect Neurosciences, Inc. (INS) to its clinical stage drug candidate, OX1, being developed for the treatment of Friedreich’s Ataxia (FA), a rare, hereditary, progressive neurodegenerative disease. We paid INS a $6.5 million up-front licensing fee and may pay additional milestones up to $120 million based upon defined events. We will also pay a tiered royalty of up to a maximum percentage of low teens, based on annual net sales. We are solely responsible for the costs of OX1 development.

On May 28, 2010 we acquired a 100% ownership interest in Auralis Limited, a UK based specialty pharmaceutical company for approximately $14.5 million in upfront consideration for the acquisition of the company and its existing pharmaceutical licenses and products. During the third quarter of 2011, we made additional payment of £10 million Pounds Sterling (approximately $15.8 million) upon the European Commission grant of a Centralized Pediatric Use Marketing Authorization (PUMA) for Buccolam during the quarter.

We intend to continue to seek to acquire additional products or product candidates. The costs associated with evaluating or 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 evaluating or acquiring business development candidates, it is not feasible to predict what our actual evaluation or acquisition costs would be, if any, however, the costs could be substantial.

Duocort Pharma AB

On October 26, 2011, we entered into an agreement to acquire a 100% ownership interest in Duocort Pharma AB (Duocort), a Swedish based specialty pharmaceutical company for approximately 220 million SEK (approximately $33 million) in cash. We have also agreed to pay future additional consideration upon the achievement of certain events. This additional consideration may range from 240 million SEK to 860 million SEK (approximately $37 million to $131 million). The closing of the transaction is subject to the prior satisfaction of certain conditions, which we anticipate will occur prior to year-end. Duocorts primary drug candidate, currently in development, is Plenadren, a once-daily duel-release hydrocortisone replacement therapy for patients with chronic adrenal insufficiency.

Share Repurchase Program

On March 9, 2011 our Board of Directors authorized the use of up to $150.0 million to repurchase shares of our common stock and/or our 2% Senior Convertible Notes due 2017. Purchases may be made by means of open market transactions, block transactions, privately negotiated purchase transactions or other techniques from time to time. The sources of cash for this repurchase program are expected to be a combination of our available liquid assets and/or our anticipated cash flows from operations, and we anticipate executing under this authorization from time to time until fully utilized.

On March 14, 2011 we entered into a three month accelerated share repurchase (ASR) agreement with a large financial institution to repurchase $50.0 million of our common stock on an accelerated basis. We paid $50.0 million to the financial institution and received approximately 2.7 million shares under this arrangement at an average purchase price of $18.74 per share.

During the third quarter of 2011, we reacquired approximately 5.5 million shares of our common stock at a cost of approximately $98.9 million or an average price of $18.04 per share. These purchases effectively completed our repurchase program authorized by our board on March 9, 2011.

 

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On September 14, 2011, our Board of Directors authorized the use of up to an additional $200 million to repurchase shares of our common stock and/or our 2% Senior Convertible Notes due 2017. Purchases may be made by means of open market transactions, block transactions, privately negotiated purchase transactions or other techniques from time to time.

From time to time, we may seek approval from our board of directors to evaluate additional opportunities to repurchase our common stock or convertible notes, including through open market purchases or individually negotiated transactions.

Senior Convertible Notes

On March 26, 2007, we issued $250.0 million of 2% senior convertible notes due March 2017 (senior convertible notes) in a public offering. Net proceeds from the issuance of the senior convertible notes were $241.8 million. The senior convertible notes are unsecured unsubordinated obligations and rank equally with any other unsecured and unsubordinated indebtedness. The senior convertible notes bear interest at a rate of 2% per annum, payable semi-annually in arrears on March 15 and September 15 of each year commencing on September 15, 2007.

As of January 1, 2009 we account for the debt and equity components of our convertible debt securities as bifurcated instruments which are accounted for separately. Accordingly, the convertible debt securities will recognize interest expense at effective rates of 8.0% as they are accreted to par value.

On March 24, 2009 we repurchased, in a privately negotiated transaction, $45.0 million in principal amount of our senior convertible notes due March 2017 for total consideration of approximately $21.2 million. The repurchase represented 18% of our then outstanding debt and was executed at a price equal to 47% of par value. Additionally, in negotiated transactions, we sold approximately 2.38 million call options for approximately $1.8 million and repurchased approximately 2.38 million warrants for approximately $1.5 million which terminated the call options and warrants that were previously entered into by us in March 2007. We recognized a $9.1 million gain in the first quarter of 2009 as a result of this debt extinguishment. For tax purposes, the gain qualifies for deferral until 2014 in accordance with the provisions of the American Recovery and Reinvestment Act.

