UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

 

Form 10-K

 

 

Commission file number 1-11397

 

 

 

 

 

Valeant Pharmaceuticals International

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

(949) 461-6000

 

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

 

 

Securities registered pursuant to Section 12(g) of the Act:
None

 

 

 

 

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

 

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

 

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 þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

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

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o

 

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

 

The aggregate market value of the Registrant’s voting stock held by non-affiliates of the Registrant on June 30, 2006, the last business day of the Registrant’s most recently completed second fiscal quarter based on the closing price of the common stock on the New York Stock Exchange on such date, was approximately $1,571,412,800.

 

The number of outstanding shares of the Registrant’s common stock as of February 23, 2007 was 94,659,944.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain information contained in Valeant Pharmaceuticals International’s definitive Proxy Statement for the 2007 annual meeting of stockholders is incorporated by reference into Part III hereof.

 

 

TABLE OF CONTENTS

 

 

In addition to current and historical information, this Report contains forward-looking statements. These statements relate to our future operations, future ribavirin royalties, prospects, potential products, developments and business strategies. Words such as “expects,” “anticipates,” “intends,” “plans”, “should,” “could,” “would,” “may,” “will,” “believes,” “estimates,” “potential,” or “continue” or similar language identify forward-looking statements.

 

Forward-looking statements involve known and unknown risks and uncertainties. Our actual results may differ materially from those contemplated by the forward-looking statements. Factors that might cause or contribute to these differences include, but are not limited to, those discussed in the sections of this report entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and sections in other documents filed with the SEC under similar captions. You should consider these in evaluating our prospects and future financial performance. These forward-looking statements are made as of the date of this report. We disclaim any obligation to update or alter these forward-looking statements in this report or the other documents in which they are found, whether as a result of new information, future events or otherwise, or any obligation to explain the reasons why actual results may differ.

 

Aclotin, Bedoyecta, Bisocard, Cesamet, Dalmane/Dalmadorm, Dermatix, Diastat AcuDial, Efudex/Efudix, Espacil, Espaven, Infergen, Kinerase, Librax, Mestinon, Migranal, Nyal, Oxsoralen/Oxsoralen-Ultra, Solcoseryl, Tasmar, Virazole and Zelapar are trademarks or registered trademarks of Valeant Pharmaceuticals International or its related companies or are used under license. This annual report also contains trademarks or tradenames of other companies and those trademarks and tradenames are the property of their respective owners.

 

Introduction

 

We are a global, specialty pharmaceutical company that develops, manufactures and markets a broad range of pharmaceutical products. We focus our greatest resources and attention principally in the therapeutic areas of neurology, dermatology, and infectious disease. Our marketing and promotion efforts focus on our Promoted Products, which consist of products marketed globally, regionally, or locally with annual sales in excess of $5,000,000. Our products are currently sold in more than 100 markets around the world, with our primary focus on the United States, Mexico, Poland, Canada, Germany, Spain, Italy, the United Kingdom and France.

 

Our value driver is a specialty pharmaceutical business with a global platform. We believe that our global reach and marketing agility differentiate us among specialty pharmaceutical companies, and provide us with the ability to leverage compounds clinical development and commercialize them in major markets around the world. In addition, we receive royalties from the sale of ribavirin by Schering-Plough and Roche. Such royalties are expected to decline as a result of market competition, and the loss of patents and data exclusivity in European markets and Japan.

 

We develop, manufacture and distribute a broad range of prescription and non-prescription pharmaceuticals. Although we focus most of our efforts on neurology, infectious disease and dermatology, our prescription pharmaceutical products also treat, among other things, neuromuscular disorders, cancer, cardiovascular disease, diabetes and psychiatric disorders. Our products are sold globally, through three pharmaceutical segments comprising: North America, International (composed of the Latin America, Asia, and Australasia regions), and EMEA (Europe, Middle East, and Africa). See Note 16 of notes to consolidated financial statements for financial information concerning each of our business segments for the last three years.

 

Our internet address is www.valeant.com. We post links on our website to the following filings as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission (“SEC”): annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendment to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. All such filings are available through our website free of charge. Our filings may also be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information on the

operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The address of that site is www.sec.gov.  

 

Specialty Pharmaceuticals

 

Our current product portfolio comprises approximately 370 branded products, with approximately 2,200 stock keeping units. We market our products globally through a marketing and sales force consisting of approximately 1,500 persons. We focus our sales, marketing and promotion efforts on our promoted products within our product portfolio. We have identified these promoted products as offering the best potential return on investment. The majority of our promoted products are in neurology, infectious disease and dermatology. Promoted products in other therapeutic areas have characteristics and regional or local market positions that also offer significant growth and returns on marketing efforts.

 

Our future growth is expected to be driven primarily by growth of our existing promoted products, the commercialization of new products and business development. Our promoted products accounted for 58% of our product sales for the year ended December 31, 2006. Sales of our promoted products increased $101,959,000 (27%) in the year ended December 31, 2006 compared to 2005. This increase includes $42,716,000 from sales of Infergen, a product we acquired on December 30, 2005 and started to sell as of January 3, 2006. Excluding Infergen, sales of promoted products increased $59,243,000 or 16% in the year ended December 31, 2006 over 2005.

The following table summarizes sales by major product for the each of the last three years (dollar amounts in thousands). It includes any product with annualized sales of greater than $10,000,000 and currently promoted products with annualized sales of greater than $5,000,000. It is categorized by therapeutic class.

 

 

 

 

NM – Not meaningful.

 

Neurology

 

Total sales of our neurology products accounted for 28% of our product sales for the year ended December 31, 2006. Products in this therapeutic category include:

 

 

Dermatology

 

Total sales of our dermatology products accounted for 21% of our product sales for the year ended December 31, 2006. Products in this therapeutic category include:

 

 

Infectious Disease

 

Total sales of our infectious disease products accounted for 10% of our product sales for the year ended December 31, 2006. Products in this therapeutic category are Infergen and Virazole.

 

 

Other Therapeutic Classes

 

Total sales of products in other therapeutic classes constituted 41% of our product sales from continuing operations for the year ended December 31, 2006 and encompass a broad range of ancillary products which are sold through our existing distribution channels. The promoted products in this category are as follows:

 

 

 

Acquisitions

 

We selectively license or acquire products, product candidates, technologies and businesses that complement our existing business and provide for effective life-cycle management of key products. We believe that our drug development expertise enables us to recognize licensing opportunities and to capitalize on research initially conducted and funded by others. Additionally, we believe that our sales and marketing organization provides us with the potential to effectively market acquired products to help recognize superior returns on our investment in such products.

 

On March 1, 2005, we acquired Xcel Pharmaceuticals, Inc. (“Xcel”), a specialty pharmaceutical company focused on the treatment of disorders of the central nervous system, for $280,000,000 in cash, plus expenses of $5,435,000. Under the terms of the purchase agreement, we paid an additional $7,470,000 as a post-closing working capital adjustment. The Xcel acquisition expanded our existing neurology product portfolio with four products that are sold within the United States, and retigabine, a late-stage clinical product candidate that is an adjunctive treatment for partial-onset seizures in patients with epilepsy. Xcel had synergies with our then existing neurology products and the acquisition added retigabine to our pipeline of product candidates.

 

On December 30, 2005, we acquired the U.S. and Canadian rights to Infergen from InterMune. Infergen is indicated for the treatment of hepatitis C when patients have not responded to other treatments (primarily the combination of pegylated interferon and ribavirin) or have relapsed after such treatment. In connection with this transaction we acquired patent rights and rights to a clinical trial underway to expand applications of Infergen. We also employed InterMune’s marketing and research staffs who were dedicated to the Infergen product and projects. We paid InterMune $120,000,000 in cash at the closing. We have also agreed to pay InterMune up to an additional $22,585,000, $20,000,000 of which is dependent on reaching certain milestones. We paid InterMune $2,585,000 as a non-contingent payment in January 2007. Additionally, as part of the acquisition transaction we assumed a contract for the transfer of the manufacturing process for Infergen from one third party supplier to another. Under the contract we are obligated to pay the new third party supplier up to $11,700,000 upon the attainment of separate milestones tied to the manufacturing process transfer. In 2006 we charged $5,200,000 to cost of sales for payments to this supplier for the achievement of milestones and we anticipate paying an additional $5,200,000 in 2007. Amgen originally developed Infergen and licensed the rights to InterMune.

 

On October 4, 2006, we signed a distribution agreement with Intendis GmbH for rights to certain dermatology products in the United Kingdom. This agreement includes the distribution rights to Finacea^®, a new topical treatment for rosacea.

 

In 2006, we also acquired the rights to Zelapar in Canada and Mexico. We had acquired the rights to Zelapar in the United States as part of the Amarin acquisition in 2004 and launched the product in the United States in 2006. In 2006, we also acquired from Novartis the rights to Melleril in Argentina, having acquired the rights to this product in Brazil in 2005.

 

See Note 3 of notes to consolidated financial statements for further discussion of these acquisitions.

 

Ribavirin Royalties

 

Our royalties are derived from sales of ribavirin, a nucleoside analog that we discovered. Ribavirin royalties are paid by both Schering-Plough and Roche. In 1995, Schering-Plough licensed from us all oral forms of ribavirin for the treatment of chronic hepatitis C. In 2002, the FDA granted Schering-Plough marketing approval for Rebetol^® capsules (Schering-Plough’s brand name for ribavirin) as a separately marketed product for use in combination with Peg-Intron (pegylated interferon alfa) for the treatment of chronic hepatitis C in patients with compensated liver disease who are at least 18 years of age. We licensed ribavirin to Roche in 2003.

 

Ribavirin royalty revenues were $81,242,000, $91,646,000, and $76,427,000 for the years ended December 31, 2006, 2005 and 2004, respectively, and accounted for 9%, 11%, and 11% of our total revenues in 2006, 2005, and 2004, respectively. Royalty revenues in 2006, 2005, and 2004 were substantially lower than those in 2003 and prior years. This decrease had been expected and relates to the introduction of generic versions of ribavirin in the United States in 2004. With respect to Schering-Plough, in some markets royalty rates increase in tiers based on increased sales levels. Upon the entry of generics into the United States in April 2004, pursuant to the terms of its contract with Valeant, Roche ceased paying royalties on sales in the United States. Schering-Plough has also launched a generic version of ribavirin. Under the license and supply agreement, Schering-Plough is obligated to pay us royalties for sales of its generic ribavirin.

 

In 2006 ribavirin royalty revenues decreased $10,404,000 or 11% due to (i) competitive dynamics between Roche and Schering-Plough in Europe, as Roche’s version of ribavirin, Copegus, gained market share over Schering-Plough’s version of ribavirin, Rebetol, (ii) reduced sales in Japan from a peak in 2005 driven by the launch of combination therapy there, and (iii) further gains in market share by generic competitors in the United States. In 2005 ribavirin royalty revenues increased $15,219,000 or 20% over the amount in 2004. This increase was attributable to an increase in sales of ribavirin in Japan following marketing approval from the Ministry of Health, Labor and Welfare of Japan for Schering-Plough’s Rebetol in combination with Peg-Intron for the treatment of hepatitis C. In 2007, Roche received similar approval in Japan for Copegus in combination with their pegylated interferon alfa.

 

We expect ribavirin royalties to continue to decline in 2007 as a result of market competition between Roche and Schering-Plough in Japan. The royalty will decline significantly in 2009 and 2010 with the loss of exclusivity in European markets and Japan.

 

In March 2001, the European Commission of the European Union granted Schering-Plough centralized marketing authorization for Peg-Intron and Rebetol for the treatment of both relapsed and treatment-naïve adult patients with histologically proven hepatitis C. European Union approval resulted in unified labeling that was immediately valid in all 15 European Union member states.

 

On January 6, 2003, we reached a settlement with Schering-Plough and Roche on pending patent and other disputes over Roche’s combination antiviral product containing Roche’s version of ribavirin, known as Copegus. Under the agreement, Roche may continue to register and commercialize Copegus globally. The financial terms of this settlement agreement include a license of ribavirin to Roche. The license authorizes Roche to make, or have made, and to sell Copegus. Roche pays royalty fees to us on its sales of Copegus for use in combination with interferon alfa or pegylated interferon alfa.

 

Approval of a generic form of oral ribavirin by the FDA in the United States was announced in April 2004, which has resulted in a decrease in royalty revenues from the U.S. market. With respect to Schering-Plough, effective royalty rates increase in tiers based on increased sales levels in markets outside the European Union including the United States and Japan. As a result of reduced sales, the likelihood of achieving the maximum effective royalty rate in the United States is diminished. Schering-Plough announced its launch of a generic version

of ribavirin. Under the license and supply agreement, Schering-Plough is obligated to pay us royalties for sales of their generic ribavirin. Under our agreement with Roche, upon the entry of generics into the United States, Roche ceased paying royalties on sales in the United States.

 

Schering-Plough also markets ribavirin for treatment in combination with interferon in many other countries based on the United States and European Union regulatory approvals.

 

Company Strategy and Restructuring

 

The key elements of our strategy, as refined by the restructuring program announced on April 3, 2006, include the following:

 

Targeted Growth Opportunities.  We focus our business on key markets, across three therapeutic areas and on products we have or may acquire where we can leverage our local market resources and particular brand recognition. We believe that our targeted core therapeutic areas are positioned for further growth and that it is possible for a mid-sized company to attain a leadership position within these categories. In addition, we intend to continue to pursue life-cycle management strategies for our regional and local brands.

 

Product Acquisitions.  We plan to selectively license or acquire product candidates, technologies and businesses from third parties which complement our existing business and provide for effective life-cycle management of key products. We believe that our drug development and commercialization expertise will allow us to recognize licensing opportunities and to capitalize on research initially conducted and funded by others.

 

Efficient Manufacturing and Supply Chain Organization.  The objective of the restructuring program as it relates to manufacturing is to further rationalize our manufacturing operations and further reduce our excess capacity. Under our global manufacturing strategy, we seek to minimize our costs of goods sold by increasing capacity utilization in our manufacturing facilities or by outsourcing and by other actions to improve efficiencies. We have undertaken major process improvement initiatives and the deployment of lean six sigma process improvements, affecting all phases of our operations, from raw material and supply logistics, to manufacturing, warehousing and distribution. The restructuring program includes the sale of manufacturing plants in Humacao, Puerto Rico and in Basel, Switzerland. We have entered into a letter of intent to sell these two manufacturing facilities and believe we will sell them in the first half of 2007. We have transferred them to “held for sale” classification in accordance with FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, in December 2006.

 

Clinical Development Activities.  We are focusing development efforts and expenditures on two late stage development projects: taribavirin, a potential treatment for hepatitis C, and retigabine, a potential treatment for partial onset seizures in patients with epilepsy. The restructuring program is designed to rationalize our investments in research and development efforts in line with our financial resources. As previously announced, we intend to sell rights to, out-license, or secure partners to share the costs of our major clinical projects and discovery programs. On January 9, 2007, we licensed the development and commercialization rights to the hepatitis B compound pradefovir to Schering-Plough. On December 21, 2006, we sold our HIV and cancer development programs and certain discovery and preclinical assets to Ardea Biosciences, Inc. (formerly IntraBiotics Pharmaceuticals) (“Ardea”), with an option for us to reacquire rights to commercialize the HIV program outside of the United States and Canada upon Ardea’s completion of Phase 2b trials. We continue to pursue partnering opportunities for taribavirin and retigabine to share the costs of development, and look to license in additional compounds in clinical development to diversify our opportunities and the inherent risks associated with product development.

 

The restructuring program is also intended to result in reduced selling, general and administrative expenses primarily through consolidation of our management functions into fewer administrative groups to achieve greater economies of scale. Management and administrative responsibilities for our regional operations in Asia, Africa and Australia, (“AAA”), which were formerly managed as a separate business unit, have been combined with those of

other regions. As a result we now have three reportable pharmaceutical segments, which comprise our pharmaceutical operations in:

 

 

We moved into a new leased headquarters building in Aliso Viejo, California in December 2006. We have reached agreement for the sale of our former headquarters building in Costa Mesa, California, where our former research laboratories were located, for cash consideration of $38,000,000. The closing, which is subject to certain customary conditions, is scheduled for March 2007. We classified this facility as “held for sale” in September 2006 in accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-lived Assets”.

