**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

**(Mark One)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe Quarterly Period Ended September 30, 2006**

**or**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition periodfrom                  to**

**Commissionfile number 0-19410**

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**Sepracor Inc.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                     |   | **22-2536587**                     |
|------------------------------------------------------------------|--------|------------------------------------|
| (State or Other  Jurisdiction of  Incorporation or Organization) |   | (IRS Employer  Identification No.) |
| **84 Waterford Drive  Marlborough, Massachusetts**               |   | **01752**                          |
| (Address of  Principal Executive Offices)                        |   | (Zip Code)                         |

 

Registrant’s telephone number, including area code: **(508) 481-6700**

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Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports) and (2) hasbeen subject to such filing requirements for the past90 days. Yes x  No o

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

Large accelerated filer x    Accelerated filer o    Non-acceleratedfiler o

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

The number of sharesoutstanding of the registrant’s class of Common Stock as of October 31,2006 was: 109,552,709 shares.

 

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**SEPRACOR INC.**

**INDEX**

| **Part I—Financial Information** |   |                                                                                                                                       |   |
|--------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.                                    |   | Condensed  Consolidated Interim Financial Statements (Unaudited)                                                                           |   |   |   |
|                                       |   | Consolidated Balance Sheets as of September 30,  2006 and December 31, 2005 (Restated and Unaudited)                             |   | 3 |   |
|                                       |   | Consolidated Statements of Operations for the Three  and Nine Months Ended September 30, 2006 and 2005 (Restated and  Unaudited) |   | 4 |   |
|                                       |   | Consolidated Statements of Cash Flows for the Nine  Months Ended September 30, 2006 and 2005 (Restated and  Unaudited)      |   | 5 |   |
|                                       |   | Notes to Condensed Consolidated Interim Financial  Statements                                                                              |   | 6 |   |
| Item 2.                                    |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                |   | 19 |   |
| Item 3.                                    |   | Quantitative and Qualitative Disclosures About Market  Risk                                                                                |   | 36 |   |
| Item 4.                                    |   | Controls and Procedures                                                                                                                    |   | 37 |   |
| **Part II—Other  Information**   |   |                                                                                                                                       |   |
| Item  1.                                   |   | Legal  Proceedings                                                                                                                         |   | 38 |   |
| Item  1A.                                  |   | Risk  Factors                                                                                                                              |   | 40 |   |
| Item 6.                                    |   | Exhibits                                                                                                                                   |   | 57 |   |
|                                       |   | Signatures                                                                                                                                 |   | 58 |   |
|                                       |   | Exhibit Index                                                                                                                         |   | 59 |   |

 

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**SEPRACOR INC.CONSOLIDATED BALANCE SHEETS(Unaudited)(In Thousands)**

| ** **                                                                                                                                                                                                                                                                      | ** ** | **September 30,  2006** | ** ** | **December 31,  2005  (as restated)** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-------------------------------------------------|------------|
| **Assets**                                                                                                                                                                                                                                                                      | ** ** |                         | ** ** | ** **                                      |       | ** ** | ** ** |
| Current assets:                                                                                                                                                                                                                                                                 |       |                         |       |                                            |       |   |   |
| Cash and cash  equivalents                                                                                                                                                                                                                                                      |       |                         | $          | 116,656                                         |       |   | $ | 178,144 |   |
| Short-term  investments                                                                                                                                                                                                                                                         |       |                         | 708,261    |                                            |       | 666,615 |   |
| Accounts receivable, net                                                                                                                                                                                                                                                        |       |                         | 187,757    |                                            |       | 140,465 |   |
| Inventories                                                                                                                                                                                                                                                                     |       |                         | 48,720     |                                            |       | 38,951 |   |
| Other assets                                                                                                                                                                                                                                                                    |       |                         | 26,811     |                                            |       | 22,370 |   |
| Total current assets                                                                                                                                                                                                                                                            |       |                         | 1,088,205  |                                            |       | 1,046,545 |   |
| Long-term  investments                                                                                                                                                                                                                                                          |       |                         | 172,243    |                                            |       | 131,442 |   |
| Property and equipment,  net                                                                                                                                                                                                                                                    |       |                         | 73,402     |                                            |       | 72,467 |   |
| Investment in affiliate                                                                                                                                                                                                                                                         |       |                         | 4,957      |                                            |       | 5,829 |   |
| Deferred financing costs  and patents, net                                                                                                                                                                                                                                      |       |                         | 13,606     |                                            |       | 18,097 |   |
| Other assets                                                                                                                                                                                                                                                                    |       |                         | 117        |                                            |       | 117 |   |
| Total assets                                                                                                                                                                                                                                                                    |       |                         | $          | 1,352,530                                       |       |   | $ | 1,274,497 |   |
| **Liabilities and Stockholders’ Equity (Deficit)**                                                                                                                                                                                                                         | ** ** |                         | ** ** | ** **                                      |       | ** ** | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                            |       |                         |       |                                            |       |   |   |
| Accounts payable                                                                                                                                                                                                                                                                |       |                         | $          | 17,903                                          |       |   | $ | 11,544 |   |
| Accrued expenses                                                                                                                                                                                                                                                                |       |                         | 104,557    |                                            |       | 187,409 |   |
| Current portion of notes  payable and capital lease obligation                                                                                                                                                                                                                  |       |                         | 592        |                                            |       | 2,030 |   |
| Current portion of  convertible subordinated debt                                                                                                                                                                                                                               |       |                         | 440,000    |                                            |       | — |   |
| Other current liabilities                                                                                                                                                                                                                                                       |       |                         | 100,687    |                                            |       | 76,923 |   |
| Total current  liabilities                                                                                                                                                                                                                                                      |       |                         | 663,739    |                                            |       | 277,906 |   |
| Notes payable and  capital lease obligation                                                                                                                                                                                                                                     |       |                         | 982        |                                            |       | 1,260 |   |
| Convertible subordinated  debt                                                                                                                                                                                                                                                  |       |                         | 720,820    |                                            |       | 1,160,820 |   |
| Total liabilities                                                                                                                                                                                                                                                               |       |                         | 1,385,541  |                                            |       | 1,439,986 |   |
| Stockholders’ equity (deficit):                                                                                                                                                                                                                                            |       |                         |       |                                            |       |   |   |
| Preferred stock, $1.00  par value, 1,000 shares authorized; none outstanding at September 30,  2006 and December 31, 2005                                                                                                                                             |       |                         | —     |                                            |       | — |   |
| Common stock, $.10 par  value, 240,000 shares authorized at September 30, 2006 and  December 31, 2005, respectively; 109,281 and 108,354 shares issued,  105,020 and 104,093 shares outstanding, at September 30, 2006 and  December 31, 2005, respectively |       |                         | 10,928     |                                            |       | 10,835 |   |
| Treasury stock, at cost  (4,261 and 4,261 shares at September 30, 2006 and December 31,  2005, respectively)                                                                                                                                                     |       |                         | (232,028   | )                                               |       | (232,028 | ) |
| Additional paid-in  capital                                                                                                                                                                                                                                                     |       |                         | 1,761,625  |                                            |       | 1,711,653 |   |
| Accumulated deficit                                                                                                                                                                                                                                                             |       |                         | (1,577,116 | )                                               |       | (1,662,627 | ) |
| Accumulated other  comprehensive income                                                                                                                                                                                                                                         |       |                         | 3,580      |                                            |       | 6,678 |   |
| Total stockholders’  equity (deficit)                                                                                                                                                                                                                                      |       |                         | (33,011    | )                                               |       | (165,489 | ) |
| Total liabilities and stockholders’ equity (deficit)                                                                                                                                                                                                                       |       |                         | $          | 1,352,530                                       |       |   | $ | 1,274,497 |   |