As of September 30, 2011, the Company has accrued $0.2 million in interest payable to holders of the senior convertible notes. Debt issuance costs of $4.8 million have been capitalized and are being amortized over the term of the senior convertible notes, with the balance to be amortized as of September 30, 2011 being $2.1 million.

The senior convertible notes are convertible into shares of our common stock at an initial conversion price of $18.87 per share. The senior convertible notes may only be converted: (i) anytime after December 15, 2016; (ii) during the five business-day period after any five consecutive trading day period (the “measurement period”) in which the price per note for each trading day of that measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such day; (iii) during any calendar quarter (and only during such quarter) after the calendar quarter ending June 30, 2007, if the last reported sale price of our common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; or (iv) upon the occurrence of specified corporate events. Upon conversion, holders of the senior convertible notes will receive shares of common stock, subject to ViroPharma’s option to irrevocably elect to settle all future conversions in cash up to the principal amount of the senior convertible notes, and shares for any excess. We can irrevocably elect this option at any time on or prior to the 35th scheduled trading day prior to the maturity date of the senior convertible notes. The senior convertible notes may be required to be repaid on the occurrence of certain fundamental changes, as defined in the senior convertible notes. As of September 30, 2011, the fair value of the principal of the $205.0 million convertible senior notes outstanding was approximately $248.1 million, based on the level 2 valuation hierarchy of the fair value measurements standard.

Concurrent with the issuance of the senior convertible notes, we entered into privately-negotiated transactions, comprised of purchased call options and warrants sold, to reduce the potential dilution of our common stock upon conversion of the senior convertible notes. The transactions, taken together, have the effect of increasing the initial conversion price to $24.92 per share. The net cost of the transactions was $23.3 million.

The call options allowed ViroPharma to receive up to approximately 13.25 million shares of its common stock at $18.87 per share from the call option holders, equal to the number of shares of common stock that ViroPharma would issue to the holders of the senior convertible notes upon conversion. These call options will terminate upon the earlier of the maturity dates of the related senior convertible notes or the first day all of the related senior convertible notes are no longer outstanding due to conversion or otherwise. Concurrently, we sold warrants to the warrant holders to receive shares of its common stock at an exercise price of $24.92 per share. These warrants expire ratably over a 60-day trading period beginning on June 13, 2017 and will be net-share settled.

 

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The purchased call options are expected to reduce the potential dilution upon conversion of the senior convertible notes in the event that the market value per share of our common stock at the time of exercise is greater than $18.87, which corresponds to the initial conversion price of the senior convertible notes, but less than $24.92 (the warrant exercise price). The warrant exercise price is 75.0% higher than the price per share of $14.24 of our stock price on the pricing date. If the market price per share of our common stock at the time of conversion of any senior convertible notes is above the strike price of the purchased call options ($18.87), the purchased call options will entitle us to receive from the counterparties in the aggregate the same number of shares of our common stock as we would be required to issue to the holder of the converted senior convertible notes. Additionally, if the market price of our common stock at the time of exercise of the sold warrants exceeds the strike price of the sold warrants ($24.92), we will owe the counterparties an aggregate of approximately 13.25 million shares of our common stock. If we have insufficient shares of common stock available for settlement of the warrants, we may issue shares of a newly created series of preferred stock in lieu of our obligation to deliver common stock. Any such preferred stock would be convertible into 10% more shares of our common stock than the amount of common stock we would otherwise have been obligated to deliver under the warrants. We are entitled to receive approximately 10.87 million shares of its common stock at $18.87 from the call option holders and if the market price of our common stock at the time of exercise of the sold warrants exceeds the strike price of the sold warrants ($24.92), will owe the counterparties an aggregate of approximately 10.87 million shares of our common stock.

The purchased call options and sold warrants are separate transactions entered into by us with the counterparties, are not part of the terms of the senior convertible notes, and will not affect the holders’ rights under the senior convertible notes. Holders of the senior convertible notes will not have any rights with respect to the purchased call options or the sold warrants. The purchased call options and sold warrants meet the definition of derivatives. These instruments have been determined to be indexed to our own stock and have been recorded in stockholders’ equity in our unaudited Condensed Consolidated Balance Sheets. As long as the instruments are classified in stockholders’ equity they are not subject to the mark to market requirements of US GAAP.