 

Research and Development

 

In conjunction with the restructuring program, we decided to sell certain assets related to our discovery operations and focus our research and development resources on pre-clinical and clinical development of identified molecules. With our restructured research and development organization, we seek to develop and commercialize innovative products for the treatment of medical needs which are significantly under-served, principally in the areas of infectious disease and neurology. We are developing certain product candidates, including two clinical stage programs: taribavirin and retigabine. In addition, we have been engaged in development activities in support of Infergen and Zelapar.

 

We licensed the development and commercialization rights to the hepatitis B compound pradefovir to Schering-Plough on January 9, 2007. On December 21, 2006, we sold our HIV and cancer development programs and certain discovery and preclinical assets to Ardea Biosciences, Inc. (formerly IntraBiotics Pharmaceuticals) (“Ardea”), with an option for us to reacquire rights to commercialize the HIV program outside of the United States and Canada upon Ardea’s completion of Phase 2b trials.

 

Our research and development expenses for the years ended December 31, 2006, 2005 and 2004 were $109,618,000, $114,100,000, and $92,858,000. The reduction in research and development expenses in 2006 compared with 2005 is principally due to the completion of certain clinical trials for taribavirin and pradefovir. Clinical development expenses are expected to decline further as a result of the restructuring described above.

 

As of December 31, 2006, there were 125 employees involved in our research and development efforts.

 

Products Under Development

 

Late Stage Development of New Chemical Entities

 

Taribavirin:  Taribavirin (formerly referred to as Viramidine) is a nucleoside (guanosine) analog that is converted into ribavirin by adenosine deaminase in the liver and intestine. We are developing taribavirin in oral form for the treatment of hepatitis C.

 

Preclinical studies indicated that taribavirin, a liver-targeting analog of ribavirin, has antiviral and immunological activities (properties) similar to ribavirin. In an animal model of acute hepatitis, taribavirin showed biologic activity similar to ribavirin. The liver-targeting properties of taribavirin were also confirmed in two animal models. Short-term toxicology studies showed that taribavirin may be safer than ribavirin at the same dosage levels. This data suggested that taribavirin, as a liver-targeting analog of ribavirin, could potentially be as effective and have a lower incidence of anemia than ribavirin.

 

In 2006, we reported the results of two pivotal Phase 3 trials for taribavirin. The VISER (Viramidine Safety and Efficacy Versus Ribavirin) trials included two co-primary endpoints: one for safety (superiority to ribavirin in incidence of anemia) and one for efficacy (non-inferiority to ribavirin in sustained viral response, SVR). The results of the VISER trials met the safety endpoint but did not meet the efficacy endpoint.

 

The studies demonstrated that 38-40 percent of patients treated with taribavirin achieved SVR and that the drug continued to demonstrate a safety advantage over ribavirin, but that it was not comparable to ribavirin in efficacy at the doses studied. We believe that the results of the studies were significantly impacted by the dosing methodology, which employed a fixed dose of taribavirin for all patients and a variable dose of ribavirin based on a patient’s weight. Our analysis of the study results leads us to believe that the dosage of taribavirin, like ribavirin, likely needs to be based on a patient’s weight to achieve efficacy comparable or superior to that of ribavirin. Additionally we think that higher doses of taribavirin than those studied in the VISER program may be necessary to achieve our efficacy objectives.

 

Based on our analysis, we initiated a Phase 2b study to evaluate the efficacy of taribavirin at 20, 25 and 30 mg/kg in combination with pegylated interferon. A ribavirin control arm also is included in the study. The primary endpoint for the study will be the week 12 analysis though a preliminary review will also be conducted at week 4.

 

The Phase 2b protocol has been agreed with the FDA and we expect to initiate the study in the first quarter of 2007. If the results of the 12-week interim analysis are positive, we plan to select a dose and initiate a large Phase 3 study. If we initiate a Phase 3 study, we will consider cost and risk sharing opportunities for this larger development program.

 

The timeline and path to regulatory approval remains uncertain at this time. The completion of another Phase 3 trial would add significantly to the drug’s development cost and the time it takes to complete development, whether or not we are able to secure a development partner, thereby delaying the commercial launch of taribavirin and possibly weakening its position in relation to competing treatments. Assuming we proceed with the Phase 3 study and assuming ultimate approval by the FDA, we expect to launch taribavirin in 2010. Our external research and development expenses for taribavirin were $16,133,000 for the year ended December 31, 2006, compared with $36,474,000 for 2005.

 

Retigabine:  We are developing retigabine as adjunctive treatment for partial-onset seizures in patients with epilepsy. Retigabine is believed to have a unique, dual-acting mechanism and has undergone several Phase 2 clinical trials. The Phase 2 trials included more than 600 patients in several dose-ranging studies compared to placebo. We successfully completed an End-of-Phase 2 meeting concerning retigabine with the FDA in November 2005. The results of the key Phase 2 study indicate that the compound is potentially efficacious with a demonstrated reduction in monthly seizure rates of 23% to 35% as adjunctive therapy in patients with partial seizures. Response rates in the two higher doses were statistically significant compared to placebo (p<0.001).

 

Following a Special Protocol Assessment by the FDA, we initiated two Phase 3 trials of retigabine in 2005. One Phase 3 trial (RESTORE1; RESTORE stands for Retigabine Efficacy and Safety Trial for partial Onset Epilepsy) is being conducted at approximately 50 sites, mainly in the Americas (U.S., Central/South America); the second Phase 3 trial (RESTORE2) is being conducted at 60 sites, mainly in Europe. The first patient in the RESTORE1 trial was enrolled in September 2005. Enrollment of the first patient in the RESTORE2 trial occurred in December 2005. The enrollment period in epilepsy studies can be lengthy, frequently requiring 12 to 18 months to complete. Both RESTORE1 and RESTORE2 are approximately two-thirds enrolled. Supportive Phase 1 trials for retigabine in healthy volunteers started in 2006.

 

Assuming successful completion of the Phase 3 trials in 2008 and approval by the FDA, we expect to launch retigabine in 2009. We also plan to evaluate a sustained release formulation of the drug and intend to investigate a new indication for use in treating neuropathic pain. We are evaluating opportunities to share the investment and risk in the development of retigabine. For the 12 months ended December 31, 2006, external research and development expenses for retigabine were $27,391,000, compared with $8,864,000 for 2005.

 

Pradefovir:  Pradefovir is a compound that we licensed from Metabasis Therapeutics, Inc., or Metabasis, in October 2001. We had been engaged in the development of this compound into an oral once-a-day monotherapy for patients with chronic hepatitis B infection. The active molecule in this compound exhibits anti-hepatitis B activity against both the wild type and lamivudine drug-resistant hepatitis B. We completed Phase 1 and Phase 2 clinical trials of pradefovir.

 

On December 13, 2006, we announced the signing of definitive agreements for the assignment and license of development and commercial rights to pradefovir to Schering-Plough. The transaction closed on January 9, 2007. Under the terms of the agreements, Schering-Plough made an upfront payment of $19,200,000 to Valeant and $1,800,000 to Metabasis and will pay up to an additional $90,000,000 in aggregate fees to Valeant and Metabasis upon the achievement of certain development and regulatory milestones. Approximately $65,000,000 of the additional fees would be paid to Valeant and $25,000,000 to Metabasis. The amount to be paid to Metabasis includes the remaining $16,000,000 in milestone payments that could have been realized by Metabasis under the previous agreement between Metabasis and Valeant. Schering-Plough also will pay royalties to Valeant and Metabasis in the event pradefovir is commercialized.

 

For the 12 months ended December 31, 2006, external research and development expenses for pradefovir were $3,981,000, compared with $8,103,000 for 2005.

 

Other Development Activities

 

Infergen:  On December 30, 2005, we completed the acquisition of the United States and Canadian rights to the hepatitis C drug Infergen (interferon alfacon-1) from InterMune. Infergen, or consensus interferon, is a bio-optimized, selective and highly potent type 1 interferon alpha originally developed by Amgen and launched in the United States in 1997. It is indicated as monotherapy for the treatment of adult patients suffering from chronic hepatitis C viral infections with compensated liver disease who have not responded to other treatments or have relapsed after such treatment. Infergen is the only interferon with data in the label regarding use in patients following relapse or non-response to certain previous treatments.

 

In connection with this transaction, we acquired patent rights and rights to a clinical trial underway to expand the applications of Infergen. In the DIRECT trial (IHRC-001) which started in the second quarter of 2004, 514 patients were enrolled. Of these 514 patients, 343 were assigned to the two treatment arms whereas 171 were assigned to the no-treatment group. In the later case, when these patients reached week 24, they were allowed to enter IRHC-002, the same trial as IRHC-001 except it omits the no-treatment arm. As of December 31, 2006, 22 patients remained in IRHC-001. We reported 24-week and 48-week data from the trial at a scientific meeting in October 2006. The percent of patients who were virus negative at end-of-treatment (treatment week 48) for the Infergen 9 mcg and 15 mcg groups were 16 percent and 19 percent, respectively (TMA Assay). Response rates at end-of-treatment using the bDNA assay were 22 percent and 25 percent for the Infergen 9 mcg and 15 mcg groups, respectively.

 

The second DIRECT trial (IHRC-002) has enrolled 144 patients of the possible 171 and is still ongoing. As of December 31, 2006, 32 patients remained in this trial. Both of the DIRECT trials are reviewed on a regular basis by an independent Data Monitoring Committee to monitor the safety of each trial. Post-treatment follow-up for the DIRECT trials are expected to be completed (i.e., last patient visit) in the first and third quarters of 2007, respectively. We expect to report and publish the results from these studies sometime in late 2007.

 

In the first quarter of 2007, we are initiating a Phase 4 study to evaluate the use of Infergen 15 mcg /day plus ribavirin (1.0-1.2 g/day) in patients who did not have an optimal response at 12 weeks of treatment with pegylated interferon and ribavirin. The multi-center, randomized U.S. study will enroll patients who received initial treatment with pegylated interferon and ribavirin and achieved a >2 log 10 decline in HCV RNA at week 12 but still have detectable virus. The patients will be immediately randomized to receive Infergen 15 mcg/day plus ribavirin (1.0-1.2 g/day) for 36 or 48 weeks or continue on their pegylated interferon and ribavirin regimen for an additional 36 weeks of therapy. All treatment groups will have a 24-week follow up period to measure sustained virologic response.

 

For the year ended December 31, 2006, external research and development expenses for Infergen were $4,176,000; we did not incur research and development expenses for Infergen in 2005.

 

Zelapar:  Zelapar was approved by the FDA on June 14, 2006 as an adjunct treatment in the management of patients with Parkinson’s disease being treated with levodopa/carbidopa. Zelapar is the first Parkinson’s disease treatment to use the patented Zydis^® fast-dissolving technology, which allows the tablets to dissolve within seconds in the mouth and deliver more active drug at a lower dose. We launched Zelapar in the U.S. market in July 2006.

 

Cesamet:  Cesamet, a synthetic cannabinoid, was approved by the FDA in 2006 for the treatment of cancer chemotherapy-induced nausea and vomiting (CINV) in patients who have failed to respond adequately to conventional antiemetic treatments. We also market Cesamet in Canada for the treatment of CINV. In recent years, there has been increasing scientific and clinical evidence regarding the efficacy of cannabinoids in different types of pain, including chronic neuropathic pain. On January 19, 2007, Valeant submitted an Investigational New Drug Application (IND) to the FDA to evaluate Cesamet in cancer chemotherapy-induced neuropathic pain (CINP). Certain chemotherapy regimens result in neuropathic pain, with more than 90% of patients being affected following certain types of chemotherapy. There are no approved therapies for CINP. Valeant intends to start the development program described in this IND in 2007.

 

Licenses and Patents (Proprietary Rights)

 

Data and Patent Exclusivity

 

We rely on a combination of regulatory and patent rights to protect the value of our investment in the development of our products.

 

A patent is the grant of a property right which allows its holder to exclude others from, among other things, selling the subject invention in, or importing such invention into, the jurisdiction that granted the patent. In both the United States and the European Union, patents expire 20 years from the date of application.

 

In the United States, for five years from the date of the first United States regulatory FDA approval of a new drug compound, only the pioneer drug company can use the data obtained at the pioneer’s expense. No generic drug company may submit an application for approval of a generic drug relying on the data used by the pioneer for approval during this five-year period.

 

A similar data exclusivity scheme exists in the European Union, whereby only the pioneer drug company can use data obtained at the pioneer’s expense for up to eight years from the date of the first approval of a drug by the European Agency for the Evaluation of Medicinal Products (“EMEA”). Under both the United States and the European Union data exclusivity programs, products without patent protection can be marketed by others so long as they repeat the clinical trials necessary to show safety and efficacy.

 

Exclusivity Rights with Respect to Ribavirin

 

Generic ribavirin was launched in the United States in the first half of 2004.

 

Various parties are opposing our ribavirin patents in actions before the European Patent Office (“EPO”), and we are responding to these oppositions. One patent has been revoked by the Opposition Division of the EPO, and we have filed an appeal within the EPO. The revoked patent benefited from patent extensions in the major European countries that provide market protection until 2010. A second European patent is also the subject of an opposition proceeding in the EPO. Oral proceedings in this second opposition are scheduled to take place in June 2007.

 

Should the opponents prevail against both of our ribavirin patents, the ribavirin component of the combination therapies marketed by Schering-Plough and Roche would lose patent protection in Europe. Although data exclusivity applies to these products until 2010, if no ribavirin patents remain in force in Europe, we will no longer receive royalties from Roche in Europe.

 

Exclusivity Rights with Respect to Taribavirin and Retigabine

 

We own a United States patent (which will expire in 2018) directed to a method of treating a viral infection using a genus of compounds that includes taribavirin. We also own a United States patent (which will expire in 2020) that specifically claims the use of taribavirin to treat hepatitis C infection. If taribavirin receives regulatory approval, these patents may be eligible for patent term extensions. To the extent permitted in foreign jurisdictions, we are pursuing the foreign patent rights that correspond to our United States patents.

 

We own a United States composition of matter patent (which will expire in 2013) directed to retigabine without regard to crystalline form. We also own two United States patents (both of which will expire in 2018) that are directed to specific crystalline forms of retigabine. In addition, we own a number of United States patents and

pending applications, with expiration dates ranging from 2016 to 2023, directed to the use of retigabine to treat a variety of disease indications. We also own several patents and pending applications in foreign countries with expiration dates ranging from 2012 to 2024.

 

Upon regulatory approval, we expect to obtain five years of data exclusivity in the United States and eight years in Europe for taribavirin and retigabine. We have various issued patents or pending applications in foreign countries. These patents or patent applications, if issued, have expiration dates ranging from 2012 to 2023.

 

Government Regulations

 

We are subject to licensing and other regulatory control by the FDA, other federal and state agencies, the EMEA and other comparable foreign governmental agencies.

 

FDA approval must be obtained in the United States, EMEA approval must be obtained for countries that are part of the European Union and approval must be obtained from comparable agencies in other countries prior to marketing or manufacturing new pharmaceutical products for use by humans.

 

Obtaining FDA approval for new products and manufacturing processes can take a number of years and involve the expenditure of substantial resources. To obtain FDA approval for the commercial sale of a therapeutic agent, the potential product must undergo testing programs on animals, the data from which is used to file an IND with the FDA. In addition, there are three phases of human testing: Phase 1 consists of safety tests for human clinical experiments, generally in normal, healthy people; Phase 2 programs expand safety tests and are conducted in people who are sick with the particular disease condition that the drug is designed to treat; and Phase 3 programs are greatly expanded clinical trials to determine the effectiveness of the drug at a particular dosage level in the affected patient population. The data from these tests is combined with data regarding chemistry, manufacturing and animal toxicology and is then submitted in the form of a New Drug Application or NDA to the FDA. The preparation of an NDA requires the expenditure of substantial funds and the commitment of substantial resources. The review by the FDA can take up to several years. If the FDA determines that the drug is safe and effective, the NDA is approved. A similar process exists in the European Union and in other countries. See Item 1A — Risk Factors for risks associated with government regulation of our business.

 

Manufacturers of drug products are required to comply with manufacturing regulations, including current good manufacturing regulations enforced by the FDA and similar regulations enforced by regulatory agencies outside the United States. In addition, we are subject to price control restrictions on our pharmaceutical products in many countries in which we operate.