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

3

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**SEPRACOR INC.CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)(In Thousands, Except Per Share Amounts)**

| ** **                                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**                  | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                      | ** ** | **September 30,  2006**     | ** ** | **September 30,  2005  (as restated)** | ** ** | **September 30,  2006** | ** ** | **September 30,  2005  (as restated)** | ** ** |
| Revenues:                                                                       |       |                             |       |                                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Product sales                                                                   |       |                             | $          | 280,086                                          |       |   |   | $ | 193,357 |   |   |   | $ | 814,018 |   |   |   | $ | 466,748 |   |   |
| Royalties                                                                       |       |                             | 9,210      |                                             |       |   | 12,363 |   |   |   | 25,362 |   |   |   | 43,081 |   |   |
| Total revenues                                                                  |       |                             | 289,296    |                                             |       |   | 205,720 |   |   |   | 839,380 |   |   |   | 509,829 |   |   |
| Costs and expenses:                                                             |       |                             |       |                                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cost of product sold                                                            |       |                             | 24,554     |                                             |       |   | 15,491 |   |   |   | 70,780 |   |   |   | 39,981 |   |   |
| Cost of royalties                                                               |       |                             | 327        |                                             |       |   | 224 |   |   |   | 769 |   |   |   | 629 |   |   |
| Research and development                                                        |       |                             | 35,520     |                                             |       |   | 38,372 |   |   |   | 121,149 |   |   |   | 104,073 |   |   |
| Selling, marketing and distribution                                             |       |                             | 151,154    |                                             |       |   | 162,731 |   |   |   | 523,750 |   |   |   | 386,121 |   |   |
| General and administrative                                                      |       |                             | 19,285     |                                             |       |   | 11,097 |   |   |   | 51,880 |   |   |   | 29,878 |   |   |
| Total costs and expenses                                                        |       |                             | 230,840    |                                             |       |   | 227,915 |   |   |   | 768,328 |   |   |   | 560,682 |   |   |
| Income (loss) from operations                                                   |       |                             | 58,456     |                                             |       |   | (22,195 | ) |   |   | 71,052 |   |   |   | (50,853 | ) |   |
| Other income (expense):                                                         |       |                             |       |                                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest income                                                                 |       |                             | 12,319     |                                             |       |   | 7,776 |   |   |   | 33,103 |   |   |   | 18,446 |   |   |
| Interest expense                                                                |       |                             | (5,538     | )                                                |       |   | (5,847 | ) |   |   | (16,632 | ) |   |   | (17,528 | ) |   |
| Gain on sale of equity investments                                              |       |                             | —     |                                             |       |   | 18,345 |   |   |   | — |   |   |   | 18,345 |   |   |
| Equity in investee losses                                                       |       |                             | (212       | )                                                |       |   | (241 | ) |   |   | (565 | ) |   |   | (709 | ) |   |
| Other expense                                                                   |       |                             | (9         | )                                                |       |   | (323 | ) |   |   | (321 | ) |   |   | (680 | ) |   |
| Income (loss) before income taxes                                               |       |                             | 65,016     |                                             |       |   | (2,485 | ) |   |   | 86,637 |   |   |   | (32,979 | ) |   |
| Income taxes                                                                    |       |                             | 585        |                                             |       |   | — |   |   |   | 1,126 |   |   |   | — |   |   |
| Net income (loss) after income taxes                                            |       |                             | $          | 64,431                                           |       |   |   | $ | (2,485 | ) |   |   | $ | 85,511 |   |   |   | $ | (32,979 | ) |   |
| Basic net income (loss) per common share                                        |       |                             | $          | 0.61                                             |       |   |   | $ | (0.02 | ) |   |   | $ | 0.82 |   |   |   | $ | (0.32 | ) |   |
| Diluted net income (loss) per common share                                      |       |                             | $          | 0.56                                             |       |   |   | $ | (0.02 | ) |   |   | $ | 0.74 |   |   |   | $ | (0.32 | ) |   |
| Shares used in computing  basic and diluted net income (loss) per common share: |       |                             |       |                                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                           |       |                             | 104,991    |                                             |       |   | 105,427 |   |   |   | 104,627 |   |   |   | 104,560 |   |   |
| Diluted                                                                         |       |                             | 115,694    |                                             |       |   | 105,427 |   |   |   | 115,447 |   |   |   | 104,560 |   |   |

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

4

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**SEPRACOR INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(In Thousands)**

| ** **                                                                            | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                            | ** ** | **September 30,  2006**    | ** ** | **September 30,  2005  (as restated)** | ** ** |
| Cash flows from  operating activities:                                                |       |                            |       |   |   |   |   |   |   |
| Net income (loss)                                                                     |       |                            | $          | 85,511 |   |   |   | $ | (32,979 | ) |   |
| Adjustments to reconcile  net income (loss) to net cash used in operating activities: |       |                            |       |   |   |   |   |   |   |
| Depreciation and amortization                                                         |       |                            | 15,259     |   |   |   | 11,307 |   |   |
| Equity in investee losses                                                             |       |                            | 565        |   |   |   | 709 |   |   |
| Stock compensation                                                                    |       |                            | 31,371     |   |   |   | 783 |   |   |
| Loss (gain) on asset disposal                                                         |       |                            | (137       | ) |   |   | 603 |   |   |
| Gain on sale of equity investment                                                     |       |                            | —     |   |   |   | (18,345 | ) |   |
| Changes in operating  assets and liabilities:                                         |       |                            |       |   |   |   |   |   |   |
| Accounts receivable                                                                   |       |                            | (47,292    | ) |   |   | (34,252 | ) |   |
| Inventories                                                                           |       |                            | (9,312     | ) |   |   | (12,073 | ) |   |
| Other current assets                                                                  |       |                            | (4,426     | ) |   |   | (2,937 | ) |   |
| Accounts payable                                                                      |       |                            | 6,288      |   |   |   | 24,000 |   |   |
| Accrued expenses                                                                      |       |                            | (82,945    | ) |   |   | (7,905 | ) |   |
| Other current liabilities                                                             |       |                            | 23,855     |   |   |   | 20,335 |   |   |
| Net cash provided  by (used in) operating activities                                  |       |                            | 18,737     |   |   |   | (50,754 | ) |   |
| Cash flows from  investing activities:                                                |       |                            |       |   |   |   |   |   |   |
| Purchases of short and long-term investments                                          |       |                            | (915,978   | ) |   |   | (1,011,167 | ) |   |
| Sales and maturities of short and long-term  investments                              |       |                            | 839,405    |   |   |   | 668,994 |   |   |
| Additions to property and equipment                                                   |       |                            | (11,929    | ) |   |   | (9,524 | ) |   |
| Proceeds from sales of equipment                                                      |       |                            | 150        |   |   |   | — |   |   |
| Investment in non-affiliate                                                           |       |                            | (8,939     | ) |   |   | (7,143 | ) |   |
| Change in other assets                                                                |       |                            | —     |   |   |   | 932 |   |   |
| Net cash used in  investing activities                                                |       |                            | (97,291    | ) |   |   | (357,908 | ) |   |
| Cash flows from  financing activities:                                                |       |                            |       |   |   |   |   |   |   |
| Net proceeds from issuance of common stock                                            |       |                            | 18,694     |   |   |   | 31,796 |   |   |
| Settlement of call spread options                                                     |       |                            | —     |   |   |   | 123,798 |   |   |
| Repayments of long-term debt and capital  leases                                      |       |                            | (1,717     | ) |   |   | (1,592 | ) |   |
| Net cash provided  by financing activities                                            |       |                            | 16,977     |   |   |   | 154,002 |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                         |       |                            | 89         |   |   |   | 165 |   |   |
| Net decrease in  cash and cash equivalents                                            |       |                            | (61,488    | ) |   |   | (254,495 | ) |   |
| Cash and cash  equivalents at beginning of period                                     |       |                            | $          | 178,144 |   |   |   | $ | 435,905 |   |   |
| Cash and cash  equivalents at end of period                                           |       |                            | $          | 116,656 |   |   |   | $ | 181,410 |   |   |
| Non cash  activities:                                                                 |       |                            |       |   |   |   |   |   |   |
| Additions to  capital leases                                                          |       |                            | —     |   |   |   | $ | 529 |   |   |