Credit Facility

On September 9, 2011, we entered into a $200 million, three-year senior secured revolving credit facility (the “Credit Facility”), the terms of which are set forth in a Credit Agreement dated as of September 9, 2011 (the “Credit Agreement”) with JPMorgan Chase Bank, N.A., as administrative agent, BMO Harris Financing Inc., TD Bank, N.A. and Morgan Stanley Bank, NA as co-syndication agents and certain other lenders.

The Credit Facility is available for working capital and general corporate purposes, including acquisitions which comply with the terms of the Credit Agreement. The Credit Agreement provides separate sub-limits for letters of credit up to $20 million and swing line loans up to $10 million.

The Credit Agreement requires us to maintain (i) a maximum senior secured leverage ratio of less than 2.00 to 1.00, (ii) a maximum total leverage ratio of less than 3.50 to 1.00, (iii) a minimum interest coverage ratio of greater than 3.50 to 1.00 and (iv) minimum liquidity equal to or greater than the sum of $100,000,000 plus the aggregate amount of certain contingent consideration payments resulting from business acquisitions payable by us within a specified time period. The Credit Agreement also contains certain other usual and customary affirmative and negative covenants, including but not limited to, limitations on capital expenditures, asset sales, mergers and acquisitions, indebtedness, liens, dividends, investments and transactions with affiliates.

Our obligations under the Credit Facility are guaranteed by certain of our domestic subsidiaries (the “Subsidiary Guarantors”) and are secured by substantially all of our assets and the assets of the Subsidiary Guarantors. Borrowings under the Credit Facility will bear interest at an amount equal to a rate calculated based on the type of borrowing and our senior secured leverage ratio (as defined in the Credit Agreement) from time to time. For loans (other than swing line loans), we may elect to pay interest based on adjusted LIBOR plus between 2.25% and 2.75% or an Alternate Base Rate (as defined in the Credit Agreement) plus between 1.25% and 1.75%. We will also pay a commitment fee of between 35 to 45 basis points, payable quarterly, on the average daily unused amount of the Credit Facility based on our senior secured leverage ratio from time to time. As of the date of this filing, we have not drawn any amounts under the Credit Facility.

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.

 

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Our summary of significant accounting policies is described in Note 2 to our Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2010. 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:

 

   

Product Sales—Our net sales consist of revenue from sales of our products, Vancocin, Cinryze and Diamorphine, less estimates for chargebacks, rebates, distribution service fees, returns and losses. We recognize revenue for product sales when title and risk of loss has passed to the customer, which is typically upon delivery to the customer, when estimated provisions for chargebacks, rebates, distribution service fees, returns and losses are reasonably determinable, and when collectability is reasonably assured. Revenue from the launch of a new or significantly unique product may be deferred until estimates can be made for chargebacks, rebates and losses and all of the above conditions are met and when the product has achieved market acceptance, which is typically based on dispensed prescription data and other information obtained during the period following launch.

At the end of each reporting period we analyze our estimated channel inventory and we would defer recognition of revenue on product that has been delivered if we believe that channel inventory at a period end is in excess of ordinary business needs. Further, if we believe channel inventory levels are increasing without a reasonably correlating increase in prescription demand, we proactively delay the processing of wholesaler orders until these levels are reduced.

We establish accruals for chargebacks and rebates, sales discounts and product returns. These accruals are primarily based upon the history of Vancocin and for Cinryze they are based on information on payee’s obtained from our SP/SD’s and CinryzeSolutions. We also consider the volume and price of our products in the channel, trends in wholesaler inventory, conditions that might impact patient demand for our product (such as incidence of disease and the threat of generics) and other factors.

In addition to internal information, such as unit sales, we use information from external resources, which we do not verify, to estimate the Vancocin channel inventory. Our external resources include prescription data reported by IMS Health Incorporated and written and verbal information obtained from our three largest wholesaler customers with respect to their inventory levels. Based upon this information, we believe that inventory held at these warehouses are within normal levels.

Chargebacks and rebates are the most subjective sales related accruals. While we currently have no contracts with private third party payors, such as HMO’s, we do have contractual arrangements with governmental agencies, including Medicaid. We establish accruals for chargebacks and rebates related to these contracts in the period in which we record the sale as revenue. These accruals are based upon historical experience of government agencies’ market share, governmental contractual prices, our current pricing and then-current laws, regulations and interpretations. We analyze the accrual at least quarterly and adjust the balance as needed. These analyses have been adjusted to reflect the U.S. healthcare reform acts and their affect on governmental contractual prices and rebates. We believe that a 10% change in our estimate of the actual rate of sales subject to governmental rebates would affect our operating income and accruals by approximately $2.5 million in the period of adjustment.