 

Environmental Regulation

 

We are subject to national, state, and local environmental laws and regulations, including those governing the handling and disposal of hazardous wastes, wastewater, solid waste and other environmental matters. Our development and manufacturing activities involve the controlled use of hazardous materials. Although we believe that our safety procedures for handling and disposing of these materials comply with applicable regulations, we cannot completely eliminate the risk of accidental contamination or injury from these materials. In the event of an accident, we could be held liable for resulting damages.

 

Marketing and Customers

 

We focus on the following major geographic markets:  the United States, Mexico, Poland, Canada, Germany, Spain, Italy, the United Kingdom, and France. During the year ended December 31, 2006, we derived approximately 79% of our specialty pharmaceutical sales from these markets. In the United States, Europe and Latin America, principally in Mexico, we currently promote our pharmaceutical products to physicians, hospitals, pharmacies and wholesalers through our own sales force. These products are typically distributed to drug stores and hospitals through wholesalers. In Canada, we have our own sales force and promote and sell directly to physicians, hospitals, wholesalers and large drug store chains. In many smaller markets we market our products through distributors or contracted sales forces.

 

As part of our marketing program for pharmaceuticals, we use direct mailings, advertise in trade and medical periodicals, exhibit products at medical conventions, sponsor medical education symposia and sell through distributors in countries where we do not have our own sales staff.

 

Competition

 

Our competitors include specialty and large pharmaceutical companies, biotechnology companies, academic and other research and development institutions, and generic manufacturers, both in the United States and abroad. In addition, our cosmeceutical Kinerase products also face competition from manufacturers of non-prescription cosmetic products. Our competitors are pursuing the development of pharmaceuticals that target the same diseases and conditions that we are targeting in neurology, infectious disease and dermatology.

 

For instance, with respect to infectious disease, some competitors are engaged in research on the development of a vaccine to prevent hepatitis C and others are developing therapies that do not incorporate the use of ribavirin or our successor in development, taribavirin, to treat hepatitis C.

 

Products being developed by our competitors to treat hepatitis C include, but are not limited to:

 

 

Products being developed by our competitors to treat epilepsy include, but are not limited to:

 

 

The success of any of our competitors’ products or products in development could hurt sales of ribavirin and Infergen and our expected revenues for taribavirin or retigabine, if approved.

 

We sell a broad range of products, and competitive factors vary by product line and geographic area in which the products are sold. Factors that may affect the competitiveness of our products in each geographic market include, but are not limited to, the effectiveness, pricing, availability and promotional efforts with respect to our products as compared to those of our competitors as well as whether we have exclusivity protections for our molecules.

 

We also face increased competition from manufacturers of generic pharmaceutical products when patents covering certain of our currently marketed products expire or are successfully challenged. We currently have two significant products, Efudex and Cesamet, which do not currently have generic competition but neither of which are protected by patent or regulatory exclusivity.

 

Manufacturing

 

As a part of our plan to improve operational performance, we adopted a global manufacturing strategy to reduce the number of manufacturing sites in our global manufacturing and supply chain network from 15 sites in 2003 to six sites by the end of 2006. As of December 31, 2006, we had disposed of nine sites targeted as non-strategic and we have a letter of intent to sell two others. We now expect to have only four manufacturing sites by the end of 2007. For information about manufacturing restructuring, see Note 2 of notes to consolidated financial statements. All of our manufacturing facilities that require certification from the FDA or foreign agencies have obtained such approval.

 

We also subcontract the manufacturing of certain of our products, including products manufactured under the rights acquired from other pharmaceutical companies. Generally, acquired products continue to be produced for a specific period of time by the selling company. During that time, we integrate the products into our own manufacturing facilities or initiate toll manufacturing agreements with third parties.

 

In 2007 we estimate that approximately 53% of our products and approximately 49% of our product sales, will be produced by third party manufacturers under toll manufacturing arrangements.

 

The principal raw materials used by us for our various products are purchased in the open market. Most of these materials are available from several sources. We have not experienced any significant shortages in supplies of such raw materials.

 

Employees

 

As of December 31, 2006, we had 3,443 employees.  These employees include 1,329 in production, 1,568 in sales and marketing, 125 in research and development, and 421 in general and administrative positions. Collective bargaining exists for some employees in a number of markets; the majority of our employees in Spain are covered by collective bargaining or similar agreements. Substantially all the employees in Europe are covered by national labor laws which establish the rights of employees, including the amount of wages and benefits paid and, in certain cases, severance and similar benefits. We currently consider our relations with our employees to be good and have not experienced any work stoppages, slowdowns or other serious labor problems that have materially impeded our business operations.

 

Product Liability Insurance

 

We have had product liability insurance to cover damages resulting from the use of our products since March 2005. Prior to 2005, we obtained product liability insurance coverage only for certain products. We have in place clinical trial insurance in the major markets where we conduct clinical trials.

 

Foreign Operations

 

Approximately 71% and 75% of our revenues from continuing operations, which includes royalties, for the years ended December 31, 2006 and 2005, respectively, were generated from operations or otherwise earned outside the United States. All of our foreign operations are subject to risks inherent in conducting business abroad, including price and currency exchange controls, fluctuations in the relative values of currencies, political instability and restrictive governmental actions including possible nationalization or expropriation. Changes in the relative values of currencies may materially affect our results of operations. The effect of these risks remains difficult to predict.

 

You should consider carefully the following risk factors, together with all of the other information included or incorporated in this Report. Each of these risk factors, either alone or taken together, could adversely affect our business, operating results and financial condition, as well as adversely affect the value of an investment in our securities. There may be additional risks that we do not presently know of or that we currently believe are immaterial which could also impair our business and financial position.

 

If we cannot successfully develop or obtain future products and commercialize those products, our growth would be delayed.

 

Our future growth will depend, in large part, upon our ability to develop or obtain and commercialize new products and new formulations of, or indications for, current products. We are engaged in an active development program involving compounds owned by us or licensed from others which we may commercially develop in the future. We are in clinical trials for taribavirin, retigabine and other compounds. The process of successfully commercializing products is time consuming, expensive and unpredictable. There can be no assurance that we will be able to develop or acquire new products, successfully complete clinical trials, obtain regulatory approvals to use

these products for proposed or new clinical indications, manufacture our potential products in compliance with regulatory requirements or in commercial volumes, or gain market acceptance for such products. In addition, changes in regulatory policy for product approval during the period of product development and regulatory agency review of each submitted new application may cause delays or rejections. It may be necessary for us to enter into other licensing arrangements, similar to our arrangements with Schering-Plough and Roche, with other pharmaceutical companies in order to market effectively any new products or new indications for existing products. There can be no assurance that we will be successful in entering into such licensing arrangements on terms favorable to us or at all.

 

There can be no assurance that the clinical trials of any of our product candidates, including taribavirin and retigabine will be successful, that we will be granted approval to market any of our product candidates for any of the indications we are seeking or that any of our product candidates will result in a commercially successful product.

 

The introduction of generic products has significantly impacted ribavirin royalties and may negatively impact future financial results.

 

While ribavirin royalty revenues earned by us under our ribavirin license agreements with Schering-Plough and Roche have declined, they still represent an important source of revenues to us. Schering-Plough markets ribavirin for use in combination with its interferon product under the trade name “Rebetol” as a therapy for the treatment of hepatitis C and Roche markets ribavirin for use in combination with its interferon product under the name “Copegus.” Under the terms of their license agreements, Schering-Plough and Roche each have sole discretion to determine the pricing of ribavirin and the amount and timing of resources devoted to their respective marketing of ribavirin.

 

Our research and development activities have historically been funded, in part, by the royalties received from Schering-Plough and Roche. Competition from generic pharmaceutical companies in the U.S. market has had a material negative impact on our royalty revenue by significantly reducing royalties payable to us by Schering-Plough and eliminating royalties payable to us by Roche in the U.S. market.

 

Various parties are opposing our ribavirin patents in actions before the European Patent Office, and we are responding to these oppositions. If we should lose patent protection in Europe, Roche will no longer be required to pay us royalties for European sales. While data exclusivity for the combination therapies marketed by Schering-Plough and Roche is scheduled to continue in the major markets of the European Union until 2009 for Schering-Plough and 2012 for Roche, regulatory approvals and schemes may change and/or studies regarding ribavirin in combination with interferon may be replicated, allowing earlier introduction of generics into such markets should the patent opposition be successful.

 

Third parties may be able to sell generic forms of our products or block our sales of our products if our intellectual property rights or data exclusivity rights do not sufficiently protect us; patent rights of third parties may also be asserted against us.

 

Our success depends in part on our ability to obtain and maintain meaningful exclusivity protection for our products and product candidates in key markets throughout the world via patent protection and/or data exclusivity protection. The patent positions of pharmaceutical, biopharmaceutical and biotechnology companies can be highly uncertain and involve complex legal and factual questions. We will be able to protect our products from generic substitution by third parties only to the extent that our technologies are covered by valid and enforceable patents, effectively maintained as trade secrets or protected by data exclusivity. However, our currently pending or future patent applications may not issue as patents. Any patent issued may be challenged, invalidated, held unenforceable or circumvented. Furthermore, our patents may not be sufficiently broad to prevent third parties from producing generic substitutes for our products. Lastly, data exclusivity schemes vary from country to country and may be limited or eliminated as governments seek to reduce pharmaceutical costs by increasing the speed and ease of approval of generic products.

 

In order to protect or enforce patent and/or data exclusivity rights, we may initiate patent litigation against third parties, and we may be similarly sued by others. We may also become subject to interference proceedings conducted in the patent and trademark offices of various countries to determine the priority of inventions. The defense and

prosecution, if necessary, of intellectual property and data exclusivity actions are costly and divert technical and management personnel from their normal responsibilities. We may not prevail in any of these suits. An adverse determination of any litigation or defense proceeding, resulting in a finding of non-infringement or invalidity of our patents, or a lack of protection via data exclusivity, may allow the entry of generic substitutes for our products.

 

Furthermore, because of the substantial amount of discovery required in connection with such litigation, there is a risk that some of our confidential information could be compromised by disclosure during such litigation. In addition, during the course of this kind of litigation, there could be public announcements of the results of hearings, motions or other interim proceedings or developments in the litigation. If securities analysts or investors perceive these results to be negative, it could have a substantial negative effect on the trading price of our securities.

 

The existence of a patent will not necessarily protect us from competition. Competitors may successfully challenge our patents, produce similar drugs that do not infringe our patents or produce drugs in countries that do not respect our patents. No patent can protect its holder from a claim of infringement of another patent. Therefore, our patent position cannot and does not provide an assurance that the manufacture, sale or use of products patented by us would not infringe a patent right of another.

 

While we know of no actual or threatened claim of infringement that would be material to us, there can be no assurance that such a claim will not be asserted. If such a claim is asserted, there can be no assurance that the resolution of the claim would permit us to continue producing the relevant product on commercially reasonable terms.

 

Products representing a significant amount of our revenue are not protected by patent or data exclusivity rights.

 

Some of the products we sell have no meaningful exclusivity protection via patent or data exclusivity rights. These products represent a significant amount of our revenues. Without exclusivity protection, competitors face fewer barriers in introducing competing products. The introduction of competing products could adversely affect our results of operations and financial condition.

 

If taribavirin and retigabine do not become approved and commercially successful products, our ability to generate future growth in revenue and earnings will be adversely affected.

 

We focus our development activities on areas in which we have particular strengths, such as the antiviral and neurology areas. The outcome of any development program is highly uncertain. Products in clinical trials may fail to yield a commercial product, or a product may be approved by the FDA yet not be a commercial success. Success in preclinical and early stage clinical trials may not necessarily translate into success in large-scale clinical trials.

 

In addition, we will need to obtain and maintain regulatory approval in order to market taribavirin and retigabine. Even if they appear promising in large-scale Phase 3 clinical trials, regulatory approval may not be achieved. The results of clinical trials are susceptible to varying interpretations that may delay, limit or prevent approval or result in the need for post-marketing studies. In addition, changes in regulatory policy for product approval during the period of product development and FDA review of a new application may cause delays or rejection. Even if we receive regulatory approval, this approval may include limitations on the indications for which we can market a product, thereby reducing the size of the market that we would be able to address or our product may not be chosen by physicians for use by their patients. There is no guarantee that we will be able to satisfy the needed regulatory requirements, and we may not be able to generate significant revenue, if any, from taribavirin and retigabine.

 

We are subject to uncertainty related to health care reform measures and reimbursement policies.

 

The levels at which government authorities, private health insurers, HMOs and other organizations reimburse the cost of drugs and treatments related to those drugs will impact the successful commercialization of our drug candidates. We cannot be sure that reimbursement in the United States or elsewhere will be available for any drugs we may develop or, if already available, will not be decreased in the future. Also, we cannot be sure that reimbursement amounts will not reduce the demand for, or the price of, our drugs. If reimbursement is not available

or is available only on a limited basis, we may not be able to obtain a satisfactory financial return on the manufacture and commercialization of existing and future drugs. Third-party payors may not establish and maintain price levels sufficient for us to realize an appropriate return on our investment in product development or our continued manufacture and sale of existing drug products.

 

We are subject to price control restrictions on our pharmaceutical products in the majority of countries in which we operate.

 

Jurisdictions outside of the United States may enact price control restrictions or increase the price control restrictions that currently exist. A significant portion of the sales of our products are in Europe, a market in which price increases are controlled, and in some instances, reductions are imposed. Our future sales and gross profit could be materially adversely affected if we are unable to obtain appropriate price increases, or if our products are subject to price reductions.

 

The matters relating to the Special Committee’s review of our historical stock option granting practices and the restatement of our consolidated financial statements have resulted in increased litigation and regulatory proceedings against us and could have a material adverse effect on us.

 

In September 2006, our board of directors appointed a Special Committee, which consisted solely of independent directors, to conduct a review of our historical stock option granting practices and related accounting during the period from 1982 through July 2006. The Special Committee identified a number of occasions on which the exercise prices for stock options granted to certain of our directors, officers and employees were set using closing prices of our common stock with dates different than the actual approval dates, resulting in additional compensation charges. To correct these and other accounting errors, we have amended our annual report on Form 10-K for the year ended December 31, 2005 and our quarterly reports on Form 10-Q for the quarters ended March 31, 2006 and June 30, 2006 to restate the consolidated financial statements contained in those reports.

 

Our historical stock option granting practices and the restatement of our prior financial statements have exposed us to greater risks associated with litigation and regulatory proceedings. We are a named defendant in two shareholder derivative lawsuits pending in the state court in Orange County, California, which assert claims related to our historic stock option practices. In addition, the SEC has opened an informal inquiry into our historical stock option grant practices. We cannot assure you that this current litigation, the SEC inquiry or any future litigation or regulatory action will result in the same conclusions reached by the Special Committee. The conduct and resolution of these matters will be time consuming, expensive and distracting from the conduct of our business. Furthermore, if we are subject to adverse findings in any of these matters, we could be required to pay damages or penalties or have other remedies imposed upon us which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

The pending SEC inquiry could adversely affect our business and the trading price of our securities.

 

In July 2006, we were contacted by the SEC, with respect to an informal inquiry regarding events and circumstances surrounding trading in our common stock and the public release of data from our first pivotal Phase 3 trial for taribavirin. In addition, the SEC later requested data regarding our stock option grants since January 1, 2000 and information about our pursuit in the Delaware Chancery Court of the return of certain bonuses paid to Milan Panic, the former chairman and chief executive officer, and others. In September 2006, our board of directors established the Special Committee to review our historical stock option practices and related accounting. The Special Committee concluded its investigation in January 2007. We have briefed the SEC with the results of the Special Committee’s investigation. We have cooperated fully and will continue to cooperate with the SEC on its informal inquiry. We cannot predict the outcome of the inquiry. In the event that the inquiry leads to SEC action against any current or former officer or director, our business (including our ability to complete financing transactions) and the trading price of our securities may be adversely impacted. In addition, if the SEC inquiry continues for a prolonged period of time, it may have an adverse impact on our business or the trading price of our securities regardless of the ultimate outcome of the investigation. In addition, the SEC inquiry has resulted in the incurrence of significant legal expenses and the diversion of management’s attention from our business, and this may continue, or increase, until the inquiry is concluded.