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

5

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**NOTES TO CONDENSEDCONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)**

**1.**                 Basisof Presentation

The accompanying condensed consolidated interimfinancial statements are unaudited and have been prepared on a basissubstantially consistent with the audited financial statements. Certaininformation and footnote disclosures normally included in our annual financialstatements have been condensed or omitted. The consolidated interim financialstatements, in the opinion of our management, reflect all adjustments(consisting of normal recurring accruals) necessary for a fair presentation ofthe results for the interim periods ended September 30, 2006 and 2005.

The condensed consolidated financial statementsinclude our accounts and the accounts of our wholly-owned subsidiaries,including Sepracor Canada Limited. We also have an investment in BioSphereMedical, Inc., or BioSphere, which we record under the equity method.

The consolidated results of operations for the interimperiods are not necessarily indicative of the results of operations to beexpected for the full fiscal year. These condensed consolidated interimfinancial statements should be read in conjunction with the audited financialstatements for the year ended December 31, 2005, which are contained in ourannual report on Form 10-K/A for the year ended December 31,2005, filed with the Securities and Exchange Commission, or SEC.

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe following: (1) the reported amounts of assets and liabilities, (2) thedisclosure of contingent assets and liabilities at the dates of the financialstatements and (3) the reported amounts of revenues and expenses duringthe reporting periods. Actual results could differ from those estimates.

**2.**                 RecentAccounting Pronouncements

In September 2006, the Financial AccountingStandards Board, or FASB, issued Statement of Financial Accounting Standards,or SFAS, No. 157, “Fair Value Measurements”, or SFAS 157, which definesfair value, establishes a framework for measuring fair value and expandsdisclosures about fair value measurements. SFAS 157 is effective forfiscal years beginning after November 15, 2007, and interim periods withinthose fiscal years. We are currently assessing the potential effects ofimplementing this standard.

In September 2006,the SEC issued Staff Accounting Bulletin, or SAB, No. 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements”, or SAB 108, which is effective for fiscalyears ending after November 15, 2006. SAB 108 provides interpretiveguidance on the consideration of the effects of prior year misstatements inquantifying current year misstatements for the purpose of a materialityassessment. We do not expect the adoption of SAB 108 to have a material impacton our consolidated financial statements. 

In June 2006, the FASB issued FASBInterpretation, or FIN, No. 48, “Accounting for Uncertainty in IncomeTaxes”, or FIN 48. FIN 48 clarifies the application of SFAS No. 109,“Accounting for Income Taxes”, or SFAS 109, by providing detailed guidance forthe financial statement recognition, measurement and disclosure of uncertaintax positions recognized in an enterprise’s financial statements. Tax positionsmust meet a more-likely-than-not recognition threshold at the effective date tobe recognized upon the adoption of FIN 48 and in subsequent periods.FIN 48 will be effective for fiscal years beginning after December 15,2006. We are currently evaluating the potential effects of FIN 48 on ourconsolidated financial statements.

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**3.**                 Restatementof Financial Statements Based on Review of Stock Option Practices

As previously announced, the SEC is conducting aninformal inquiry into our stock option practices, and we have been cooperatingwith such inquiry. In June 2006, we appointed a special committee ofoutside directors to conduct an internal review relating to our stock option grantsand stock option practices. The special committee, with the assistance of legalcounsel and accounting specialists, has reviewed the stock option grants to ourofficers, directors and employees from 1996 to the present under our variousstock option plans in effect during this period. We cooperated with the specialcommittee’s review and our finance department also reviewed the stock optiongrants and stock option practices from 1996 to present. Although the specialcommittee has completed its stock option related review, the committee willremain in place for the duration of the SEC’s inquiry.

Based on these reviews, we have determined that themeasurement dates for certain stock option grants to employees, officers anddirectors during prior periods differed from the recorded dates for such awardsprimarily due to the following circumstances: (i) stock option grantswhich specified effective dates that may have preceded the dates of receipt ofall necessary signatures or approvals, finalization of lists specifying stockoption grants or an employee’s first date of employment; and (ii) stockoption awards that were approved with exercise prices lower than fair marketvalue on the effective date of grant. In addition, we have determined that (a) themodification of certain stock option grants in connection with an employee’stermination of employment and (b) the exercise of certain stock optionsthat had not vested prior to an employee’s termination, resulted in a newmeasurement date for such stock options. As a result, we are required to recordadjustments to non-cash charges for additional stock-based compensation expensein periods prior to July 1, 2006. For periods prior to January 1,2006, such charges are recorded in accordance with APB 25 and for subsequentperiods in accordance with SFAS 123(R). These non-cash charges had no impact onreported revenue, cash or cash equivalents. The aggregate amount of theadditional stock-based compensation expense we have incurred as a result of thestock option review is approximately $43.3 million, of which, $668,000 wasrecorded in the nine months ended September 30, 2006.

As a result of the review, we have restated ourfinancial statements for the quarters ended March 31, June 30, September 30and December 31, 2005, the quarter ended March 31, 2006 and thefiscal years ended December 31, 2005, 2004 and 2003.