Annually, as part of our process, we performed an analysis on the share of Vancocin and Cinryze sales that ultimately go to Medicaid recipients and result in a Medicaid rebate. As part of that analysis, we considered our actual Medicaid historical rebates processed, total units sold and fluctuations in channel inventory. We also consider our payee mix for Cinryze based on information obtained at the time of prescription.

Under the PPACA we are required to fund 50% of the Medicare Part D insurance coverage gap for prescription drugs sold to eligible patients staring on January 1, 2011. For Vancocin sales subject to this discount we recognize this cost using an effective rebate percentage for all sales to Medicare patients throughout the year. For applicable Cinryze sales we recognize this cost at the time of sale for product expected to be purchased by a Medicare Part D insured patient when we estimate they are within the coverage gap.

Product return accruals are estimated based on Vancocin’s history of damage and product expiration returns and are recorded in the period in which we record the sale of revenue. Cinryze has a no returns policy.

 

   

Impairment of Long-lived Assets—We test our long-lived fixed and intangible assets for recoverability whenever events occur or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. The impairment test is a two-step test. Under step one we assess the recoverability of an asset (or asset group). The carrying amount of an asset (or asset group) is not recoverable if it exceeds the sum of the undiscounted cash flows expected from the use and eventual disposition of the asset (or asset group). The impairment loss is measured in step two as the difference between the carrying value of the asset (or asset group) and its fair value. Assumptions and estimates used in the evaluation of impairment may affect the carrying value of long-lived assets, which could result in impairment

 

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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 undiscounted cash flows, and if necessary, the fair value of the asset and whether impairment exists. These assumptions are subjective and could result in a material impact on operating results in the period of impairment.

On an ongoing periodic basis, we evaluate the useful life of intangible assets and determine if any economic, governmental or regulatory event has modified their estimated useful lives.

On August 4, 2009 the FDA’s Pharmaceutical Science and Clinical Pharmacology Advisory Committee voted in favor of the component of the OGD’s 2008 draft guidelines on bioequivalence for Vancocin that permits bioequivalence to be demonstrated through comparable in vitro dissolution for potential vancomycin HCl capsule generic products that contain the same active and inactive ingredients in the same amounts as Vancocin, among other requirements. If FDA’s proposed bioequivalence method for Vancocin becomes effective, the time period in which a generic competitor could be approved would be reduced and multiple generics may enter the market, which would materially impact our operating results, cash flows and possibly intangible asset valuations. This could also result in a reduction to the useful life of the Vancocin-related intangible assets. Management currently believes there are no indicators that would require a change in useful life as management believes that Vancocin will continue to be utilized along with generics that may enter the market, and the number of generics and the timing of their market entry is unknown.

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. We will continue to monitor the actions of the OGD and consider the effects of our opposition actions and any announcements by generic competitors or other adverse events for additional impairment indicators. We will reevaluate the expected cash flows and fair value of our Vancocin-related assets at such time a triggering event occurs.

 

   

Impairment of Goodwill and Indefinite-lived Intangible Assets—We review the carrying value of goodwill and indefinite-lived intangible assets, to determine whether impairment may exist. The goodwill impairment test consists of two steps. The first step compares a reporting unit’s fair value to its carrying amount to identify potential goodwill impairment. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the second step of the impairment test must be completed to measure the amount of the reporting unit’s goodwill impairment loss, if any. Step two requires an assignment of the reporting unit’s fair value to the reporting unit’s assets and liabilities to determine the implied fair value of the reporting unit’s goodwill. The implied fair value of the reporting unit’s goodwill is then compared with the carrying amount of the reporting unit’s goodwill to determine the goodwill impairment loss to be recognized, if any. The impairment test for indefinite-lived intangible assets is a one-step test, which compares the fair value of the intangible asset to its carrying value. If the carrying value exceeds its fair value, an impairment loss is recognized in an amount equal to the excess. Based on accounting standards, it is required that these assets be assessed at least annually for impairment unless a triggering event occurs between annual assessments which would then require an assessment in the period which a triggering event occurred.

 

   

Share-Based Payments—We record the estimated grant date fair value of awards granted as stock-based compensation expense in our consolidated statements of operations over the requisite service period, which is generally the vesting period.