 

If competitors develop vaccines or more effective or less costly drugs for our target indications, our business could be seriously harmed.

 

The biotechnology and pharmaceutical industries are intensely competitive and subject to rapid and significant technological change. Our existing products and many of the drugs that we are attempting to develop or discover compete with or will be competing with new and existing therapies. Many companies in the United States and abroad are pursuing the development of pharmaceuticals that target the same diseases and conditions that we are targeting. If, for example, other therapies that do not incorporate the use of our products prove to be more clinically or cost effective treatments, then our revenues could be adversely affected. For example, there are institutions engaged in the research and development of a vaccine to prevent hepatitis C. The availability of such a vaccine could have an adverse effect on our existing revenues from sales of products treating hepatitis C and could materially and adversely affect our expected revenue from products under development.

 

Many of our competitors, particularly large pharmaceutical companies, have substantially greater financial, technical and human resources than we do. Many of our competitors spend significantly more on research and development related activities than we do. Others may succeed in developing products that are more effective than those currently marketed or proposed for development by us. Progress by other researchers in areas similar to those being explored by us may result in further competitive challenges. In addition, academic institutions, government agencies, and other public and private organizations conducting research may seek patent protection with respect to potentially competitive products. They may also establish exclusive collaborative or licensing relationships with our competitors.

 

Obtaining necessary government approvals is time consuming and not assured.

 

FDA approval must be obtained in the United States and approval must be obtained from comparable agencies in other countries prior to marketing or manufacturing new pharmaceutical products for use by humans. Obtaining FDA approval for new products and manufacturing processes can take a number of years and involves the expenditure of substantial resources. Numerous requirements must be satisfied, including preliminary testing programs on animals and subsequent clinical testing programs on humans, to establish product safety and efficacy. No assurance can be given that we will obtain approval in the United States, or any other country, of any application we may submit for the commercial sale of a new or existing drug or compound. Nor can any assurance be given that if such approval is secured, the approved labeling will not have significant labeling limitations, or that those drugs or compounds will be commercially successful.

 

Furthermore, changes in existing regulations or adoption of new regulations could prevent or delay us from obtaining future regulatory approvals or jeopardize existing approvals, which could significantly increase our costs associated with obtaining approvals and negatively impact our market position.

 

If we or our third-party manufacturers are unable to manufacture our products or the manufacturing process is interrupted due to failure to comply with regulations or for other reasons, the manufacture of our products could be interrupted.

 

We manufacture and have contracted with third parties to manufacture some of our drug products, including products under the rights acquired from other pharmaceutical companies. Manufacturers are required to adhere to current good manufacturing (“cGMP”) regulations enforced by the FDA or similar regulations required by regulatory agencies in other countries. Compliance with the FDA’s cGMP requirements applies to both drug products seeking regulatory approval and to approved drug products. Our manufacturing facilities and those of our contract manufacturers must be inspected and found to be in full compliance with cGMP standards before approval for marketing. We and contract manufacturers of our approved products are subject to ongoing regulation by the FDA, including compliance with cGMP requirements, and to similar regulatory requirements enforced by regulatory agencies in other countries.

 

Our dependence upon others to manufacture our products may adversely affect our profit margins and our ability to develop and obtain approval for our products on a timely and competitive basis, if at all. Our failure or that of our contract manufacturers to comply with cGMP regulations or similar regulations outside of the United States can result in enforcement action by the FDA or its foreign counterparts, including, among other things, warning

letters, fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production, refusal of the government to renew marketing applications and criminal prosecution. In addition, delays or difficulties with our contract manufacturers in producing, packaging, or distributing our products could adversely affect the sales of our current products or introduction of other products.

 

Schering-Plough manufactures and sells ribavirin under license from us. In May 2002, Schering-Plough signed a consent decree of permanent injunction with the FDA, agreeing to measures to assure that the drug products manufactured at their Puerto Rico plant are made in compliance with FDA’s current good manufacturing practice regulations. While Schering-Plough has advised us that the deficiencies were not specifically applicable to the production of ribavirin, the consent decree covers the facility producing ribavirin. Schering-Plough’s ability to manufacture and ship ribavirin could be affected by temporary interruption of some production lines to install system upgrades and further enhance compliance, and other technical production and equipment qualification issues. If the FDA is not satisfied with Schering-Plough’s compliance under the consent decree, the FDA could take further regulatory actions against Schering-Plough, including the seizure of products, an injunction against further manufacture, a product recall or other actions that could interrupt production of ribavirin. Interruption of ribavirin production for a sustained period of time could materially reduce our royalty revenue.

 

In addition to regulatory compliance risks, our contract manufacturers in the United States and in other countries are subject to a wide range of business risks, such as seizure of assets by governmental authorities, natural disasters, and domestic and international economic conditions. Were any of our contract manufacturers not able to manufacture our products because of regulatory, business or any other reasons, the manufacture of our products would be interrupted. This could have a negative impact on our sales, financial condition and competitive position.

 

Many of our key processes, opportunities and expenses are a function of existing national and/or local government regulation. Significant changes in regulations could have a material adverse impact on our business.

 

The process by which pharmaceutical products are approved is lengthy and highly regulated. We have developed expertise in managing this process in the many markets around the world. Our multi-year clinical trials programs are planned and executed to conform to these regulations, and once begun, can be difficult and expensive to change should the regulations regarding approval of pharmaceutical products significantly change.

 

In addition, we depend on patent law and data exclusivity to keep generic products from reaching the market in our evaluations of the development of our products. In assessing whether we will invest in any development program, or license a product from a third party, we assess the likelihood of patent and/or data exclusivity under the laws and regulations then in effect. If those schemes significantly change in a large market, or across many smaller markets, our ability to protect our investment may be adversely affected.

 

Appropriate tax planning requires that we consider the current and prevailing national and local tax laws and regulations, as well as international tax treaties and arrangements that we enter into with various government authorities. Changes in national/local tax regulations, or changes in political situations may limit or eliminate the effects of our tax planning and could result in unanticipated tax expenses.

 

Our business, financial condition and results of operations are subject to risks arising from the international scope of our operations.

 

We conduct a significant portion of our business outside the United States. Including ribavirin royalties, approximately 71% and 75% of our revenue was generated outside the United States during the year ended December 31, 2006 and 2005, respectively. We sell our pharmaceutical products in more than 100 countries around the world and employ approximately 2,600 individuals in countries other than the United States. The international scope of our operations may lead to volatile financial results and difficulties in managing our operations because of, but not limited to, the following:

 

 

 

Our debt agreements permit us to incur additional debt; however, we may not be able to secure sufficient or acceptable financing to fund our operations.

 

We have funded our operations, including our research and development activities, with existing cash reserves, cash flows from operations and cash from sales of unsecured debt and equity securities. Our existing debt agreements permit us to borrow at least $150,000,000 on a secured basis from banks.

 

While we believe that we can obtain at least $150,000,000 in secured financings to finance our operations, we can give no assurances that such financings will be obtained or available on terms acceptable to us. Further, if we obtain such financing, we cannot be sure that the amount will be sufficient to meet all our cash requirements, including the marketing of new products and paying quarterly dividends, which have been suspended since October 2006. There are significant contractual limitations on our ability to pay future dividends under the terms of the indenture governing our 7% senior notes due 2011. Incurring additional debt may also subject us to covenants, in addition to those in our existing debt agreements, that may restrict how we operate our business.

 

Cash earned by our foreign subsidiaries is held at those subsidiaries and transferring that cash to the United States would likely have a negative impact on our earnings.

 

A substantial portion of our cash balances and reserves result from the operations of, and are held by, our subsidiaries outside of the United States. The income in these countries has been taxed in the various countries where it was earned, but it has not been subject to tax in the United States. Income tax expense has been calculated on the basis that foreign earnings will be indefinitely invested in non-U.S. assets

 

If we find it necessary to utilize the cash reserves of our foreign subsidiaries to finance our research and development and other activities in the United States, our income generated in foreign countries will become subject to taxation in the United States. Given the net operating loss carryforwards that we have available to offset income in the United States, it is unlikely in the near term that we would incur significant cash obligations to pay tax on repatriated foreign earnings. However, repatriating our cash resources from foreign jurisdictions would likely increase income tax expense in our financial statements which would significantly reduce our earnings. It would also use our net operating loss carryforwards, which would increase future cash obligations to pay taxes on U.S. income.

 

Much of our operating cash flow is earned outside of the United States.

 

We are involved in various legal proceedings that could adversely affect us.

 

We are involved in several legal proceedings, including those described in Note 15 of notes to the consolidated financial statements. Defending against claims and any unfavorable legal decisions, settlements or orders could have a material adverse effect on us.

 

If our products are alleged to be harmful, we may not be able to sell them and we may be subject to product liability claims not covered by insurance.

 

The nature of our business exposes us to potential liability risks inherent in the testing, manufacturing and marketing of pharmaceutical products. Using our drug candidates in clinical trials also exposes us to product

liability claims. These risks will expand with respect to drugs, if any, that receive regulatory approval for commercial sale. Even if a drug were approved for commercial use by an appropriate governmental agency, there can be no assurance that users will not claim that effects other than those intended may result from our products. While to date no material adverse claim for personal injury resulting from allegedly defective products has been successfully maintained against us, a substantial claim, if successful, could have a material negative impact on us.

 

In the event that anyone alleges that any of our products are harmful, we may experience reduced consumer demand for our products or our products may be recalled from the market. In addition, we may be forced to defend lawsuits and, if unsuccessful, to pay a substantial amount in damages.

 

We currently maintain clinical trial insurance in the major markets in which we conduct clinical trials. There is no assurance, however, that such insurance will be sufficient to cover all claims.

 

Existing and future audits by, or other disputes with, taxing authorities may not be resolved in our favor.

 

Our income tax returns are subject to audit in various jurisdictions. Existing and future audits by, or other disputes with, tax authorities may not be resolved in our favor and could have an adverse effect on our reported effective tax rate and after-tax cash flows.

 

The Internal Revenue Service has completed an examination of our tax returns for the years 1997 through 2001 and has proposed adjustments to our tax liabilities for those years plus associated interest and penalties. While we have written a formal protest in response to the proposed adjustments, we have also recorded an additional tax provision of $27,368,000 should we not prevail in our position. The provision consists of $62,317,000 as the estimated additional taxes, interest and penalties associated with the period 1997 to 2001. This amount is offset by $34,949,000 in deferred tax benefits that would be realized if the tax assessment is upheld. While we have substantial net operating loss and other carryforwards available to offset our U.S. tax liabilities, the additional tax provision we recorded results from annual utilization limitations on those carryforwards that would result if the Internal Revenue Service adjustments are upheld.

 

In 1999, we restructured our operations by contributing the stock of several non-United States subsidiaries to a wholly-owned Dutch company. At the time of the restructuring, the Company intended to avail itself of the non-recognition provisions of the Internal Revenue Code to avoid generating taxable income on the intercompany transfer. One of the requirements under the non-recognition provisions was to file Gain Recognition Agreements with our timely filed 1999 United States Corporate Income Tax Return. We discovered and voluntarily informed the IRS that the Gain Recognition Agreements had been inadvertently omitted from the 1999 tax return. The IRS has denied our request to rule that reasonable cause existed for the failure to provide the agreements, the result of which is additional taxable income in that year of approximately $120,000,000. We are pursuing resolution through the formal appeals process. The impact of the IRS position on this issue is considered in the adjustments noted above.

 

Our flexibility in maximizing commercialization opportunities for our compounds may be limited by our obligations to Schering-Plough.

 

In November 2000, we entered into an agreement that provides Schering-Plough with an option to acquire the rights to up to three of our products intended to treat hepatitis C that they designate prior to our entering into Phase 2 clinical trials and a right for first/last refusal to license various compounds we may develop and elect to license to others. Taribavirin was not subject to the option of Schering-Plough, but it would be subject to their right of first/last refusal if we elected to license it to a third party. In addition, the agreement provides for certain other disclosures about our research and development activities. The interest of potential collaborators in obtaining rights to our compounds or the terms of any agreements we ultimately enter into for these rights may be negatively impacted by our agreement with Schering-Plough. A commercialization partner other than Schering-Plough may be preferable in a given disease area or geographic region or due to that potential partner’s strength or for other reasons.

 

Difficulties in completing, financing and integrating acquisitions could have a material adverse impact on our future growth.

 

We intend to pursue a strategy of targeted expansion through the acquisition of compatible businesses and product lines and the formation of strategic alliances, joint ventures and other business combinations. There can be no assurance that we will successfully complete or finance any future acquisition or investment or that any acquisitions that we do complete will be completed at prices or on terms that prove to be advantageous to us. Failure in integrating the operations of companies that we have acquired or may acquire in the future may have a material adverse impact on our operating results, financial condition and future growth.

 

Due to the large portion of our business conducted outside the United States, we have significant foreign currency risk.

 

We sell products in many countries that are susceptible to significant foreign currency risk. In some of these markets we sell products for U.S. Dollars. While this eliminates our direct currency risk in such markets, it increases our risk that we could lose market share to competitors because if a local currency is devalued significantly, it becomes more expensive for customers in that market to purchase our products in U.S. Dollars.

 

Our stockholder rights plan and anti-takeover provisions of our charter documents could provide our board of directors with the ability to delay or prevent a change in control of us.

 

Our stockholder rights plan, provisions of our certificate of incorporation, bylaws and the Delaware General Corporation Law provide our board of directors with the ability to deter hostile takeovers or delay, deter or prevent a change in control of the company, including transactions in which stockholders might otherwise receive a premium for their shares over then current market prices.

 

We are authorized to issue, without stockholder approval, approximately 10,000,000 shares of preferred stock, 200,000,000 shares of common stock and securities convertible into either shares of common stock or preferred stock. The board of directors can also use issuances of preferred or common stock to deter a hostile takeover or change in control of the Company.

 

We are subject to a consent order with the Securities and Exchange Commission.

 

We are subject to a consent order with the SEC, which permanently enjoins us from violating securities laws and regulations. The consent order also precludes protection for forward-looking statements under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to forward-looking statements we made prior to November 28, 2005. The existence of the permanent injunction under the consent order, and the lack of protection under the safe harbor with respect to forward-looking statements we made prior to November 28, 2005 may limit our ability to defend against future allegations.

 

We are subject to “fraud and abuse” and similar laws and regulations, and a failure to comply with such regulations or prevail in any litigation related to noncompliance could harm our business.

 

Pharmaceutical and biotechnology companies have faced lawsuits and investigations pertaining to violations of health care “fraud and abuse” laws, such as the federal false claims act, the federal anti-kickback statute, and other state and federal laws and regulations. If any such actions are instituted against us, and we are not successful in defending ourselves or asserting our rights, those actions could have a significant impact on our business, including the imposition of significant fines or other sanctions.

 

If we do not realize the expected benefits from the restructuring plan we announced in April 2006, our operating results and financial conditions would be negatively impacted.

 

In April 2006, we announced a strategic restructuring designed to focus our resources on programs and products that have the greatest opportunity for success. Accordingly, we elected to rationalize certain of our assets, including our discovery program and certain manufacturing facilities. We have sold and out licensed pradefovir and certain discovery programs, and any future compensation relating thereto is contingent upon the transferee’s

successful development of the applicable product and/or program. Such success is subject to the risks inherent in developing and obtaining approval for pharmaceutical products. Accordingly, it is possible that we may not receive any financial benefit from the sale or out license of these assets. In addition, if we are unable to realize the expected operational efficiencies from our restructuring plan, our operating results and financial condition would be adversely affected.

 

None.

 

Our major facilities are in the following locations:

 

 

 

 

In our opinion, facilities occupied by us are more than adequate for present requirements, and our current equipment is considered to be in good condition and suitable for the operations involved.

 

See Note 15 of notes to consolidated financial statements.

 

None.

 

Price Range of Common Stock

 

Our common stock is traded on the New York Stock Exchange (Symbol: VRX). As of February 23, 2007 there were 4,989 holders of record of our common stock.

 

The following table sets forth, for the periods indicated the high and low sales prices of our common stock on the New York Stock Exchange — Composite Transactions reporting system.