Thetable below sets forth the restatement impact as a result of the non-cashcharges for stock-based compensation expense within our consolidated statementof operations in the following periods:  

| ** **                                                                   | ** ** | **Three Months Ended  September 30, 2005** | ** ** | **Nine Months Ended  September 30, 2005** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Net income (loss)  as previously reported                                    |       |                                                           | $          | (2,224                                                        | )          |   |   | $ | (32,196 | ) |   |
| Charge for  additional stock-based compensation                              |       |                                                           | (261       | )                                                             |       |   | (783 | ) |   |
| Net income (loss)  as restated                                               |       |                                                           | $          | (2,485                                                        | )          |   |   | $ | (32,979 | ) |   |
| Basic and diluted  net income (loss) per common share as previously reported |       |                                                           | $          | (0.02                                                         | )          |   |   | $ | (0.31 | ) |   |
| Basic and diluted net  income (loss) per common share as restated            |       |                                                           | $          | (0.02                                                         | )          |   |   | $ | (0.32 | ) |   |

 

7

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Thetable below sets forth the impact of the additional non-cash charges forstock-based compensation expense within our restated consolidated balance sheetfor the year ended December 31, 2005.

| ** **                  | ** ** | **As of**                       | ** ** |
|-----------------------------|------------|--------------------------------------|------------|
| ** **                  | ** ** | **December 31,  2005**          | ** ** |
| ** **                  | ** ** | **(in thousands)  (unaudited)** | ** ** |
| Additional  paid-in capital |       |                                 |       |   |   |
| As previously reported      |       |                                 | $          | 1,669,541 |   |   |
| As restated                 |       |                                 | $          | 1,711,653 |   |   |
| Accumulated deficit         |       |                                 |       |   |   |
| As previously reported      |       |                                 | $          | (1,620,515 | ) |   |
| As restated                 |       |                                 | $          | (1,662,627 | ) |   |

 

Our financial statements for the nine months ended September 30,2006 includes a restatement impact of $223,000 for additional stock-basedcompensation in the period ended March 31, 2006 as reported in our Form 10-Q/Afiled on September 12, 2006.

All financial informationincluded in this quarterly report on Form 10-Q reflects therestatement.

**4.**                 Basicand Diluted Net Loss Per Common Share

Basic earnings (loss) per share, or EPS, excludesdilution and is computed by dividing net income by the weighted-averagenumber of common shares outstanding for the period. Diluted EPS is based uponthe weighted average number of common shares outstanding during the period plusthe additional weighted average potential common shares during the period.Potential common shares are not included in the per share calculation when theeffect of their inclusion would be anti-dilutive. Potential common sharesresult from the assumed conversion of convertible subordinated debt, vesting ofrestricted stock awards and the assumed exercise of outstanding stock options,the proceeds of which are then assumed to have been used to repurchaseoutstanding stock options using the treasury stock method. Purchased calloptions are also not included in the per share calculations for the periodended September 30, 2005 because including them would be anti-dilutive.There were no outstanding purchased call options during 2006.

For the three andnine months ended September 30, 2006, basic and diluted net income percommon share is computed based on the weighted-average number of common sharesoutstanding during the period; however, diluted net income for that period alsoincludes the dilutive effect of potential common shares. For the three and ninemonths ended September 30, 2005, basic and diluted net loss per commonshare is computed based on the weighted-average number of common sharesoutstanding during the period because the effect of potential common shareswould be anti-dilutive. Certain securities were not included in the computationof diluted EPS because they would have an anti-dilutive effect due to exerciseprice or net losses for such periods. These securities include the following:

a.                 Optionsto purchase shares of common stock:

| ** **            | ** ** | **Three Months  Ended  September 30, 2006**                    | ** **      | **Three Months  Ended  September 30, 2005** | ** ** | **Nine Months  Ended  September 30, 2006** | ** **     | **Nine Months  Ended  September 30, 2005** | ** ** |
|-----------------------|------------|-------------------------------------------------------------------------------|-----------------|------------------------------------------------------------|------------|-----------------------------------------------------------|----------------|-----------------------------------------------------------|------------|
| ** **            | ** ** | **(in thousands, except price per share data)** | ** **      |
| Number of options     |       | 4,175                                                                         |            |                                                       | 11,422     |                                                      |           | 3,779                                                     |       |   | 11,422 |   |   |
| Price range per share |       | $                                                                             | 48.52 to $87.50 |                                                       |       | $                                                         | 5.75 to $87.50 |                                                      |       | $ | 52.08 to $87.50 |   |   | $ | 5.75 to $87.50 |   |   |
|                       |            |                                                                               |                 |                                                            |            |                                                           |                |                                                           |            |  |  |  |  |  |  |  |  |

 

8

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b.                Sharesof common stock reserved for issuance upon conversion of convertiblesubordinated debt:

| ** **                                                            | ** ** | **September 30,  2006** | ** ** | **September 30,  2005** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                            | ** ** | **(in thousands)**      | ** ** |
| 5% convertible  subordinated debentures due 2007                 |       |                         | 4,763      |                         |       |   | 4,763 |   |   |
| 0% Series A  convertible senior subordinated notes due 2008 |       |                         | —     |                         |       |   | 2,283 |   |   |
| 0% Series B  convertible senior subordinated notes due 2010 |       |                         | —     |                         |       |   | 4,961 |   |   |
| Total                                                                 |       |                         | 4,763      |                         |       |   | 12,007 |   |   |

 

We have issued 0%convertible subordinated notes due 2024, which were not convertible as of September 30,2006 and 2005 or at any time during the three and nine months ended September 30,2006 and 2005. Once these notes become convertible, shares of common stock willbe reserved under the conversion formula for issuance upon conversion if andwhen our common stock price exceeds $67.20 per share on the NASDAQ GlobalSelect Market. Prior to such occurrence, the notes are only convertible intocash.

**5.**                 Accountingfor Stock-Based Compensation

Effective January 1, 2006, we adopted theprovisions of SFAS 123(R), which establishes accounting for equityinstruments exchanged for employee services. Under the provisions ofSFAS 123(R), share-based compensation cost is measured at the grant date,based on the fair value of the award, and is recognized as an expense over theemployee’s requisite service period (generally the vesting period of the equityaward). Prior to January 1, 2006, we accounted for share-basedcompensation to employees in accordance with APB 25 and relatedinterpretations. We also followed the disclosure requirements of SFAS 123.We elected to adopt the modified prospective transition method as provided bySFAS 123(R) and, accordingly, financial statement amounts for theprior periods presented in this quarterly report on Form 10-Q havenot been restated to reflect the fair value method of expensing stock-basedcompensation.

Our equity incentive plans were adopted in 1997, 1999,2000 and 2002. Stock options granted under the equity incentive plans aregenerally non-qualified stock options, but the equity incentive plans permitthe granting of “incentive stock options” under the U.S. Internal Revenue Codeof 1986, as amended, or the Code. The exercise price of a stock optiongenerally is equal to the fair market value of our common stock on the optiongrant date. The contractual term of stock options granted under our equityincentive plans is generally 10 years.

Under the equity incentive plans, in addition to stockoptions, we granted certain employees restricted stock awards. Restricted stockawards are non-vested stock awards. Restricted stock awards are independent ofstock option grants and are subject to forfeiture or repurchase if employmentterminates prior to the release of the restrictions. Such awards generally vestannually over a two to five year period from the date of grant. Ownership ofrestricted stock typically cannot be transferred until the shares have vested.In connection with restricted stock grants, we record compensation expensebased on the fair value of the shares granted. This stock compensation is beingamortized on a straight-line basis over the vesting periods.