 

   

Income Taxes—Our annual effective tax rate is based on projected pre-tax earnings, enacted statutory tax rates, limitations on the use of tax credits and net operating loss carryforwards, evaluation of qualified expenses related to the orphan drug credit and tax planning opportunities available in the jurisdictions in which we operate. Significant judgment is required in determining our annual effective tax rate.

We calculate our quarterly effective tax rate based on projected income, permanent differences and credits by jurisdiction, enacted statutory tax rates, and other items. Discrete tax impacts are recorded in the quarter in which they occur.

On a periodic basis, we evaluate the realizability of our deferred tax assets and will adjust such amounts in light of changing facts and circumstances, including but not limited to projections of future taxable income, the reversal of deferred tax liabilities, tax legislation, rulings by relevant tax authorities, tax planning strategies and the progress of ongoing tax examinations. As part of this evaluation, we consider whether it is more likely than not that all or some portion of the deferred tax asset will not be realized. The ultimate realization of a deferred tax asset is dependent upon the generation of future taxable income during the period in which the related temporary difference becomes deductible or the NOL and credit carryforwards can be utilized. With respect to the reversal of valuation allowances, we consider the level of past and future taxable income, the existence and nature of reversing deferred tax liabilities, the utilization of 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.

 

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We recognize the benefit of tax positions that we have taken or expect to take on the income tax returns we file if such tax position is more likely than not of being sustained. Settlement of filing positions that may be challenged by tax authorities could impact our income tax expense in the year of resolution.

 

   

Acquisition Accounting—The application of the purchase accounting requires certain estimates and assumptions especially concerning the determination of the fair values of the acquired intangible assets and property, plant and equipment as well as the liabilities assumed at the date of the acquisition. Moreover, the useful lives of the acquired intangible assets, property, plant and equipment have to be determined.

The total purchase price of businesses acquired will be allocated to the net tangible assets and identifiable intangible assets based on their fair values as of the date of the acquisition and the fair value of any contingent consideration. Changes in the fair value of contingent consideration will be expensed in the period in which the change in fair value occurs. Additionally, acquired IPR&D projects will initially be capitalized and considered indefinite-lived assets subject to annual impairment reviews or more often upon the occurrence of certain events. For those compounds that reach commercialization, the assets are amortized over the expected useful lives.

Measurement of fair value and useful lives are based to a large extent on anticipated cash flows. If actual cash flows vary from those used in calculating fair values, this may significantly affect our future results of operations. In particular, the estimation of discounted cash flows of intangible assets of newly developed products is subject to assumptions closely related to the nature of the acquired products. Factors that may affect the assumptions regarding future cash flows:

 

   

long-term sales forecasts,

 

   

anticipation of selling price erosion after the end of orphan exclusivity due to follow-on biologic competition in the market,

 

   

behavior of competitors (launch of competing products, marketing initiatives etc.).

For significant acquisitions, the purchase price allocation is carried out with assistance from independent third-party valuation specialists. The valuations are based on information available at the acquisition date.

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

Contractual Obligations

We have committed to purchase a minimum number of liters of plasma per year through 2015 from our supplier. Additionally, we are required to purchase a minimum number of units from our third party toll manufacturers. The total minimum purchase commitments for these continuing arrangements as of September 30, 2011 are approximately $150.6 million.

 

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Our holdings of financial instruments are primarily comprised of money market funds holding only U.S. government securities and fixed income securities, including a mix of corporate debt and government securities. 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 optimizing 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. We generally invest in financial instruments with maturities of less than one year. The carrying amount, which approximates fair value based on the level 1 valuation hierarchy of the fair value measurement standard, and the annualized weighted average nominal interest rate of our investment portfolio at September 30, 2011, was approximately $119.8 million and 0.28%, respectively. The weighted average length to maturity was 8.0 months. A one percent change in the interest rate would have resulted in a $0.3 million impact to interest income for the quarter ended September 30, 2011.