 

 

Performance Graph

 

The following graph compares the cumulative total return on our common stock with the cumulative return on the Standard and Poor’s Mid Cap 400 Index (“S&P Mid Cap 400 Index”) and a 10-Stock Custom Composite Index (the “New Custom Composite Index”) for the five years ended December 31, 2006. The New Custom Composite consists of Allergan, Inc., Biovail Corporation, Cephalon, Inc., Forest Laboratories, Inc., Gilead Sciences, Inc., King Pharmaceuticals, Inc., Medicis Pharmaceutical Corporation, Mylan Laboratories Inc., Shire Pharmaceuticals Group plc and Watson Pharmaceuticals, Inc. The second graph compares the cumulative total return of our common stock with its previously used 10-Stock Composite Index (the “Old Custom Composite Index”) which consisted of AAIPharma, Inc., Allergan, Inc., Biovail Corporation, Forest Laboratories, Inc., Gilead Sciences, Inc., King Pharmaceuticals, Inc., Medicis Pharmaceutical Corporation, Mylan Laboratories Inc., Shire Pharmaceuticals Group plc and Watson Pharmaceuticals, Inc. AAIPharma, Inc. was been removed from the composite index and replaced with Cephalon, Inc. AAIPharma, Inc. was delisted from the Nasdaq Stock Market in April 2005 and is no longer a publicly traded company. Factors used in deciding to include Cephalon, Inc. in the New Custom Composite Index include similarity of market capitalization, international presence and existence of branded products. Cephalon, Inc. is also a Nasdaq-listed component of the S&P Mid Cap 400 index.

 

Based on reinvestment of $100 beginning on December 31, 2001

 

 

 

Based on reinvestment of $100 beginning on December 31, 2001

 

 

Dividend Policy

 

We paid cash dividends of $0.0775 per share for the first three quarters during the year ended December 31, 2006 and for each of the quarters during the year ended December 31, 2005. We announced in October 2006 that we would not pay a dividend for the fourth quarter of 2006.

 

Our board of directors will continue to review our dividend policy. The amount and timing of any future dividends will depend upon our financial condition and profitability, the need to retain earnings for use in the development of our business, contractual restrictions and other factors. There are significant contractual limitations on our ability to pay future dividends under the terms of the indenture governing our 7% senior notes due 2011.

 

The following table sets forth financial data for each of the five years ended December 31, 2006. The selected historical financial data as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005, 2004 and 2003, respectively, has been derived from the audited restated consolidated financial statements. The data as of December 31, 2003 and 2002, respectively, and for the year ended December 31, 2002 has been derived from unaudited restated financial statements, which are not included in this Form 10-K.

 

 

 

Notes to Selected Financial Data:

 

 

Company Overview

 

We are a global specialty pharmaceutical company that develops, manufactures and markets a broad range of pharmaceutical products, primarily in the areas of neurology, infectious disease, and dermatology. Our marketing and promotion efforts focus on our Promoted Products. Our products are currently sold in more than 100 markets around the world, with our primary focus on the United States, Canada, Mexico, the United Kingdom, France, Italy, Poland, Germany, and Spain.

 

Our primary value driver is a specialty pharmaceutical business with a global platform. We believe that our global reach and marketing agility differentiate us among specialty pharmaceutical companies, and provide us with the ability to leverage compounds in the clinical stage and commercialize them in major markets around the world. In addition, we receive royalties from the sale of ribavirin by Schering-Plough and Roche, although such royalties are expected to decline as a result of market competition and the loss of exclusivity in European markets and Japan.

 

Specialty Pharmaceuticals

 

Product sales from our specialty pharmaceuticals segment accounted for 91% of our total revenues from continuing operations for the year ended December 31, 2006, compared to 89% for 2005. Product sales increased $93,756,000 (13%) for the year ended December 31, 2006 compared with 2005. Infergen, the product we acquired from InterMune, Inc. on December 30, 2005, contributed $42,716,000 to the increase. Excluding Infergen, specialty pharmaceutical sales grew 7% in 2006. On a net basis, excluding Infergen, volume sales of our products was flat year over year with volume growth in our Promoted Products being offset by declines in volume on our non-promoted products. Specialty pharmaceutical product sales in 2006 include an approximate 1% favorable impact from foreign exchange rate fluctuations.

 

Our current product portfolio comprises approximately 370 branded products, with approximately 2,200 stock keeping units. We market our products globally through a marketing and sales force consisting of approximately 1,568 employees. We focus our sales, marketing and promotion efforts on the Promoted Products within our product portfolio. We have identified these Promoted Products as offering the best potential return on investment. The majority of our Promoted Products are in our three targeted therapeutic areas. Promoted Products in other therapeutic areas have characteristics and regional or local market positions that also offer significant growth and returns on marketing investments.

 

Our future growth is expected to be driven primarily by the commercialization of new products, growth of our existing products, and business development. Our Promoted Products accounted for 58% and 51% of our specialty pharmaceutical product sales for the years ended December 31, 2006 and 2005, respectively. Sales of our Promoted Products increased $101,959,000 (27%) in the year ended December 31, 2006 compared to 2005. This increase includes $42,716,000 from Infergen, a product we did not sell in 2005. Excluding Infergen, sales of Promoted Products increased $59,243,000 or 16% in the year ended December 31, 2006 compared to 2005. Our increased sales of Promoted Products were partially offset by declines in non-promoted products.

 

We have experienced generic challenges and other competition to our products, as well as pricing challenges through government imposed price controls and reductions, and expect these challenges to continue in 2007 and beyond.

 

Ribavirin Royalties

 

Ribavirin royalty revenues decreased $10,404,000 (11%) in 2006 over 2005 due to (i) competitive dynamics between Roche and Schering-Plough in Europe, as Roche’s version of ribavirin, Copegus, gained market share over Schering-Plough’s version of ribavirin, Rebetol, (ii) reduced sales in Japan from a peak in 2005 driven by the launch of combination therapy there, and (iii) further gains in market share by generic competitors in the United States. We expect ribavirin royalties to continue to decline in 2007 as a result of market competition between Roche and Schering-Plough in Japan. The royalty will reduce significantly in 2009 and 2010 with the loss of exclusivity in European markets and Japan.

 

Research and Development

 

We are developing certain product candidates, including two clinical stage programs, taribavirin and retigabine, which target large market opportunities. Taribavirin is a pro-drug of ribavirin, for the treatment of chronic hepatitis C in treatment-naive patients in conjunction with a pegylated interferon. Retigibine was added to our pipeline with the acquisition of Xcel in March 2005. Retigabine is being developed as an adjunctive treatment for partial-onset seizures in patients with epilepsy. Clinical development expenses in 2007 will be impacted by the results of a Phase 2(b) study on taribavirin, results of implementing strategies to acquire Phase 1 and Phase 2 compounds to augment our existing development portfolio and whether we ultimately determine and are successful at sharing the cost of development and associated risk of our existing development portfolio.

 

Chronic Hepatitis C

 

Worldwide, approximately 170 million individuals are infected with HCV. In the United States alone, 3-4 million individuals are infected. Current therapies consist of (pegylated) interferon alpha and ribavirin with a sustained virological response ranging as high as 54% to 56%.

 

Epilepsy

 

There are more than 50 million people worldwide who have epilepsy, with approximately 6 million people afflicted with the disease in the United States, the European Union, and Japan. Approximately half of all epilepsy patients become seizure free with their first medication. Another 20% to 30% become seizure free when other therapies are tried or added to the first medication. The remaining 20% to 30% of patients who do not respond to multiple AED’s are considered to have refractory epilepsy, thus representing the greatest unmet need in epilepsy treatment.

 

Acquisitions

 

We made the following acquisitions in 2006 and 2005:

 

In 2006 we acquired rights to new product lines in Poland and the UK. In Poland we acquired the rights of a number of branded generic products for nominal cash consideration. In the UK we acquired exclusive rights to distribute certain dermatological skin care products from Intendis AG, including Finacea, Skinoren, Scheriproct, and Ultrabase. We also purchased additional rights to Melleril in Latin America and additional rights to Zelapar in Canada and Mexico. Aggregate consideration for these transactions was $4,568,000 in 2006.

 

On March 1, 2005, we acquired Xcel, a specialty pharmaceutical company focused on the treatment of disorders of the central nervous system, for $280,000,000 in cash, plus expenses of approximately $5,000,000. Xcel’s portfolio consists of four products that are sold within the United States, and retigabine, a late-stage clinical product candidate that is an adjunctive treatment for partial-onset seizures for patients with epilepsy, which is being developed for commercialization in all major markets. We have filed a claim for indemnification from the former Xcel stockholders with respect to certain breaches of representation and warranties made by Xcel under the Xcel purchase agreement and certain third-party claims. As of December 31, 2006, approximately $5,230,000 of the Xcel purchase price remained in an escrow fund to pay indemnification claims.

 

In the third quarter of 2005 we acquired product rights to Melleril in Brazil and Acurenal in Poland for cash consideration of $7,900,000.

 

On December 30, 2005, we acquired the U.S. and Canadian rights to Infergen from InterMune. Infergen is indicated for the treatment of hepatitis C when patients have not responded to other treatments (primarily the combination of pegylated interferon and ribavirin) or have relapsed after such treatment. In connection with this transaction we acquired patent rights and rights to a clinical trial underway to expand applications of Infergen. We also employed InterMune’s marketing and research staffs who were dedicated to the Infergen product and projects. We paid InterMune $120,000,000 in cash at the closing. We have also agreed to pay InterMune up to an additional $22,585,000, $20,000,000 of which is dependent on reaching certain milestones.

We paid InterMune $2,585,000 as a non-contingent payment in January 2007. Additionally, as part of the acquisition transaction we assumed a contract for the transfer of the manufacturing process for Infergen from one third party supplier to another. Under the contract we are obligated to pay the new third party supplier up to $11,700,000 upon the attainment of separate milestones tied to the manufacturing process transfer. In 2006 we charged $5,200,000 to cost of sales for payments to this supplier for the achievement of milestones and we anticipate paying an additional $5,200,000 in 2007. Amgen originally developed Infergen and licensed the rights to InterMune.

 

See Note 3 of notes to consolidated financial statements for a discussion of these acquisitions.

 

Results of Operations

 

We have three specialty pharmaceutical segments comprising our pharmaceuticals operations in North America, International (Latin America, Asia and Australasia) and Europe, Middle East, and Africa (EMEA). In addition, we have a research and development division. Certain financial information for our business segments is set forth below (in thousands). This discussion of our results of operations should be read in conjunction with the consolidated financial statements included elsewhere in this document. For additional financial information by business segment, see Note 16 of notes to consolidated financial statements included elsewhere in this document.

 

 

Year Ended December 31, 2006 Compared to 2005

 

Specialty Pharmaceutical Revenues:  Total specialty pharmaceutical product sales increased $93,756,000 for the year ended December 31, 2006 over 2005. Significant factors that contributed to this increase included the acquisition of Infergen on December 30, 2005, the full year of sales from Xcel products compared with ten months

of sales of these products in 2005, certain product launches, general price increases and success in the growth of our Promoted Products.

 

Approximately 58% of our total pharmaceutical revenues resulted from sales of Promoted Products in 2006. We define Promoted Products as being those that we promote with annual sales of greater than $5,000,000. Worldwide sales of Promoted Products totaled $476,211,000 in 2006, an increase of $101,959,000 or 27% over 2005. Infergen sales in 2006 were $42,716,000. Sales of other Promoted Products in 2006 increased $59,243,000 or 16% over 2005 sales levels. The increased sales in Promoted Products were partially offset by declines in sales of non-promoted products.

 

In our North America pharmaceuticals segment, revenues for the year ended December 31, 2006 increased $74,768,000 over 2005. This increase reflects the acquisition of Infergen, the full year of Xcel products compared with ten months in 2005, the launch of Cesamet and Zelapar in the United States, the growth in Cesamet sales in Canada, and the $14,337,000 increase in Efudex sales, which totaled $66,695,000 in 2006. Efudex sales increases resulted from a combination of factors, including changes in wholesaler buying patterns, price increases taken earlier in the year, and the launch at the end of the year of our generic version of the product. The increase also reflects higher sales of Promoted Products which totaled $257,497,000 in 2006, an increase of $72,977,000 (40%) over 2005 sales levels. These increases were partially offset by volume decreases of non-promoted products. The increase in North American pharmaceutical sales for the year ended December 31, 2006, excluding Infergen, was due to 5% percent increase in volume, an 8% increase in price, and a 1% percent positive contribution from the appreciation of the Canadian Dollar.

 

In our International pharmaceuticals segment, revenues for the year ended December 31, 2006 increased $21,334,000. Revenues from Bedoyecta, which is our highest revenue product in Mexico, were $50,366,000 in 2006, an increase of $3,482,000 (7%) over 2005 reflecting a successful direct-to-consumer marketing campaign. Sales of Promoted Products in the region totaled $129,636,000 in 2006, an increase of $14,585,000 (13%) over 2005. The increases in revenues were partially offset by volume decreases of non-promoted products. On a net basis, the increase in sales in the International segment were primarily impacted by price increases and reduced discounts to wholesalers. International sales in 2006 resulted from an aggregate 11% price increase, a 1% reduction in volume, and a negligible currency impact.

 

In our EMEA pharmaceuticals segment, revenues for the year ended December 31, 2006 were $277,862,000, a decrease of $2,346,000. The increase in the value of currencies in the region relative to the U.S. Dollar contributed $4,596,000 to revenues in the region in 2006. Sales of Promoted Products in 2006 were $154,136,000 compared to $152,024,000 in 2005 an increase of $2,112,000 (1%). The increases in revenues from higher promoted product sales and stronger European currencies were offset by reductions in sales of non-promoted products. Sales in several European countries were also negatively affected by pricing policies imposed by governmental authorities. EMEA sales in 2006 were impacted by a 2% positive contribution from currency fluctuations, a 3% reduction in volume, and a negligible change in aggregate prices.

 

Ribavirin Royalties:  Ribavirin royalties from Schering-Plough and Roche for the year ended December 31, 2006 were $81,242,000 compared to $91,646,000 for 2005, a decrease of $10,404,000 (11%). 2006 ribavirin royalty revenues decreased due to (i) competitive dynamics between Roche and Schering-Plough in Europe, as Roche’s version of ribavirin, Copegus, gained market share over Schering-Plough’s version of ribavirin, Rebetol, (ii) reduced sales in Japan from a peak in 2005 driven by the launch of combination therapy there, and (iii) further gains in market share by generic competitors in the United States.

 

Gross Profit Margin:  The decline in gross profit margin in 2006 from 70% to 69% is largely due to changes in the product mix resulting from recent acquisitions, higher inventory obsolescence charges in 2006, and a $5,200,000 technology transfer milestone payment paid to the future manufacturer of Infergen. Gross profit calculations exclude amortization which is discussed below. Consolidated cost of goods sold in 2006 included a

provision of $1,255,000 related to employee stock options and purchase programs following the implementation of SFAS 123(R). Gross profits by segment are as follows (dollar amounts in thousands):

 

 

Selling Expenses:  Selling expenses were $264,834,000 for the year ended December 31, 2006 compared to $232,316,000 for 2005, an increase of $32,518,000 (14%). As a percent of product sales, selling expenses were 32% for the years ended December 31, 2006 and 2005. Included in selling expenses for the year ended December 31, 2005 were severance charges of $3,000,000 related to the sales force restructuring in Europe. The increase in selling expenses includes the additional sales force associated with the acquisition of Infergen. This increase reflects our increased promotional efforts primarily in North America and Latin America and includes costs related to new product launches and line extensions. Selling expenses in 2006 includes a provision of $3,580,000 related to employee stock options and purchase programs following the implementation of SFAS 123(R).

 

General and Administrative Expenses:  General and administrative expenses were $117,172,000 for the year ended December 31, 2006 compared to $108,252,000 for 2005, an increase of $8,920,000 (8%). As a percent of product sales, general and administrative expenses were 14% for the year ended December 31, 2006 compared to 15% for 2005. General and administrative expenses in 2006 includes a provision of $13,699,000 related to employee stock options and purchase programs following the implementation of SFAS 123(R).