The 1998 Employee Stock Purchase Plan, or 1998 ESPP,permits an aggregate of 1,400,000 shares of common stock to be purchased byemployees at 85% of market value on the first or last day of each six-monthoffering period, whichever is lower, through accumulation of payroll deductionsranging from 1% to 10% of compensation, as defined, subject to certainlimitations.

9

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As required by SFAS 123(R), management has made anestimate of expected stock option and restricted stock forfeitures, and we arerecognizing compensation costs only for those equity awards expected to vest.

Thefollowing table presents stock-based employee compensation expenses included inour unaudited condensed consolidated statements of operations:

| ** **                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | ** **                       | ** ** | **September 30,**          | ** ** | ** ** | ** ** | **September 30,** | ** ** |
| ** **                           | ** ** | **September 30,**           | ** ** | **2005**                        | ** ** | **September 30,** | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **2006**                         | ** ** | **(as restated)**          | ** ** | **2006** | ** ** | **(as restated)** | ** ** |
| ** **                           | ** ** | **(in thousands)**          | ** ** |
| Cost of products  sold               |       |                             | $          | 115                             |       |   |   | $ | — |   |   |   | $ | 397 |   |   |   | $ | — |   |   |
| Research and  development            |       |                             | 2,616      |                            |       |   | — |   |   |   | 7,558 |   |   |   | — |   |   |
| Selling,  marketing and distribution |       |                             | 3,583      |                            |       |   | 35 |   |   |   | 10,456 |   |   |   | 105 |   |   |
| General and  administrative          |       |                             | 4,214      |                            |       |   | 226 |   |   |   | 12,960 |   |   |   | 678 |   |   |
| Stock-based compensation  expense    |       |                             | $          | 10,528                          |       |   |   | $ | 261 |   |   |   | $ | 31,371 |   |   |   | $ | 783 |   |   |

 

As a result of adopting SFAS 123(R), our netincome for the three and nine months ended September 30, 2006 is$10,305,000 and $30,703,000, respectively, less than if we had continued toaccount for stock-based compensation under APB 25. Basic and dilutedincome per share for the three months ended September 30, 2006 were alsoless by $0.10 and $0.09, respectively, due to the adoption of SFAS 123(R).Basic and diluted income per share for the nine months ended September 30,2006 were less by $0.29 and $0.27, respectively, due to the adoption of SFAS123(R).

Thefollowing table presents stock-based employee compensation expenses by type ofaward:

| ** **                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                        | ** ** | ** **                       | ** ** | **September 30,**          | ** ** | ** ** | ** ** | **September 30,** | ** ** |
| ** **                        | ** ** | **September 30,**           | ** ** | **2005**                        | ** ** | **September 30,** | ** ** | **2005** | ** ** |
| ** **                        | ** ** | **2006**                         | ** ** | **(as restated)**          | ** ** | **2006** | ** ** | **(as restated)** | ** ** |
| ** **                        | ** ** | **(in thousands)**          | ** ** |
| Employee stock  options           |       |                             | $          | 9,626                           |       |   |   | $ | 261 |   |   |   | $ | 28,840 |   |   |   | $ | 783 |   |   |
| Restricted shares                 |       |                             | 409        |                            |       |   | — |   |   |   | 1,320 |   |   |   | — |   |   |
| Employee stock  purchase plan     |       |                             | 493        |                            |       |   | — |   |   |   | 1,211 |   |   |   | — |   |   |
| Stock-based compensation  expense |       |                             | $          | 10,528                          |       |   |   | $ | 261 |   |   |   | $ | 31,371 |   |   |   | $ | 783 |   |   |

 

We estimate the fair value of stock options using theBlack-Scholes valuation model. This valuation model takes into account the exerciseprice of the award, as well as a variety of assumptions. The assumptions we useto estimate the fair value of stock options include the expected term, theexpected volatility of our stock over the expected term, the risk-free interestrate over the expected term, and our expected annual dividend yield. We believethat the valuation technique and the approach we utilized to develop theunderlying assumptions are appropriate in calculating the fair values of thestock options granted in the three and nine months ended September 30,2006. Estimates of fair value are not intended to predict actual future eventsor the value ultimately realized by persons who receive equity awards.

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Assumptionsused to determine the fair value of stock options granted during the three andnine months ended September 30, 2006, using the Black-Scholes valuationmodel, were:

| ** **                      | ** ** | **Three Months Ended September 30, 2006** | ** ** | **Nine Months Ended September 30, 2006** | ** ** |
|---------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                      | ** ** | **Employee Stock  Option Plans**                         | ** ** | **1998 Employee Stock  Purchase Plan**             | ** ** | **Employee Stock  Option Plans** | ** ** | **1998 Employee Stock  Purchase Plan** | ** ** |
| Expected term                   |       |                                                               | 5.7 years  |                                                              |       |   | 0.5 years |   |   |   | 5.4 years |   |   |   | 0.5 years |   |   |
| Expected  volatility factor     |       |                                                               | 25.1       | %                                                                 |       |   | 32.5 | % |   |   | 29.4 | % |   |   | 30.7 | % |   |
| Risk-free  interest rate        |       |                                                               | 5.1        | %                                                                 |       |   | 4.9 | % |   |   | 4.7 | % |   |   | 4.6 | % |   |
| Expected annual dividend  yield |       |                                                               |       | —                                                            |       |   |   | — |   |   |   | — |   |   |   | — |   |

 

Priorto January 1, 2006, we accounted for stock-based compensation to employeesin accordance with APB 25. We also had previously adopted the disclosureprovisions of SFAS 123, which required disclosure only of stock-basedcompensation and its impact on net loss and net loss per share. The followingtable illustrates the effects on net loss and net loss per share for the threeand nine months ended September 30, 2005 as if we had applied the fairvalue recognition provisions of SFAS 123 to stock-based employee awards.

| ** **                                                                                     | ** ** | **Three Months Ended  September 30, 2005  (as restated)** | ** ** | **Nine Months Ended  September 30, 2005  (as restated)** | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|
| ** **                                                                                     | ** ** | **(in thousands, except price per share data)**      | ** ** |
| Net loss as  reported                                                                          |       |                                                                               | $          | (2,485                                                                            | )          |   |   | $ | (32,979 | ) |   |
| Add: Stock-based  employee compensation expense included in restated results                   |       |                                                                               | 261        |                                                                              |       |   | 783 |   |   |
| Less: Total  stock-based employee compensation expense determined under the fair value  method |       |                                                                               | (11,587    | )                                                                                 |       |   | (36,241 | ) |   |
| Pro forma net  loss                                                                            |       |                                                                               | $          | (13,811                                                                           | )          |   |   | $ | (68,437 | ) |   |
| Net loss per  share:                                                                           |       |                                                                               |       |                                                                              |       |   |   |   |   |
| Basic and  diluted—as reported                                                       |       |                                                                               | $          | (0.02                                                                             | )          |   |   | $ | (0.32 | ) |   |
| Basic and diluted—pro  forma                                                              |       |                                                                               | $          | (0.13                                                                             | )          |   |   | $ | (0.65 | ) |   |

 