 

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At September 30, 2011, we had principal outstanding of $205.0 million of our senior convertible notes. The senior convertible notes bear interest at a rate of 2% per annum, payable semi-annually in arrears on March 15 and September 15 of each year commencing on September 15, 2007. The senior convertible notes are convertible into shares of our common stock at an initial conversion price of $18.87 per share. The senior convertible notes may only be converted: (i) anytime after December 15, 2016; (ii) during the five business-day period after any five consecutive trading day period (the “measurement period”) in which the price per note for each trading day of that measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such day; (iii) during any calendar quarter (and only during such quarter) after the calendar quarter ending June 30, 2007, if the last reported sale price of our common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; or (iv) upon the occurrence of specified corporate events. Upon conversion, holders of the senior convertible notes will receive shares of common stock, subject to our option to irrevocably elect to settle all future conversions in cash up to the principal amount of the senior convertible notes, and shares for any excess. We can irrevocably elect this option at any time on or prior to the 35th scheduled trading day prior to the maturity date of the senior convertible notes. The senior convertible notes may be required to be repaid on the occurrence of certain fundamental changes, as defined in the senior convertible notes. As of September 30, 2011, the fair value of the principal of the $205.0 million convertible senior notes outstanding was approximately $248.1 million, based on the level 2 valuation hierarchy of the fair value measurements standard. The carrying value of the debt at September 30, 2011 is $151.5 million.

In connection with the issuance of the senior convertible senior notes, we have entered into privately-negotiated transactions with two counterparties (the “counterparties”), comprised of purchased call options and warrants sold. These transactions are expected to generally reduce the potential equity dilution of our common stock upon conversion of the senior convertible notes. These transactions expose us to counterparty credit risk for nonperformance. We manage our exposure to counterparty credit risk through specific minimum credit standards, and diversification of counterparties.

Additionally, if we were to utilize amounts under our revolving credit facility, we could be exposed to interest rate risk.

 

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 September 30, 2011. Based on that evaluation, our management, including our CEO and CFO, concluded that as of September 30, 2011 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 third quarter of 2011 there were no 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.

 

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PART II—OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

On May 26, 2011, we filed a notice of appeal to the United States Court of Appeals for the District of Columbia Circuit from the final order granting a motion to dismiss the Company’s motion for declaratory relief (the “Complaint”) against the Food and Drug Administration, Margaret A. Hamburg, M.D., in her official capacity as Commissioner of Food and Drug Administration, the United States Department of Health and Human Services (“HHS”), and Kathleen Sebelius, in her official capacity as Secretary of HHS, (collectively “FDA”) entered in the United States District Court for the District of Columbia (the “District Court”) on April 15, 2011. Pursuant to the Complaint, we sought review under the Administrative Procedure Act (“APA”) of the FDA’s decision to change its regulations to abandon its longstanding rule that an applicant for an Abbreviated New Drug Application (“ANDA”) seeking to demonstrate bioequivalence must do so through in vivo evidence unless the applicant obtains a waiver pursuant to the enumerated waiver criteria set forth in 21 C.F.R. § 320.22. We had requested that the Court determine that (i) the plain reading of FDA’s regulations requires in vivo bioequivalence testing unless one of the criteria set forth in 21 C.F.R. § 320.22 is satisfied, and (ii) FDA’s amendment of its regulations governing waiver of submission of in vivo bioequivalence evidence, without notice-and-comment rulemaking, violates 5 U.S.C. § 553 of the APA and was therefore invalid. The District Court did not address these arguments but instead granted the motion to dismiss brought by the defendants on a basis of a lack of standing. On October 6, 2011, we filed a brief with the United States Court of Appeals for the District of Columbia Circuit.

From time to time we are a party to litigation in the ordinary course of our business. We do not believe these matters, even if adversely adjudicated or settled, would have a material adverse effect on our financial condition, results of operations or cash flows.

 

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ITEM 1A. Risk Factors

We are providing the following information regarding changes that have occurred to previously disclosed risk factors from our Annual Report on Form 10-K for the year ended December 31, 2010. In addition to the other information set forth below and elsewhere in this report, you should carefully consider the factors discussed under the heading “Risk Factors” in our Form 10-K for the year ended December 31, 2010 and Form 10-Q filings for the periods ended March 31, 2011 and June 30, 2011. The risks described in our Quarterly Report on Form 10-Q are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

We currently depend, and will in the future continue to depend, on third parties to manufacture raw, intermediate and finished goods for Vancocin, Cinryze 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 quantities of pharmaceutical products to supply our clinical or commercial needs under the current Good Manufacturing Practice regulations, or cGMPs, required by the FDA and other regulatory agencies. 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. As such, 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. For example, Cinryze is a biologic which requires processing steps that are more difficult than those required for most chemical pharmaceuticals and therefore the third party contracts must have additional technical skills and multiple steps to attempt to control the manufacturing processes.