 

Research and Development:  Research and development expenses were $109,618,000 for the year ended December 31, 2006 compared $114,100,000 for 2005, a reduction of $4,482,000 (4%). The decrease in research and development expenses was primarily attributable to the completion of the VISER Phase 3 clinical trials for taribavirin, the completion of phase 2 clinical trials for pradefovir, and the strategic restructuring announced April 3, 2006. Research and development expenses in 2006 included a $7,000,000 milestone payment related to the development of retigabine. It is expected that clinical development expenses will decline in 2007 as a result of the restructuring initiatives. Research and development expenses in 2006 includes a provision of $2,504,000 related to employee stock options and purchase programs following the implementation of SFAS 123(R).

 

Amortization:  Amortization expense was $71,876,000 for the year ended December 31, 2006 compared to $68,832,000 for 2005, an increase of $3,044,000 (4%). The increase was primarily due to amortization of intangibles acquired with the acquisition of Infergen, offset in part by a decrease in the amortization of a royalty intangible which was acquired in the Ribapharm acquisition and is being amortized on an accelerated basis. Additionally, in 2006, we recorded asset impairment charges on certain products sold in Spain in the amount of $1,075,000. In 2005, we recorded asset impairment charges on certain products sold in the UK, Germany and Spain in the amount of $7,400,000.

 

Gain on Litigation Settlement:  Litigation settlements contributed significantly to operating profit in 2006. The recoveries in 2006 included the settlement with the Republic of Serbia relating to the ownership and operations of a joint venture we formerly participated in known as Galenika of $34,000,000 of which $28,000,000 was received in 2006, and the settlement of litigation with the former Chief Executive Officer, Milan Panic relating to Ribapharm bonuses, for which we received $20,000,000 and recorded a gain from litigation of $17,550,000 in 2006.

Restructuring Charges and Asset Impairments:  In 2006 we incurred $138,181,000 in restructuring charges relating to severance charges, contract cancellations, and asset impairments. In 2005 we made the decision to dispose of a manufacturing plant in China which resulted in an asset impairment charge of $2,300,000. In 2005 we also recorded net gains of approximately $1,800,000 resulting from the sale of the manufacturing plants in the U.S., Argentina and Mexico.

 

Restructuring Charge Details

 

In April 2006, we announced a restructuring program to reduce costs and accelerate earnings growth.

 

The program is primarily focused on our research and development and manufacturing operations. The objective of the restructuring program as it relates to research and development activities is to focus our efforts and expenditures on two late stage development projects: Taribavirin, a potential treatment for hepatitis C, and retigabine, a potential treatment for partial onset seizures in patients with epilepsy. As previously announced, we intend to sell rights to, out-license, or secure partners to share the costs of our major clinical projects and discovery programs. On January 9, 2007, we licensed the development and commercialization rights to the hepatitis B compound pradefovir to Schering-Plough. On December 21, 2006, we sold our HIV and cancer development programs and certain discovery and preclinical assets to Ardea Biosciences, Inc. (formerly IntraBiotics Pharmaceuticals) (“Ardea”), with an option for us to reacquire rights to commercialize the HIV program outside of the United States and Canada upon Ardea’s completion of Phase 2b trials. We continue to pursue partnering opportunities for taribavirin and retigabine to share the costs of development, and look to license in additional compounds in clinical development to diversify our opportunities and the inherent risks associated with product development.

 

The objective of the restructuring program as it relates to manufacturing is to further rationalize our manufacturing operations and further reduce our excess capacity. Under our global manufacturing strategy, we also seek to minimize our costs of goods sold by increasing capacity utilization in our manufacturing facilities or by outsourcing and by other actions to improve efficiencies. We have undertaken major process improvement initiatives and the deployment of lean six sigma process improvements, affecting all phases of our operations, from raw material and supply logistics, to manufacturing, warehousing and distribution. The restructuring program includes the sale of manufacturing plants in Humacao, Puerto Rico and in Basel, Switzerland. We have entered into a letter of intent to sell these two manufacturing facilities and believe we will sell them in the first half of 2007. We have transferred them to “held for sale” classification in accordance with FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, in December 2006. Recent negotiations for the sale of these facilities have been used to estimate the fair value of the facilities.

 

The restructuring program will also result in savings in our selling, general and administrative expenses primarily through consolidation of our management functions into fewer administrative groups to achieve greater economies of scale. Management and administrative responsibilities for our regional operations in Asia, Africa and Australia, (“AAA”), which were formerly managed as a separate business unit, have been combined with those of other regions. As a result we now have three reportable pharmaceutical segments, which comprise our pharmaceutical operations in:

 

 

We moved into a new leased headquarters building in Aliso Viejo, California, in December 2006. We have reached agreement for the sale of our former headquarters building in Costa Mesa, California, where our former research laboratories were located, for $38,000,000. We classified this facility as “held for sale” in September 2006 in accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-lived Assets”.

 

We anticipate that the total restructuring program will result in restructuring and asset impairment charges that will range between $140,000,000 and $145,000,000. In 2006 we incurred an expense of $138,181,000 relating to a

restructuring program. Restructuring and asset impairment charges are recorded as a component of costs and expenses in the consolidated statement of income.

 

 

Severance charges recorded in the year ended December 31, 2006 relate to employees whose positions were eliminated in the restructuring. When completed, we anticipate that approximately 750 employees in total will be impacted by the restructuring, the majority of whom work in the two manufacturing facilities being sold. We intend to dispose of these manufacturing plants by selling to a buyer who will continue to operate the plant, including the assumption of certain employee obligations. We have signed a letter of intent for the sale of these two facilities, with the sale expected to close in the first half of 2007. It is intended that the buyer will continue to operate the plant, including the assumption of certain employee obligations. In 2006 severance benefits were accrued for 259 employees within the restructuring program. Severance payments to 67 employees are accounted for under SFAS 112, Employers’ Accounting for Post-employment Benefits with the remaining 192 being accounted for under SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities.

 

Abandoned software and other capital assets included an expense of $20,453,000, relating to an Enterprise Resource Planning (ERP) project which was discontinued in March 2006. It also includes $632,000 of cash-related charges.

 

Non-cash asset impairment charges include $37,223,000 related to our manufacturing plant in Humacao, Puerto Rico, $45,624,000 related to a manufacturing plant in Birsfelden, Switzerland, $5,946,000 related to equipment used in our discovery operations and $8,551,000 related to the building in Costa Mesa which previously served as our corporate headquarters and principal research facility.

 

Cash-related charges in the above table relate to severance payments and other costs which have been either paid with cash expenditures or have been accrued and will be paid with cash in future quarters. A summary of accruals and expenditures of restructuring costs which will be paid in cash for 2006 follows:

 

Reconciliation of Cash Restructuring Payments with Restructuring Accrual (in thousands)

 

 

In the first, second, third and fourth quarters of 2006 we incurred expenses of $26,466,000, $53,082,000, 17,139,000 and $41,494,000 respectively relating to the restructuring program.

 

The restructuring and asset impairment charges for the year ended December 31, 2006 represent charges of $37,223,000, $50,201,000, $242,000, $5,485,000 and $45,030,000 in the North America, EMEA, International, R&D and Corporate reporting segments, respectively.

 

The benefits achieved as a result of the restructuring program are estimated at $30,000,000 for 2006. For 2007 the benefits are expected to exceed $50,000,000.

 

Acquired In-Process Research and Development (IPR&D):  We did not incur IPR&D charges in 2006. In 2005, we expensed $173,599,000 as IPR&D in connection with the acquisition of Xcel ($126,399,000) and with the Infergen business acquired from InterMune ($47,200,000). The amounts expensed as IPR&D represent our estimate of fair value of purchased in-process technology for projects that, as of the acquisition dates, had not yet reached technological feasibility and had no alternative future use.

 

We estimated the fair value of the IPR&D in connection with the acquisition of Xcel based on the use of a discounted cash flow model (including an estimate of future sales at an average gross margin of 80%). For each project, the estimated after-tax cash flows (using a tax rate of 35%) were probability weighted to take account of the stage of completion and risks surrounding the successful development and commercialization. The assumed tax rate is our estimate of the effective statutory tax rate for an acquisition of similar types of assets. The cash flows were discounted to a present value using a discount rate of 18%, which represents our risk adjusted after tax weighted average cost of capital for each product. We estimated we would incur future research and development costs of approximately $50,000,000 to complete the retigabine IPR&D project.

 

The estimated fair value of the IPR&D related to the Infergen business acquired from InterMune was based on the use of a discounted cash flow model (based on an estimate of future sales and an average gross margin of 80%). For each project, the estimated after-tax cash flows (using a tax rate of 41%) were then probability weighted to take account of the stage of completion and the risks surrounding the successful development and commercialization. The assumed tax rate is our estimate of the effective statutory tax rate for an acquisition of similar types of assets. These cash flows were then discounted to a present value using a discount rate of 15% which represents our estimated risk adjusted after tax weighted average cost of capital. We estimated we would incur future research and development costs of approximately $25,000,000 to complete the Infergen IPR&D project.

 

Other Income, Net, Including Translation and Exchange:  Other income, net, including translation and exchange was income of $1,152,000 for the year ended December 31, 2006 compared with a loss of $6,358,000 in 2005. In both 2006 and 2005 the amounts represent primarily the effects of translation gains and losses in Europe and Latin America. Translation and exchange gains are primarily related to U.S. Dollar denominated assets and liabilities at our foreign currency denominated subsidiaries.

 

Interest Expense and Income:  Interest expense increased $3,400,000 during the year ended December 31, 2006 compared to 2005, due to higher interest rates associated with our variable rate debt. Interest income decreased $559,000 during the year ended December 31, 2006 compared to 2005 due primarily to lower cash balances.

 

Income Taxes:  Despite reporting losses from continuing operations, we recorded tax expense of $34,219,000 in 2006 and $55,151,000 in 2005. This occurred primarily because, due to the valuation allowances, no tax benefits are recorded for the U.S. operating losses. In 2006, the effective rate was also affected by the pre-tax losses resulting from restructuring in Puerto Rico of $37,223,000 for which no tax benefit was recorded. The valuation allowance also has the effect of deferring certain amounts that would normally impact the effective tax rate. In addition, the 2005 Xcel IPR&D charge of $126,400,000 was not deductible for tax purposes resulting in higher effective tax rates for the year. Tax expense in 2005 was also impacted by a charge of $27,400,000 resulting from an Internal Revenue Service examination of our U.S. tax returns for the years 1997 to 2001 and taxes imposed on the repatriation of foreign earnings of $4,500,000.

 

In 2006, 2005 and 2004 we recorded valuation allowances against the deferred tax assets associated with the U.S. tax benefits we will receive as income tax loss carryforwards are offset against U.S. taxable income in future years. The reserve was recorded since we cannot be certain that sufficient U.S. taxable income will be generated to utilize the tax benefits of the loss and credit carryforwards before they expire. As of December 31, 2006 the valuation allowance against deferred tax assets totaled $161,713,000.

 

Income (Loss) from Discontinued Operations:  Income from discontinued operations was $7,494,000 in 2006 compared to a loss of $2,366,000 for the year ended December 31, 2005. The income in 2006 primarily relates to the partial release of an environmental reserve for a former Biomedicals site. The losses in 2005 primarily relate to our former raw materials businesses and manufacturing operations in Central Europe.

 

Year Ended December 31, 2005 Compared to 2004

 

Specialty Pharmaceutical Revenues:  Total specialty pharmaceutical product sales increased $124,416,000 for the year ended December 31, 2005 over 2004. The largest portion of this increase ($73,400,000) resulted from the addition of new products to our portfolio as a result of the Xcel acquisition.

 

Approximately 51% of our total pharmaceutical revenues resulted from sales of Promoted Products in 2005. We define Promoted Products as being those that we promote with annual sales of greater than $5,000,000. Worldwide sales of Promoted Products totaled $374,252,000 in 2005, an increase of $124,968,000, or 50% over 2004. Approximately $60,600,000 of this increase in promoted product sales consisted of two new products acquired in the Xcel transaction. Sales of other Promoted Products in 2005 increased $64,368,000, or 26% over 2004 sales levels. The increased sales in Promoted Products and those resulting from the acquisition of Xcel were partially offset by declines in sales of non-promoted products.

 

In our North America pharmaceuticals segment, revenues for the year ended December 31, 2005 increased $87,812,000 over 2004. The increase reflects the inclusion of sales of products acquired from Xcel in March 2005 ($73,400,000). The increase also reflects higher sales of Promoted Products other than those acquired in the Xcel transaction which totaled $119,500,000 in 2005, an increase of $23,500,000 (25%) over 2004 sales levels. These increases were partially offset by lower sales of non-promoted products. The increase in sales in North America resulted from a 50% increase in volume, a 9% increase in price, and a 1% benefit from the appreciation of the Canadian Dollar.

 

In our International pharmaceuticals segment, revenues for the year ended December 31, 2005 increased $27,142,000. The increase was primarily due to a reduction in discounts offered to distributors in the region aggregating $23,900,000. Revenues from Bedoyecta, which is our highest revenue product in Mexico, were $46,884,000 in 2005, an increase of $16,230,000 (53%) over 2004 reflecting a successful direct-to-consumer marketing campaign. Sales of other Promoted Products in the region totaled $34,300,000 in 2005, an increase of $4,400,000 (15%) over those in 2004. The increases in revenues were partially offset by volume decreases in sales of non-promoted products. The increase in sales in the International pharmaceutical sector resulted from a 12% increase in price, a 5% positive contribution from currency, which offset a 3% reduction in volume.

 

In our EMEA pharmaceuticals segment, revenues for the year ended December 31, 2005 were $280,208,000, an increase of $9,462,000. The increase in the value of currencies in the region relative to the U.S. Dollar contributed $7,600,000 to the increase in revenues in the region in 2005. Sales of Promoted Products in 2005 were $116,341,000 compared to $101,244,000 in 2004, an increase of $15,097,000 (15%). The increases in revenues from higher promoted product sales and stronger European currencies were offset by reductions in sales of non-promoted products. Sales in many parts of Europe were negatively affected by pricing policies imposed by governmental authorities. The increase in sales in EMEA resulted from a 3% benefit from currency, a 2% increase in price, offsetting a 1% reduction in volume.

 

Ribavirin Royalties:  Ribavirin royalties from Schering-Plough and Roche for the year ended December 31, 2005 were $91,646,000 compared to $76,427,000 for 2004, an increase of $15,219,000 (20%). This increase primarily resulted from increased sales in Japan where the Ministry of Health, Labor and Welfare approved the marketing of ribavirin in combination with Peg-Intron for the treatment of hepatitis C.

 

The 2005 and 2004 royalty amounts are significantly less than amounts received in 2003 and prior years. The decrease in ribavirin royalties reflect the effects of the launch of generic ribavirin in the United States and competition between Schering-Plough and Roche. Approval of a generic form of oral ribavirin by the FDA in the United States was announced in April 2004. Competition from generic pharmaceutical companies has had, and continues to have, a material negative impact on our royalty revenue. With respect to Schering-Plough, in some markets royalty rates increase in tiers based on increased sales levels. Upon the entry of generics into the United States in April 2004, pursuant to the terms of their contract, Roche ceased paying royalties on sales in the United States. Schering-Plough has also launched a generic version of ribavirin. Under the license and supply agreement, Schering-Plough is obligated to pay us royalties for sales of their generic ribavirin.

 

Selling Expenses:  Selling expenses were $232,316,000 for the year ended December 31, 2005 compared to $196,642,000 for 2004, an increase of $35,674,000 (18%). As a percent of product sales, selling expenses were 32%

for the years ended December 31, 2005 and 2004. Included in selling expenses for the year ended December 31, 2005 and 2004 were severance charges of $3,000,000 and $3,600,000, respectively, related to a sales force restructuring in Europe. The increase in selling expenses also reflects our increased promotional efforts primarily in North America and Latin America and includes costs related to new product launches and unified promotional materials and campaigns for our global products.

 

General and Administrative Expenses:  General and administrative expenses were $108,252,000 for the year ended December 31, 2005 compared to $99,443,000 for 2004, an increase of $8,809,000 (9%). As a percent of product sales, general and administrative expenses were 15% for the year ended December 31, 2005 compared to 16% for 2004.