11

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Indetermining the stock-based compensation expense to be disclosed under SFAS123, we were required to estimate the fair value of stock awards granted toemployees using a Black-Scholes valuation model. However, differences betweenthe requirements of SFAS 123(R) and SFAS 123 resulted in a different setof assumptions for our valuation model, including the utilization of aforfeiture rate. Assumptions used to determine the fair value of stock optionsgranted under SFAS 123 during the three and nine months ended September 30,2005 were:

| ** **                      | ** ** | **Three Months Ended**                 | ** **     | **Nine Months Ended**                       | ** ** |
|---------------------------------|------------|--------------------------------------------------|----------------|-------------------------------------------------------|------------|
| ** **                      | ** ** | **September 30, 2005**                 | ** **     | **September 30, 2005**                      | ** ** |
| ** **                      | ** ** | **Employee Stock   Option Plans** | ** **     | **1998 Employee Stock  Purchase Plan** | ** ** | **Employee Stock  Option Plans** | ** ** | **1998 Employee Stock  Purchase Plan** | ** ** |
| Expected term                   |       |                                             | 5.0 years |                                                  |       |   | 0.5 years |   |   |   | 5.0 years |   |   |   | 0.5 years |   |   |
| Expected  volatility factor     |       |                                             | 37.0           | %                                                     |       |   | 36.0 | % |   |   | 67.4 | % |   |   | 36.0 | % |   |
| Risk-free  interest rate        |       |                                             | 4.0            | %                                                     |       |   | 3.2 | % |   |   | 3.9 | % |   |   | 2.7 | % |   |
| Expected annual dividend  yield |       |                                             | —         |                                                  |       |   | — |   |   |   | — |   |   |   | — |   |   |

 

We issue common stock from previously authorized butunissued shares to satisfy stock option exercises, restricted stock grants andpurchases under the 1998 ESPP.

Asummary of our stock option activity for the nine months ended September 30,2006 is as follows:

| ** **                              | ** ** | **Number of  Options  (in thousands)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term   (in years)** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| Outstanding,  December 31, 2005    |       |                                             | 10,859     |                                       |       |                                                                       | $          | 32.78 |   |   |   |   |   |   |
| Granted                                 |       |                                             | 1,824      |                                       |       |                                                                       | $          | 54.31 |   |   |   |   |   |   |
| Exercised                               |       |                                             | (841       | )                                          |       |                                                                       | $          | 17.74 |   |   |   |   |   |   |
| Cancelled                               |       |                                             | (240       | )                                          |       |                                                                       | $          | 42.65 |   |   |   |   |   |   |
| Outstanding,  September 30, 2006   |       |                                             | 11,602     |                                       |       |                                                                       | $          | 37.05 |   |   |   | 5.9 |   |   |
| Exercisable at  September 30, 2006 |       |                                             | 6,549      |                                       |       |                                                                       | $          | 28.09 |   |   |   | 4.3 |   |   |

 

All stock options granted during the nine months endedSeptember 30, 2006 and 2005 were granted with exercise prices equal to thefair market value of our common stock on the grant date.

At September 30, 2006, the aggregate intrinsicvalue of stock options outstanding and stock options exercisable was$182,400,000 and $148,274,000, respectively. The intrinsic value of a stockoption is the amount by which the market value of the underlying stock exceedsthe exercise price of the stock option.

The aggregate intrinsic value of stock optionsexercised during the three and nine months ended September 30, 2006 was$2,791,000 and $30,413,000, respectively.

12

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Thefollowing table summarizes the stock options outstanding at September 30,2006:

| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**    | ** ** |
|---------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **Exercise Price Range**          | ** ** | ** **                   | ** ** | **Number  (in thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted Average  Remaining  Contractual  Term (in years)** | ** ** | **Number  (in thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $  6.24  – $  8.31 |       |                         | 733        |                            |       |   | $ | 6.30 |   |   |   | 5.9 |   |   |   | 718 |   |   |   | $ | 6.27 |   |   |
| $11.25 – $16.78                        |       |                         | 1,841      |                            |       |   | $ | 13.11 |   |   |   | 4.2 |   |   |   | 1,384 |   |   |   | $ | 12.89 |   |   |
| $18.38 – $27.15                        |       |                         | 2,470      |                            |       |   | $ | 21.18 |   |   |   | 4.3 |   |   |   | 1,982 |   |   |   | $ | 20.72 |   |   |
| $27.70 – $39.07                        |       |                         | 1,085      |                            |       |   | $ | 34.47 |   |   |   | 3.9 |   |   |   | 956 |   |   |   | $ | 35.35 |   |   |
| $42.38 – $59.45                        |       |                         | 4,316      |                            |       |   | $ | 52.16 |   |   |   | 7.8 |   |   |   | 1,239 |   |   |   | $ | 53.57 |   |   |
| $64.50 – $87.50                        |       |                         | 1,157      |                            |       |   | $ | 74.32 |   |   |   | 6.3 |   |   |   | 270 |   |   |   | $ | 75.45 |   |   |
| $  6.24 – $87.50             |       |                         | 11,602     |                            |       |   | $ | 37.05 |   |   |   | 5.9 |   |   |   | 6,549 |   |   |   | $ | 28.09 |   |   |
|                                             |            |                              |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Ournon-vested share activity for the nine months ended September 30, 2006 wasas follows:

| ** **                             | ** ** | **Stock Options**  | ** ** | **Restricted Stock** | ** ** |
|----------------------------------------|------------|-------------------------|------------|---------------------------|------------|
| ** **                             | ** ** | ** **              | ** ** | **Weighted**              | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Number of**      | ** ** | **Average**               | ** ** | **Number of** | ** ** | **Weighted** | ** ** |
| ** **                             | ** ** | **Shares**              | ** ** | **Fair**                  | ** ** | **Shares** | ** ** | **Average** | ** ** |
| ** **                             | ** ** | **(in thousands)** | ** ** | **Value**                 | ** ** | **(in thousands)** | ** ** | **Fair Value** | ** ** |
| Non-vested at  December 31, 2005  |       |                    | 4,563      |                      |       |   | $ | 28.74 |   |   |   | — |   |   |   | — |   |   |
| Granted                                |       |                    | 1,824      |                      |       |   | $ | 19.77 |   |   |   | 174 |   |   |   | $ | 55.34 |   |   |
| Vested                                 |       |                    | (1,105     | )                         |       |   | $ | 21.99 |   |   |   | — |   |   |   | — |   |   |
| Forfeited                              |       |                    | (229       | )                         |       |   | $ | 24.61 |   |   |   | — |   |   |   | — |   |   |
| Non-vested at  September 30, 2006 |       |                    | 5,053      |                      |       |   | $ | 27.17 |   |   |   | 174 |   |   |   | $ | 55.34 |   |   |

 

The weighted average fair value of the options grantedfor the nine months ended September 30, 2005 was $36.86.

At September 30, 2006, unrecognized compensationexpense related to non-vested stock options and restricted stock was$94,614,000 and $7,956,000, respectively, which is expected to be recognizedover weighted average periods of 3.3 years and 3.9 years, respectively.