Problems with these manufacturing processes such as equipment malfunctions, facility contamination, labor problems, raw material shortages or contamination, natural disasters, power outages, terrorist activities, or disruptions in the operations of our suppliers and even minor deviations from the normal process, could result in product defects or manufacturing failures that result in lot failures, product recalls, product liability claims and insufficient inventory.

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 and other regulatory agencies routinely inspect manufacturing facilities before approving a new drug application, or NDA, or biologic application, or BLA, for a drug or biologic manufactured at those sites. If any of our manufacturers or processors fails to satisfy regulatory requirements, the approval and eventual commercialization of our products and product candidates may be delayed. For example, in addition to FDA, Sanquin is also subject to the requirements of the European health authorities which may impose on Sanquin obligations relating to facility maintenance and/or equipment modifications that could cause delays in Cinryze production.

In addition, regulatory agencies subject a marketed therapy, its manufacturer and the manufacturer’s facilities to continual review and periodic inspections. The discovery of previously unknown problems with a therapy or the facility or process used to produce the therapy could prompt a regulatory authority to impose restrictions on us or delay approvals for new products or could cause us to voluntarily adopt restrictions, including withdrawal of one or more of our products or services from the market.

In connection with several inspections of two facilities maintained by Sanquin, our contract manufacturer for Cinryze, FDA issued notices of observations on FDA Form 483 for each site. The FDA also issued a complete response letter regarding Cinryze™ (C1 Esterase Inhibitor [Human]) industrial scale manufacturing expansion activities. The FDA requested additional information related to observations from the pre-approval inspection and review of the technical processes. Responses to the observations have been provided to the FDA, however, several of the responses remain the subject of continuing corrective and preventive action procedures. If any of our manufacturers or processors fails to satisfy regulatory requirements, operations at such facility may be halted which could result in our inability to supply product to patients and reduce our revenues.

 

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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, we may be subject to product liability claims, 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.

We are taking steps to increase manufacturing capacity for Cinryze, and a failure to increase timely such capacity could limit the rate at which additional new patients will receive Cinryze and will limit the number of doses provided to patients. This would result in a reduction of potential future revenues.

Pursuant to our distribution agreement, Sanquin Blood Supply Foundation supplies us with certain annual minimum and maximum amounts of C1 INH. We and Sanquin are undertaking process improvements and facility expansions to increase the capacity of the facilities involved in manufacturing Cinryze. Our efforts to increase manufacturing capacity have included several approaches. First, using the current processing scale equipment, an additional chromatography unit (PCP, or parallel chromatography process) was added which enabled the addition of production shifts to increase manufacturing output.

We also are working on industrial scale manufacturing expansion activities. Sanquin must obtain the requisite regulatory approvals for this expansion in order to manufacture Cinryze for us at an increased capacity. On October 21, 2010, the United States Food and Drug Administration (FDA) issued a complete response letter regarding the facility to be utilized for the Cinryze industrial scale manufacturing expansion activities. The FDA requested additional information related to both (i) observations at the close of the pre-approval inspection and (ii) review of the technical processes. In order to manufacture Cinryze at the industrial scale we must respond to all FDA questions and satisfactorily complete the FDA review. We have submitted responses to FDA’s questions regarding the industrial scale process. While we believe that the data collected from our industrial scale manufacturing process demonstrates equivalence with the existing manufacturing process, we cannot guarantee that the FDA will agree with us in the timeframes we anticipate or at all as biologics such as Cinryze require processing steps that are more complex than those required for most chemical pharmaceuticals. When the industrial scale processing line is fully staffed and registered with FDA, it will provide additional output. This work is still ongoing and there can be no assurance that the personnel and regulatory review issues associated with this effort can be accomplished in a timely manner.

The FDA may view the data regarding equivalence of the industrial scale manufacturing process as insufficient or inconclusive, request additional data, require additional conformance batches, delay any decision past the time frames anticipated by us, or deny the approval of the industrial scale manufacturing process. In addition, our plans to increase manufacturing capacity through the construction of another small scale manufacturing line may not be completed in the time frame we anticipate or may not yield the volume of Cinryze we anticipate. In both cases, delays could arise as a result of many factors, including but not limited to, the availability of necessary equipment, validation of such equipment, the timing of regulatory reviews and approvals.