 

Research and Development:  Research and development expenses were $114,100,000 for the year ended December 31, 2005 compared $92,858,000 for 2004, an increase of $21,242,000 (23%). The increase in research and development expenses was primarily attributable to the progression of clinical trials for taribavirin, retigabine and pradefovir and costs associated with the completion of safety studies for Zelapar. We completed enrollment of two Phase 3 studies for taribavirin and a Phase 2 study for pradefovir. We also advanced the clinical trials for retigabine acquired in March 2005 with the initiation of two Phase 3 trials.

 

Amortization:  Amortization expense was $68,832,000 for the year ended December 31, 2005 compared to $59,303,000 for 2004, an increase of $9,529,000 (16%). The increase was primarily due to amortization of intangibles acquired with the acquisition of Xcel, offset in part by a decrease in the amortization of a royalty intangible which was acquired in the Ribapharm acquisition and is being amortized on an accelerated basis. Additionally, in 2005, we recorded asset impairment charges on certain products sold in the UK, Germany and Spain in the amount of $7,400,000. In 2004, we recorded asset impairment charges of $4,800,000 primarily related to products sold in Italy for which the patent life was reduced by a decree by the Italian government.

 

Restructuring Charges and Asset Impairments:  In 2004 we incurred an expense of $19,344,000 related to the manufacturing rationalization plan. Our manufacturing sites were tested for impairment resulting in an asset impairment of asset value on three of the sites. Accordingly, we wrote these sites down to their fair value and recorded asset impairment charges of $18,102,000 and severance charges of $1,242,000 in the year ended December 31, 2004. In 2005 we modified the Manufacturing Restructuring Plan to include the disposition of the manufacturing site in China and recorded an asset impairment reserve of $3,602,000 for this facility and one in Poland. Also in 2005, we sold a plant in the United States, two plants in Argentina and one plant in Mexico and recorded a net gain of $2,349,000 on these sales.

 

Acquired In-Process Research and Development (IPR&D):  In 2005, we expensed $173,599,000 as IPR&D in connection with the acquisition of Xcel ($126,399,000) and with the Infergen business acquired from InterMune ($47,200,000). In 2004, we incurred an expense of $11,770,000 associated with IPR&D related to the acquisition of Amarin that occurred in February 2004. The amounts expensed as IPR&D represent our estimate of fair value of purchased in-process technology for projects that, as of the acquisition dates, had not yet reached technological feasibility and had no alternative future use.

 

We estimated the fair value of the IPR&D in connection with the acquisition of Xcel based on the use of a discounted cash flow model (including an estimate of future sales at an average gross margin of 80%). For each project, the estimated after-tax cash flows (using a tax rate of 35%) were probability weighted to take account of the stage of completion and risks surrounding the successful development and commercialization. The assumed tax rate is our estimate of the effective statutory tax rate for an acquisition of similar types of assets. The cash flows were discounted to a present value using a discount rate of 18%, which represents our risk adjusted after tax weighted average cost of capital for each product. We estimated we would incur future research and development costs of approximately $50,000,000 to complete the retigabine IPR&D project.

 

The estimated fair value of the IPR&D related to the Infergen business acquired from InterMune was based on the use of a discounted cash flow model (based on an estimate of future sales and an average gross margin of 80%). For each project, the estimated after-tax cash flows (using a tax rate of 41%) were then probability weighted to take account of the stage of completion and the risks surrounding the successful development and commercialization. The assumed tax rate is our estimate of the effective statutory tax rate for an acquisition of similar types of assets.

These cash flows were then discounted to a present value using a discount rate of 15% which represents our estimated risk adjusted after tax weighted average cost of capital. We estimated we would incur future research and development costs of approximately $25,000,000 to complete the Infergen IPR&D project.

 

Other Income, Net, Including Translation and Exchange:  Other income, net, including translation and exchange was a loss of $6,358,000 for the year ended December 31, 2005 compared to a net gain of $141,000 in 2004. In both 2005 and 2004 the amounts represent primarily the effects of translation gains and losses in Europe and Latin America. Translation and exchange gains are primarily related to U.S. Dollar denominated assets and liabilities at our foreign currency denominated subsidiaries.

 

Loss on Early Extinguishment of Debt:  The loss on early extinguishment of debt in 2004, $19,892,000 related to the repurchase of $326,000,000 aggregate principal amount of our 61/2% Convertible Subordinated Notes due 2008. We did not have a similar transaction in 2005.

 

Interest Expense, net:  Interest expense, net decreased $9,676,000 during the year ended December 31, 2005 compared to 2004. The decrease was due to repurchases of our 61/2% Convertible Subordinated Notes due 2008 in July 2004, which eliminated the associated interest expense.

 

Income Taxes:  Despite reporting losses from continuing operations, we recorded tax expense of $55,151,000 in 2005 and $68,640,000 in 2004. This occurs primarily because, due to valuation allowances, no tax benefits are recorded for the U.S. operating losses. The valuation allowance also has the effect of deferring certain amounts that would normally impact the effective tax rate. In addition, the 2005 Xcel IPR&D charge of $126,399,000 is not deductible for tax purposes resulting in higher effective tax rates for the year. Tax expense in 2005 was also impacted by a charge of $27,400,000 resulting from an Internal Revenue Service examination of our U.S. tax returns for the years 1997 to 2001 and taxes imposed on the repatriation of foreign earnings of $4,500,000.

 

In 2005 and 2004 we recorded valuation allowances against the deferred tax assets associated with the U.S. tax benefits we will receive as income tax loss carryforwards are offset against U.S. taxable income in future years. The reserve was recorded since we cannot be certain that sufficient U.S. taxable income will be generated to utilize the tax benefits of the loss and credit carryforwards before they expire. As of December 31, 2005 the valuation allowance against deferred tax assets totaled $148,100,000.

 

The 2004 tax provision was also negatively impacted by restructuring and asset impairment charges relating to facilities in certain foreign jurisdictions. We recorded minimal tax benefits in connection with these charges due to uncertainties about our ability to realize the benefits as reductions of our foreign tax liabilities. Some of these tax benefits were, however, recorded in 2005 as the likelihood of realizing the benefits increased.

 

Income (Loss) from Discontinued Operations:  The loss from discontinued operations was $2,366,000 in 2005 compared to $33,544,000 for the year ended December 31, 2004. The losses in 2005 primarily relate to our former raw materials businesses and manufacturing operations in Central Europe. In 2004 the loss also includes environmental charges of $16,000,000 related to a former operating site of our Biomedicals division, for which we retained the liability when we sold this business.

 

Liquidity and Capital Resources

 

Cash and marketable securities totaled $335,745,000 at December 31, 2006 compared to $235,066,000 at December 31, 2005. Working capital was $480,663,000 (excluding assets held for sale) at December 31, 2006 compared to $344,245,000 at December 31, 2005. The increase in working capital of $125,159,000 was primarily attributable to cash generated from operations, litigation settlements and the exercise of stock options.

 

During the year ended December 31, 2006, cash provided by operating activities totaled $125,061,000 compared to $64,458,000 for 2005. The improvement was mainly attributable to recoveries in 2006 resulting from the settlement with the Republic of Serbia relating to the ownership and operations of a joint venture we formerly participated in known as Galenika of $34,000,000 of which $28,000,000 was received in 2006 and the settlement of litigation with the former Chief Executive Officer, Milan Panic relating to Ribapharm bonuses, for which we received $20,000,000 in 2006.

 

Cash used in investing activities was $32,153,000 for the year ended December 31, 2006. This compares to cash used in investing activities of $218,350,000 for the year ended December 31, 2005. In 2006, $4,568,000 was used for the purchase of product rights. Additionally, cash was used for capital expenditures of $42,142,000. Cash generated from net sales of marketable securities totaled $1,413,000 and sales of assets generated $10,022,000. In 2005 cash used in investing activities consisted of net proceeds from sales of marketable securities of $228,007,000 and proceeds from asset sales of $7,252,000, which was offset by the use of $413,621,000 in the acquisitions of Xcel and Infergen, the purchase of product rights in Brazil and Poland, and the purchase of the minority interest in our Polish operations. Additionally, cash used for capital expenditures was $45,525,000.

 

Cash flows used in financing activities were $6,810,000 in 2006 and primarily consisted of dividends paid of $21,552,000 and payments on long-term debt and notes payable of $6,662,000. This was partially offset by proceeds from stock option exercises and employee stock purchases of $17,389,000 and proceeds from capitalized lease financing and long-term debt of $4,015,000. Cash flows provided by financing activities were $164,544,000 in 2005 and primarily consisted of the proceeds of a common stock offering in connection with the Xcel acquisition, which raised net proceeds of approximately $192,822,000, offset by dividend payments of $27,966,000.

 

In January 2004, we entered into an interest rate swap agreement with respect to $150,000,000 principal amount of our 7.0% Senior Notes due 2011. The interest rate on the swap is variable at six-month LIBOR plus 2.41%. The effect of this transaction was to initially lower our effective interest rate by exchanging fixed rate payments for floating rate payments. On a prospective basis, the effective rate will float and correlate to the variable interest earned on our cash held. At December 31, 2006 the effective rate on the $150,000,000 of debt under the swap agreement was 7.78%. We have collateral requirements on the interest rate swap agreement. The amount of collateral varies monthly depending on the fair value of the underlying swap contracts. As of December 31, 2006, we have collateral of $8,600,000 included in marketable securities and other assets related to this instrument.

 

We believe that our existing cash and cash equivalents and funds generated from operations will be sufficient to meet our operating requirements at least through December 31, 2007, and to provide cash needed to fund capital expenditures and our clinical development program. We may seek additional debt financing or issue additional equity securities to finance future acquisitions or for other purposes. We fund our cash requirements primarily from cash provided by our operating activities. Our sources of liquidity are our cash and cash equivalent balances and our cash flow from operations.

 

We paid quarterly cash dividends in all four quarters of 2005 and in the first three quarters of 2006. We did not pay a quarterly dividend in the final quarter of 2006. There are significant contractual limitations on our ability to pay future dividends under the terms of the indenture governing our 7% senior notes due 2011.

 

Contractual Obligations

 

The following table summarizes our contractual obligations as of December 31, 2006, and the effect such obligations are expected to have on our liquidity and cash flow in future periods:

 

We have no material commitments for purchases of property, plant and equipment and we expect that for 2007, such expenditures will approximate $20,000,000 to $30,000,000.

 

As part of the acquisition of Infergen from InterMune in December 2005, we agreed to pay InterMune up to an additional $22,585,000, $20,000,000 of which is dependent on reaching certain milestones. We paid InterMune $2,585,000 as a non-contingent payment in January 2007. Additionally, as part of the acquisition transaction we assumed a contract for the transfer of the manufacturing process for Infergen from one third party supplier to another. Under the contract we are obligated to pay the new third party supplier up to $11,700,000 upon the attainment of separate milestones tied to the manufacturing process transfer. In 2006 we charged $5,200,000 to cost of sales for payments to this supplier for the achievement of milestones and we anticipate paying an additional $5,200,000 in 2007.

 

Off-Balance Sheet Arrangements

 

We do not use special purpose entities or other off-balance sheet financing techniques except for operating leases disclosed in our table contained in the “Contractual Obligations” section above. Our 3% and 4% Notes include conversion features that are considered as off-balance sheet arrangements under SEC requirements.

 

Products in Development

 

We expect our research and development expenses to decrease in 2007 in comparison to 2006 as a result of the sale of certain discovery and pre-clinical assets undertaken as part of our restructuring program. A large percentage of our research and development expenses will support the continuing product development programs for the late-stage development projects of taribavirin and retigabine. We expect that for 2007, we will spend approximately $70,000,000 on external research and development costs related to our external product development programs.

 

Late Stage Development of New Chemical Entities

 

Taribavirin:  Taribavirin (formerly referred to as Viramidine) is a nucleoside (guanosine) analog that is converted into ribavirin by adenosine deaminase in the liver and intestine. We are developing taribavirin in oral form for the treatment of hepatitis C.

 

Preclinical studies indicated that taribavirin, a liver-targeting analog of ribavirin, has antiviral and immunological activities (properties) similar to ribavirin. In an animal model of acute hepatitis, taribavirin showed biologic activity similar to ribavirin. The liver-targeting properties of taribavirin were also confirmed in two animal models. Short-term toxicology studies showed that taribavirin may be safer than ribavirin at the same dosage levels. This data suggested that taribavirin, as a liver-targeting analog of ribavirin, could potentially be as effective and have a lower incidence of anemia than ribavirin.

 

In 2006, we reported the results of two pivotal Phase 3 trials for taribavirin. The VISER (Viramidine Safety and Efficacy Versus Ribavirin) trials included two co-primary endpoints: one for safety (superiority to ribavirin in incidence of anemia) and one for efficacy (non-inferiority to ribavirin in sustained viral response, SVR). The results of the VISER trials met the safety endpoint but did not meet the efficacy endpoint.

 

The studies demonstrated that 38-40 percent of patients treated with taribavirin achieved SVR and that the drug has a clear safety advantage over ribavirin, but that it was not comparable to ribavirin in efficacy at the doses studied. We believe that the results of the studies were significantly impacted by the dosing methodology which employed a fixed dose of taribavirin for all patients and a variable dose of ribavirin based on a patient’s weight. Our analysis of the study results leads us to believe that the dosage of taribavirin, like ribavirin, likely needs to be based on a patient’s weight to achieve efficacy equal or superior to that of ribavirin. Additionally we think that higher doses of taribavirin than those studied in the VISER program may be necessary to achieve our efficacy objectives.

 

Based on our analysis, we initiated a Phase 2b study to evaluate the efficacy of taribavirin at 20, 25 and 30 mg/kg in combination with pegylated interferon. A ribavirin control arm also is included in the study. The primary endpoint for the study will be the week 12 analysis though a preliminary review will also be conducted at week 4. If the results of the 12-week analysis are positive, we plan to select a dose and initiate a large Phase 3 study.

If we initiate a Phase 3 study, we may seek a partner to share the investment and risk of this larger development program.

 

The timeline and path to regulatory approval remains uncertain at this time. The completion of another Phase 3 trial would add significantly to the drug’s development cost and the time it takes to complete development, whether or not we are able to secure a development partner, thereby delaying the commercial launch of taribavirin and possibly weakening its position in relation to competing treatments. Our external research and development expenses for taribavirin were $16,133,000 for the year ended December 31, 2006, compared with $36,474,000 for 2005.

 

Retigabine:  We are developing retigabine as adjunctive treatment for partial-onset seizures in patients with epilepsy. Retigabine is believed to have a unique, dual-acting mechanism and has undergone several Phase 2 clinical trials. The Phase 2 trials included more than 600 patients in several dose-ranging studies compared to placebo. We successfully completed an End-of-Phase 2 meeting concerning retigabine with the FDA in November 2005. The results of the key Phase 2 study indicate that the compound is potentially efficacious with a demonstrated reduction in monthly seizure rates of 23% to 35% as adjunctive therapy in patients with partial seizures. Response rates in the two higher doses were statistically significant compared to placebo (p<0.001).

 

Following a Special Protocol Assessment by the FDA two Phase 3 trials of retigabine were initiated in 2005. One Phase 3 trial (RESTORE1; RESTORE stands for Retigabine Efficacy and Safety Trial for partial Onset Epilepsy) is being conducted at approximately 50 sites, mainly in the Americas (U.S., Central/South America); the second Phase 3 trial (RESTORE2) is being conducted at 60 sites, mainly in Europe. The first patient in the RESTORE1 trial was enrolled in September 2005. Enrollment of the first patient in the RESTORE2 trial occurred in December 2005. Both RESTORE1 and RESTORE2 are approximately two-thirds enrolled. The enrollment period in epilepsy studies can be lengthy, frequently requiring twelve to eighteen months to complete.

 

A number of standard supportive Phase 1 trials necessary for successful registration of retigabine will start in 2007. Additionally in 2007 we intend to initiate development of a sustained release formulation of retigabine and open an IND so that we can conduct a study evaluating the potential of retigabine to treat patients with neuropathic pain.

 

Assuming successful completion of the Phase 3 trials and approval by the FDA, we expect to launch retigabine in 2009. We plan to seek a partner to share the investment and risk in the development of retigabine. For the twelve months ended December 31, 2006, external research and development expenses for retigabine were $27,391,000, compared with $8,864,000 for 2005.