At September 30,2006, the estimated unrecognized compensation expense related to the June 1,2006 offering period of the 1998 ESPP, which concludes on November 30,2006, was $329,000. The associated expense is amortized on a straight-linebasis over the offering period.

**6.**                 Inventories

Inventoriesconsist of the following:

| ** **     | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **     | ** ** | **(in thousands)**      | ** ** |
| Raw materials  |       |                         | $          | 22,772                      |       |   |   | $ | 21,780 |   |   |
| Finished goods |       |                         | 25,948     |                        |       |   | 17,171 |   |   |
| Total          |       |                         | $          | 48,720                      |       |   |   | $ | 38,951 |   |   |

 

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**7.**                 DeferredFinancing and Patents Costs

The followingschedule details the carrying value of our patents and deferred financingcosts:

| ** **                       | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                       | ** ** | **(in thousands)**      | ** ** |
| Deferred  financing costs, gross |       |                         | $          | 34,440                      |       |   |   | $ | 34,440 |   |   |
| Accumulated  amortization        |       |                         | (21,779    | )                           |       |   | (17,474 | ) |   |
| Deferred  financing costs, net   |       |                         | $          | 12,661                      |       |   |   | $ | 16,966 |   |   |
| Patents, gross                   |       |                         | $          | 2,785                       |       |   |   | $ | 2,785 |   |   |
| Accumulated  amortization        |       |                         | (1,840     | )                           |       |   | (1,654 | ) |   |
| Patents, net                     |       |                         | $          | 945                         |       |   |   | $ | 1,131 |   |   |

 

Thefollowing schedule details our amortization expense related to patents anddeferred financing costs:

| ** **                                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **September 30,  2006**     | ** ** | **September 30,  2005**    | ** ** | **September 30,  2006** | ** ** | **September 30,  2005** | ** ** |
| ** **                                | ** ** | **(in thousands)**          | ** ** |
| Amortization of  deferred financing costs |       |                             | $          | 1,435                           |       |   |   | $ | 903 |   |   |   | $ | 4,305 |   |   |   | $ | 2,709 |   |   |
| Amortization of  patents                  |       |                             | 60         |                            |       |   | 136 |   |   |   | 186 |   |   |   | 426 |   |   |
| Total                                     |       |                             | $          | 1,495                           |       |   |   | $ | 1,039 |   |   |   | $ | 4,491 |   |   |   | $ | 3,135 |   |   |

 

**8.**                 ConvertibleSubordinated Debt

Convertiblesubordinated debt consists of the following:

| ** **                                                                     | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                     | ** ** | **(in thousands)**      | ** ** |
| 5% convertible  subordinated debentures due February 2007                 |       |                         | $          | 440,000                     |       |   |   | $ | 440,000 |   |   |
| 0% Series A  convertible senior subordinated notes due December 2008 |       |                         | 72,800     |                        |       |   | 72,800 |   |   |
| 0% Series B  convertible senior subordinated notes due December 2010 |       |                         | 148,020    |                        |       |   | 148,020 |   |   |
| 0% convertible  senior subordinated notes due October 2024                |       |                         | 500,000    |                        |       |   | 500,000 |   |   |
| Total                                                                          |       |                         | $          | 1,160,820                   |       |   |   | $ | 1,160,820 |   |   |

 

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**9.**                 ComprehensiveIncome (Loss)

Totalcomprehensive income (loss) consists of net income (loss), net foreign currencytranslation adjustments and net unrealized gain (loss) on available-for-salesecurities.

| ** **                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**                  | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                      | ** ** | **September 30,  2006**     | ** ** | **September 30,  2005  (as restated)** | ** ** | **September 30,  2006** | ** ** | **September 30,  2005  (as restated)** | ** ** |
| ** **                                                      | ** ** | **(in thousands)**          | ** ** |
| Comprehensive income  (loss):                                   |       |                             |       |                                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                                               |       |                             | $          | 64,431                                           |       |   |   | $ | (2,485 | ) |   |   | $ | 85,511 |   |   |   | $ | (32,979 | ) |   |
| Net foreign  currency translation adjustment                    |       |                             | 93         |                                             |       |   | 826 |   |   |   | 774 |   |   |   | 558 |   |   |
| Unrealized gain  (loss) on available-for-sale securities        |       |                             | (8         | )                                                |       |   | 4,164 |   |   |   | (3,872 | ) |   |   | 12,716 |   |   |
| Reclassification  adjustment for (gains) included in net income |       |                             | —     |                                             |       |   | (18,345 | ) |   |   | — |   |   |   | (18,345 | ) |   |
| Total comprehensive  income (loss)                              |       |                             | $          | 64,516                                           |       |   |   | $ | (15,840 | ) |   |   | $ | 82,413 |   |   |   | $ | (38,050 | ) |   |

 

**10.**          LegalProceedings

**Stock OptionInquiry and Derivative Stockholder Complaints**

In June 2006, we announced that we had received aletter of inquiry from the Securities and Exchange Commission, or SEC,requesting documents related to our stock option grants and stock optionpractices, and we have been cooperating with such inquiry. We appointed aspecial committee of outside directors to conduct an internal review relatingto our stock option grants and stock option practices. The special committee,with the assistance of legal counsel and accounting specialists, has reviewedstock option grants to our officers, directors and employees from 1996 topresent under our various stock option plans in effect during this period. Wecooperated with the review, and our finance department also reviewed our stockoption grants and stock option practices. The special committee has completedits stock option related review, but will remain in place for the duration ofthe SEC’s inquiry. See Note 3 to our financial statements for additionalinformation concerning these reviews.

We have accepted service of three stockholderderivative complaints relating to certain of our stock option grants that werefiled in the Superior Court, Middlesex County, Commonwealth of Massachusetts,naming Sepracor as nominal defendant and also naming as defendants certaincurrent members of our board of directors and certain of our current and formeremployees. The complaints allege purported breaches of fiduciary duties andunjust enrichment in connection with certain stock option grants made by usbetween June 1998 and May 2001. The complaints seek monetary damagesin unspecified amounts, equitable and injunctive relief, including disgorgementof profits obtained by certain defendants and other relief as determined by theCourt. On September 12, 2006, the three complaints were consolidated intoone action, and on September 22, 2006, the action was transferred to theBusiness Litigation Session of the Superior Court, Suffolk County, Commonwealthof Massachusetts. Plaintiffs filed a consolidated complaint on October 19,2006.

Three stockholder derivative complaints relating tothe same subject matter were filed against Sepracor, certain current members ofour board of directors and certain of our current and former employees in theUnited States District Court for the District of Massachusetts on September 28,2006, October 3, 2006 and October 12, 2006. We have not been servedwith these complaints.

We are unable to reasonably estimate any possiblerange of loss or liability associated with the stock option inquiry and/orderivative suits due to their uncertain resolution.