The number of patients enrolling into our treatment support service for patients with HAE and their healthcare providers, CinryzeSolutions, has periodically exceeded our expectations. For example, in 2010 we began to temporarily limit the rate at which additional patients are started on drug to ensure that those already receiving commercial product continue with a supply of Cinryze until capacity increases. If our manufacturing capacity expansion projects at Sanquin are delayed, or do not result in the capacity we anticipate, or if Sanquin cannot obtain necessary regulatory approvals for the contemplated facility expansions in the time frames we anticipate, or if we are not able to manufacture the anticipated volume of product at the existing scale, we may not be able to satisfy patient demand. Our inability to obtain adequate product supplies to satisfy our patient demand may create opportunities for our competitors and we will suffer a loss of potential future revenues.

 

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ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities

Below is a summary of stock repurchases for the three months ended September 30, 2011:

 

Month

   Total Number
of Shares
Purchased(1)
     Average
Price Paid
per Share(2)
     Total Number of
Shares Purchased
as Part of  Publicly
Announced
Plans or
Programs
     Approximate
Dollar Value of Shares
that May Yet Be
Purchased under the
Plans or Programs
(in thousands)(1) (3)
 

July 1 – July 31

     —         $ —           —         $ 100,000,000   

August 1 – August 31

     4,296,354       $ 17.61         4,296,354       $ 24,357,423   

September 1 – September 30

     1,186,485       $ 19.59         1,186,485       $ 201,115,508   
  

 

 

       

 

 

    

Total

     5,482,839       $ 18.04         5,482,839      
  

 

 

       

 

 

    

 

(1) In March 2011, our Board of Directors authorized up to $150.0 million for repurchases of ViroPharma Incorporated’s outstanding shares of common stock and 2% senior convertible notes due 2017. The $150.0 million authorization authorizes management to repurchase shares in the open market, in block transactions, in private transactions or other techniques from time to time, depending on market conditions. All shares repurchased in the first and second quarters of 2011 were purchased pursuant to an accelerated share repurchase agreement that we entered into on March 14, 2011 with a large financial institution, pursuant to which we paid $50.0 million to the financial institution and received approximately 2.7 million shares under this arrangement at an average purchase price of $18.74 per share.

During the third quarter of 2011, through open market purchases and a pre-established trading plan designed to satisfy Rule 10b5-1(c) under the Securities Exchange Act of 1934, which provides an affirmative defense from insider trading liability, we reacquired approximately 5.5 million shares at a cost of approximately $98.9 million or an average price of $18.04 per share. These purchases effectively completed our repurchases program authorized by our board on March 9, 2011.

 

(2) The Average Price Paid per Share is based on the price paid per share in the open market. The average price was determined based on the volume weighted-average-price of our stock during the day the repurchases had occurred.

 

(3) In September 2011, our Board of Directors authorized up to an additional $200.0 million for repurchases of ViroPharma Incorporated’s outstanding shares of common stock and 2% senior convertible notes due 2017. The $200.0 million authorization authorizes management to repurchase shares in the open market, in block transactions, in private transactions or other techniques from time to time, depending on market conditions. No transactions under this additional authorization have occurred to date.

During the period covered by this report, we did not sell any of our equity shares that were not registered under the Securities Act of 1933, as amended.

 

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ITEM 6. Exhibits

List of Exhibits:

 

  10.1*   Credit Agreement, dated as of September 9, 2011 among the Company, the lenders named therein, JPMorgan Chase Bank, N.A., as administrative agent, and BMO Harris Financing Inc., TD Bank, N.A. and Morgan Stanley Bank, NA as co-syndication agents.
  10.2*†   Exclusive License Agreement by and among the Company, Intellect Neurosciences, Inc. and Intellect USA, Inc. dated September 29, 2011.
  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.
101   The following financial information from this Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2011, formatted in XBRL (Extensible Business Reporting Language) and furnished electronically herewith: (i) the Condensed Consolidated Balance Sheets; (ii) the Consolidated Statements of Operations; (iii) the Consolidated Statements of Stockholders’ Equity; (iv) the Consolidated Statements of Cash Flows; and, (v) the Notes to the Consolidated Financial Statements.

 

* Filed herewith.
Portions of this exhibit were omitted and filed separately with the Secretary of the Commission pursuant to an application for confidential treatment filed with the Commission pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, as amended.

 

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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: October 27, 2011     By:  

/s/ Vincent J. Milano

     

Vincent J. Milano

President and Chief Executive Officer

(Principal Executive Officer)

    By:  

/s/ Charles A. Rowland, Jr.

      Charles A. Rowland, Jr.
     

Vice President, Chief Financial Officer

(Principal Financial Officer)

    By:  

/s/ Richard S. Morris

     

Richard S. Morris

Vice President, Chief Accounting Officer

(Principal Accounting Officer)

 

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