 

Pradefovir:  Pradefovir is a compound that we licensed from Metabasis Therapeutics, Inc., or Metabasis, in October 2001. We had been engaged in the development of this compound into an oral once-a-day monotherapy for patients with chronic hepatitis B infection. The active molecule in this compound exhibits anti-hepatitis B activity against both the wild type and lamivudine drug-resistant hepatitis B. We have completed Phase 1 and Phase 2 clinical trials of pradefovir.

 

On December 13, 2006, we announced the signing of definitive agreements for the assignment and license of development and commercial rights to pradefovir to Schering-Plough. The transaction closed on January 9, 2007. Under the terms of the agreements, Schering-Plough made an upfront cash payment of $19,200,000 to Valeant and $1,800,000 to Metabasis and will pay up to an additional $90,000,000 in aggregate cash fees to Valeant and Metabasis upon the achievement of certain development and regulatory milestones. Approximately $65,000,000 of the additional fees would be paid to Valeant and $25,000,000 to Metabasis. The amount to be paid to Metabasis includes the remaining $16,000,000 in milestone payments that could have been realized by Metabasis under the previous agreement between Metabasis and Valeant. Schering-Plough also will pay royalties to Valeant and Metabasis in the event pradefovir is commercialized.

 

For the twelve months ended December 31, 2006, external research and development expenses for pradefovir were $3,981,000, compared with $8,103,000 for 2005.

 

Other Development Activities

 

Infergen:  On December 30, 2005, we completed the acquisition of the United States and Canadian rights to the hepatitis C drug Infergen (interferon alfacon-1) from InterMune. Infergen, or consensus interferon, is a bio-optimized, selective and highly potent type 1 interferon alpha originally developed by Amgen and launched in the United States in 1997. It is indicated as monotherapy for the treatment of adult patients suffering from chronic hepatitis C viral infections with compensated liver disease who have not responded to other treatments or have relapsed after such treatment. Infergen is the only interferon with data in the label regarding use in patients following relapse or non-response to certain previous treatments.

 

In connection with this transaction, we acquired patent rights and rights to a clinical trial underway to expand the labeled indications of Infergen. In the DIRECT trial (IHRC-001) which started in the second quarter of 2004, 514 patients were enrolled. Of these 514 patients, 343 were assigned to the two treatment arms whereas 171 were assigned to the no-treatment group. In the later case, when these patients reached week 24, they were allowed to enter IRHC-002, the same trial design as IRHC-001 except it omits the no-treatment arm. As of December 31, 2006, 22 patients remained in IRHC-001. We reported 24-week and 48-week data from the trial at a scientific meeting in October 2006. The percent of patients who were virus negative at end-of-treatment (treatment week 48) for the Infergen 9 mcg and 15 mcg groups were 16 percent and 19 percent, respectively (TMA Assay). Response rates at end-of-treatment using the bDNA assay were 22 percent and 25 percent for the Infergen 9 mcg and 15 mcg groups, respectively.

 

The second DIRECT trial (IHRC-002) has enrolled 144 patients of the possible 171 and is still ongoing. As of December 31, 2006, 32 patients remained in this trial. Both of the DIRECT trials are reviewed on a regular basis by an independent Data Monitoring Committee to monitor the safety of each trial. Post-treatment follow-up for the DIRECT trials are expected to be completed (i.e., last patient visit) in the first and third quarters of 2007, respectively. We expect to report and publish the results from these studies sometime in late 2007.

 

In the first quarter of 2007, we plan to initiate a Phase 4 study to evaluate the use of Infergen 15 mcg/day plus ribavirin (1.0-1.2 g/day) in patients who did not have an optimal response at 12 weeks of treatment with pegylated interferon and ribavirin. The multi-center, randomized U.S. study will enroll patients who received initial treatment with pegylated interferon and ribavirin and achieve a >2log 10 decline in HCV RNA at week 12 but still have detectable virus (“partial responders”). The patients will be immediately randomized to receive Infergen 15 mcg/day plus ribavirin (1.0-1.2 g/day) for 36 or 48 weeks or continue on their pegylated interferon and ribavirin regimen for an additional 36 weeks of therapy. All treatment groups will have a 24-week follow up period to measure sustained virologic response.

 

For the year ended December 31, 2006, external research and development expenses for Infergen were $4,176,000; we did not incur research and development expenses for Infergen in 2005.

 

Zelapar:  Zelapar was approved by the FDA on June 14, 2006 as an adjunct treatment in the management of patients with Parkinson’s disease being treated with levodopa/carbidopa. Zelapar is the first Parkinson’s disease treatment to use the patented Zydis^® fast-dissolving technology, which allows the tablets to dissolve within seconds in the mouth and deliver more active drug at a lower dose. We launched Zelapar in the U.S. market in July 2006.

 

Cesamet:  Cesamet (nabilone), a synthetic cannabinoid, was approved by the FDA on May 15, 2006 for the treatment of cancer chemotherapy-induced nausea and vomiting (CINV) in patients who have failed to respond adequately to conventional antiemetic treatments. We also market the product in Canada for CINV. In recent years, there has been increasing scientific and clinical evidence regarding the efficacy of cannabinoids in different types of pain, including chronic neuropathic pain. Certain chemotherapy regimens result in neuropathic pain, with more than 90% of patients being affected. We submitted an Investigational New Drug Application to the FDA in January 2007, to evaluate Cesamet in the treatment of chronic neuropathic pain associated with cancer chemotherapy. We will start this development program in 2007.

 

Foreign Operations

 

Approximately 70% and 75% of our revenues from continuing operations, which includes royalties, for the years ended December 31, 2006 and 2005, respectively, were generated from operations or otherwise earned outside

the United States. All of our foreign operations are subject to risks inherent in conducting business abroad. See Item 1A. Risk Factors.

 

Inflation and Changing Prices

 

We experience the effects of inflation through increases in the costs of labor, services and raw materials. We are subject to price control restriction on our pharmaceutical products in the majority of countries in which we operate. While we attempt to raise selling prices in anticipation of inflation, we operate in some markets which have price controls that may limit our ability to raise prices in a timely fashion. Future sales and gross profit will be impacted if we are unable to obtain price increases commensurate with the levels of inflation.

 

Recent Accounting Pronouncements

 

In December 2004, the FASB issued a revision of Statement of Financial Accounting Standards (or “FAS”) No. 123, “Accounting for Stock-Based Compensation.” The revision is referred to as “FAS 123R — Share-Based Payment” (“FAS 123R”), which supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and requires companies to recognize compensation expense, using a fair-value based method, for costs related to share-based payments including stock options and stock issued under our employee stock plans. We adopted FAS 123R using the modified prospective basis effective January 1, 2006. Our adoption of FAS 123R resulted in compensation expense of $21,038,000 for 2006. However, our estimate of future stock-based compensation expense is affected by our stock price, the number of stock-based awards our board of directors may grant, as well as a number of complex and subjective valuation assumptions and the related tax effect. These valuation assumptions include, but are not limited to, the volatility of our stock price and employee stock option exercise behaviors.

 

Future stock compensation expense for restricted stock and stock option incentive awards outstanding at December 31, 2006 is as follows:

 

 

SFAS No. 155.  In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments, amendment of FASB Statements No. 133 and 140” (SFAS No. 155). SFAS No. 155 gives entities the option of applying fair value accounting to certain hybrid financial instruments in their entirety if they contain embedded derivatives that would otherwise require bifurcation under SFAS No. 133. SFAS No. 155 became effective for Valeant as of January 1, 2007. The adoption of this standard did not have a material impact on our financial statements.

 

FIN 48.  In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 applies to all income tax positions taken on previously filed tax returns or expected to be taken on a future tax return. FIN 48 prescribes a benefit recognition model with a two-step approach, a more-likely-than-not recognition criterion and a measurement attribute that measures the position as the largest amount of tax benefit that is greater than 50% likely of being ultimately realized upon ultimate settlement. If it is not more likely than not that the benefit will be sustained on its technical merits, no benefit will be recorded. Uncertain tax positions that relate only to timing of when an item is included on a tax return are considered to have met the recognition threshold for purposes of applying FIN 48. Therefore, if it can be established that the only uncertainty is when an item is taken on a tax return, such positions have satisfied the recognition step for purposes of FIN 48 and uncertainty related to timing should be assessed as part of measurement. FIN 48 also requires that the amount of interest expense and income to be recognized related to uncertain tax positions be computed by applying the applicable statutory rate of interest to the difference between the tax position recognized in accordance with FIN 48 and the amount previously taken or expected to be taken in a tax return.

 

FIN 48 became effective for Valeant as of January 1, 2007. The change in net assets as a result of applying this pronouncement will be a change in accounting principle with the cumulative effect of the change required to be treated as an adjustment to the opening balance of retained earnings. Valeant has not fully completed the process of evaluating the impact of adopting FIN 48.

 

EITF 06-3.  In June 2006, the FASB ratified the Emerging Issues Task Force’s Issue No. 06-3, “How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross Versus Net Presentation)” (EITF 06-3). EITF 06-3 provides guidance on disclosing the accounting policy for the income statement presentation of any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer on either a gross (included in revenues and costs) or a net (excluded from revenues) basis. In addition, EITF 06-3 requires disclosure of any such taxes that are reported on a gross basis as well as the amounts of those taxes in interim and annual financial statements for each period for which an income statement is presented. EITF 06-3 will be effective for Valeant as of January 1, 2007. Valeant presents sales taxes on a net basis. The adoption of this standard did not have any significant impact on Valeant.

 

SFAS No. 157.  In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS No. 157). SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements but does not change the requirements to apply fair value in existing accounting standards. Under SFAS No. 157, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts. The standard clarifies that fair value should be based on the assumptions market participants would use when pricing the asset or liability. SFAS No. 157 will be effective for Valeant as of January 1, 2008 and we are currently assessing the impact that SFAS No. 157 may have on our financial statements.

 

SFAS No. 158.  In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)”, which became effective for Valeant as of December 31, 2006. SFAS No. 158 requires companies to recognize the over-funded or under-funded status of defined benefit postretirement plans as an asset or liability on the balance sheet. Valeant does not have defined benefit postretirement plans for its U.S. operations but does maintain such plans for certain of its foreign operations. SFAS No. 158 also prescribes that, by December 31, 2008, the measurement date of a plan to be the date of its year-end balance sheet, which is the measurement date Valeant already uses for most its plans. The impact of adopting FAS 158 resulted in an increase in pension related assets and an increase in other comprehensive income of approximately $7,813,000. In addition, we have disclosed additional information about certain effects on net periodic benefit cost for the next fiscal year.

 

SFAS 159.  In February 2007 the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”, (SFAS 159) which provides companies with an option to report selected financial assets and liabilities at fair value. The objective of SFAS 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 does not eliminate any disclosure requirements included in other accounting standards. We have not yet determined if we will elect to apply the options presented in SFAS 159, the earliest effective date that we can make such an election is January 1, 2008.

 

EITF Issue 07-B.  The Emerging Issues Task Force has added an item to its 2007 agenda entitled “Accounting for Convertible Instruments That Require or Permit Partial Cash Settlement upon Conversion”. This issue involves reconsideration of the conclusions reached in EITF Issues 90-19 “Convertible Bonds with Issuer Option to Settle for Cash Upon Conversion”, EITF Issue 00-19 “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock” and EITF 03-07 “Accounting for the Settlement of the Equity-Settled Portion of a Convertible Debt Instrument That Permits or Requires the Conversion Spread to Be Settled in Stock”. We accounted for the issuance of our Convertible Subordinated Notes in accordance with these EITF conclusions (see Notes 6 and 9). Changes in the EITF’s previous conclusions on these issues could effect the calculations of interest expense and diluted earnings per share related to debt issues such as our Convertible

Subordinated Notes. At this time it is unclear what effect, if any, the Emerging Issues Task Force actions will have on our financial statements.

 

SAB No. 108.  In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (SAB No. 108) regarding the quantification of financial statement misstatements. SAB No. 108 requires a “dual approach” for quantifications of errors using both a method that focuses on the income statement impact, including the cumulative effect of prior years’ misstatements, and a method that focuses on the period-end balance sheet. SAB No. 108 will be effective for Valeant as of January 1, 2007. The adoption of this standard is not expected to have a material impact on Valeant.

 

Critical Accounting Estimates

 

The consolidated financial statements appearing elsewhere in this document have been prepared in conformity with accounting principles generally accepted in the United States. The preparation of these statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates, including those related to product returns, rebates, collectibility of receivables, inventories, intangible assets, income taxes and contingencies and litigation. The actual results could differ materially from those estimates.

 

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

 

Revenue Recognition

 

We recognize revenues from product sales when title and risk of ownership transfers to the customer. Revenues are recorded net of provisions for rebates, discounts and returns, which are estimated and recorded at the time of sale. Allowances for future returns of products sold to our direct and indirect customers, who include wholesalers, retail pharmacies and hospitals, are calculated as a percent of sales based on historical return percentages taking into account additional available information on competitive products and contract changes.

 

Our product sales are subject to a variety of deductions, primarily representing rebates and discounts to government agencies, wholesalers and managed care organizations. These deductions represent estimates of the related obligations and, as such, judgment is required when estimating the impact of these sales deductions on revenues for a reporting period.

 

In the United States we record provisions for Medicaid, Medicare and contract rebates based upon our actual experience ratio of rebates paid and actual prescriptions written during prior quarters. We apply the experience ratio to the respective period’s sales to determine the rebate accrual and related expense. This experience ratio is evaluated regularly and adjusted if necessary to ensure that the historical trends are as current as practicable. We adjust the ratio to better match our current experience or our expected future experience, as appropriate. In developing this ratio, we consider current contract terms, such as changes in formulary status and discount rates. If our ratio is not indicative of future experience, our results could be materially affected.

 

Outside of the United States, the majority of our rebates are contractual or legislatively mandated and our estimates are based on actual invoiced sales within each period; both of these elements help to reduce the risk of variations in the estimation process. Some European countries base their rebates on the government’s unbudgeted pharmaceutical spending and we use an estimated allocation factor against our actual invoiced sales to project the expected level of reimbursement. We obtain third party information that helps us to monitor the adequacy of these accruals. If our estimates are not indicative of actual unbudgeted spending, our results could be materially affected.

 

Historically, our adjustments to actual have not been material; on a quarterly basis, they generally have been less than 5% of product sales. The sensitivity of our estimates can vary by program, type of customer and geographic location. However, estimates associated with U.S. Medicaid and contract rebates are most at-risk for material adjustment because of the extensive time delay between the recording of the accrual and its ultimate settlement. This interval can range up to one year. Because of this time lag, in any given quarter, our adjustments to actual can incorporate revisions of several prior quarters.

 

We record sales incentives as a reduction of revenues at the time the related revenues are recorded or when the incentive is offered, whichever is later. We estimate the cost of our sales incentives based on our historical experience with similar incentives programs.

 

We use third-party data to estimate the level of product inventories, expiration dating, and product demand at our major wholesalers. Actual results could be materially different from our estimates, resulting in future adjustments to revenue. For the years ended December 31, 2006 and 2005, the provision for sales returns was less than 3% of product sales. We conduct a review of the current methodology and assess the adequacy of the allowance for returns on a quarterly basis, adjusting for changes in assumptions, historical results and business practices, as necessary.

 

We earn ribavirin royalties as a result of sales of products by third-party licensees, Schering-Plough and Roche. Ribavirin royalties are earned at the time the products subject to the royalty are sold by the third party and are reduced by an estimate for discounts and rebates that will be paid in subsequent periods for those products sold during the current period. We rely on a limited amount of financial information provided by Schering-Plough and Roche to estimate the amounts due to us under the royalty agreements.

 

Sales Incentives

 

In the U.S. market, our current practice is to offer sales incentives primarily in connection with launches of new products or changes of existing products where demand has not yet been established. We monitor and restrict sales in the U.S. market in order to limit wholesaler purchases in excess of their ordinary-course-of-business inventory levels. We operate Inventory Management Agreements (IMAs) with major wholesalers in the United States. However, specific events such as the case of sales incentives described above or seasonal demand (e.g. antivirals during an outbreak) may justify larger purchases by wholesalers. We may offer sales incentives primarily in international markets, where typically no right of return exists except for goods damaged in transit, product recalls or replacement of existing products due to packaging or labeling changes. Our revenue recognition policy on these types of purchases and on incentives in international markets is consistent with the policies described above.

 

Income Taxes