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**Tecastemizole Class ActionComplaints**

We and several of ourcurrent and former officers and a current director are named as defendants inseveral class action complaints which have been filed on behalf of certainpersons who purchased our common stock and/or debt securities during differenttime periods, beginning on various dates, the earliest being May 17, 1999,and all ending on March 6, 2002. These complaints allege violations of theSecurities Exchange Act of 1934, as amended, and the rules and regulationspromulgated thereunder by the SEC. Primarily, they allege that the defendantsmade certain materially false and misleading statements relating to thetesting, safety and likelihood of approval of tecastemizole by the UnitedStates Food and Drug Administration, or FDA. In both the debt purchasers’action and equity purchasers’ action, the court has granted the plaintiffs’motion for class certification. In late February 2006, two corrected andamended consolidated complaints were filed, one on behalf of the purchasers ofour common stock and the other on behalf of the purchasers of our debtsecurities. These corrected and amended consolidated complaints reiterate theallegations contained in the previously filed complaints and define the allegedclass periods as May 17, 1999 through March 6, 2002. The parties arecurrently engaged in discovery. We are unable to reasonably estimate anypossible range of loss related to the lawsuits due to their uncertainresolution. However, any conclusion of these matters in a manner adverse to uswould have a material adverse effect on our financial position and results ofoperations.

**LevalbuterolHydrochloride Inhalation Solution ANDAs**

In September 2005, we received notification thatthe FDA had received an abbreviated new drug application, or ANDA, from BreathLimited seeking approval of a generic version of our 1.25 mg, 0.63 mg and 0.31mg levalbuterol hydrochloride inhalation solution. Breath Limited’s submissionincludes a Paragraph IV certification alleging that our patents listed in theFDA publication entitled “Approved Drug Products With Therapeutic EquivalenceEvaluations,” commonly referred to as the “Orange Book,” for XOPENEX InhalationSolution are invalid, unenforceable or not infringed by Breath Limited’sproposed product. We have filed a civil action against Breath Limited forpatent infringement. We were notified in January 2006 of a second ANDA seekingapproval of a generic version of our 1.25 mg, 0.63 mg and 0.31 mg levalbuterolhydrochloride inhalation solution including a Paragraph IV certification, whichwas submitted to the FDA by Dey, L.P. We have filed a civil action against Dey,L.P. for patent infringement.

In April 2006, we were notified of a third ANDAseeking approval of a generic version of our 1.25 mg, 0.63 mg and 0.31 mglevalbuterol hydrochloride inhalation solution including a Paragraph IVcertification, which was submitted to the FDA by Watson Laboratories, Inc.Watson’s paragraph IV certification was limited to our patent that expires in2021 and covers certain levalbuterol hydrochloride inhalation solutions,including XOPENEX Inhalation Solution. We have decided not to file a civilaction against Watson Laboratories, Inc. for patent infringement at thistime.

In August 2006, we received notification that theFDA had received an ANDA, including a Paragraph IV certification, from Dey, L.Pseeking approval of a generic version of our 1.25 mg/0.5 mL levalbuterolhydrochloride inhalation solution concentrate. We have filed a civil actionagainst Dey, L.P for patent infringement.

Should we successfully enforce our patents, ANDAapproval will not occur until the expiration of the applicable patents.Otherwise, the FDA will stay its approval of the relevant ANDA until 30 monthsfollowing the date we received notice of such ANDA or until a court decidesthat our patents are invalid, unenforceable or not infringed, whichever isearlier.

Patent litigation involves complex legal and factualquestions. We can provide no assurance concerning the outcome or the durationof the lawsuit. If we are not successful in enforcing our patents, we will notbe able to exclude the generic company, for the full term of our patents, frommarketing their generic version of XOPENEX Inhalation Solution. Introduction ofa generic copy of XOPENEX 

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InhalationSolution before the expiration of our patents would have a material adverseeffect on our business.

**Fexofenadine PatentClaim**

In June 2006, we werenotified that Teva Pharmaceutical Industries Limited and Teva UK Limited havefiled a claim naming us as defendant in the United Kingdom’s High Court ofJustice, Chancery Division, Patents Court. The claim alleges that our twopatents relating to fexofenandine, which we have licensed to sanofi-aventis inconnection with its sale of ALLEGRA® (fexofenadine HCl), are invalid, and seeks tohave them invalidated. Sanofi-aventis is defending this action. If patent-basedexclusivity for ALLEGRA is lost in the United Kingdom or in any otherjurisdiction where a similar action is brought, our rights to receive royaltyrevenue in any such jurisdiction will terminate.

**LUNESTA TrademarkClaim**

In September 2006, Tharos Laboratories, Inc.filed suit against us in the United States District Court, District of Utah,Central Division, alleging trademark infringement, dilution, unfaircompetition, false advertising, and false designation of origin arising out ofour use of our silk moth design in connection with LUNESTA. Tharos seeksunspecified monetary damages and an injunction of our use of the silk mothdesign. In October 2006, we filed a motion to dismiss Tharos’ claims. Weare unable to reasonably estimate any possible range of loss related to thislawsuit due to its uncertain resolution.

**11.**          Investments

On January 13, 2006, we completed the second$10 million purchase of ACADIA Pharmaceuticals Inc. common stock inconnection with the collaboration between the two companies that was formed in January 2005.Our purchase was made at a price of approximately $12.29 per share, whichrepresented a 25 percent premium over the 30-day trailing averageclosing price of ACADIA’s common stock on the NASDAQ Global Market and resultedin the issuance to us of 813,393 shares of ACADIA common stock. We recorded thepremium amount of $1,061,000 as research and development expense and theremaining amount of $8,939,000 as an investment in ACADIA.

On January 10, 2005, we completed the initial$10 million purchase of ACADIA Pharmaceuticals Inc. common stock inconnection with the collaboration. Our purchase was made at a price ofapproximately $9.28 per share, which represented a 40 percent premium overthe 30-day trailing average closing price of ACADIA’s common stock on theNASDAQ Global Market and resulted in the issuance to us of 1,077,029 shares ofACADIA common stock. We recorded the premium amount of $2,857,000 as researchand development expense and the remaining amount of $7,143,000 as an investmentin ACADIA.

Our agreement with ACADIA includes an option to selecta preclinical candidate from ACADIA’s 5-HT2a program for use incombination with LUNESTA. We have decided not to exercise this option.

On June 15, 2005,Vicuron Pharmaceuticals, Inc. entered into an agreement and plan ofmerger, or merger agreement, with Pfizer, Inc. Under the merger agreement,Pfizer agreed to purchase all outstanding shares of Vicuron for a purchaseprice of $29.10 per share in cash. On September 11, 2005, Pfizer announcedthe closing of the merger. At the time of the closing, we owned 687,766 sharesof Vicuron common stock, which we were carrying at fair market value with thecorresponding unrealized gain recorded through equity. Upon closing of themerger, this gain was recognized in other income. In exchange for our shares ofVicuron, we received approximately $20,014,000 in cash from Pfizer, of which,approximately $18,345,000 was recorded as a gain on sale of investment and isincluded in other income on the consolidated statements of operations.

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**12.**          Commitmentsand Contingencies

In conjunction with the review of our stock optiongranting practices, we have also evaluated the related tax issues to determineif we may be subject to additional tax liability as a result of the mattersunder review. As a result of such charges, previously deducted compensationrelated to exercised stock options may be non-deductible under Section 162(m) ofthe Internal Revenue Code. Accordingly, our net operating loss carryforward, maybe reduced, however, we have a full valuation allowance against our deferredtax assets and, as a result, do not expect any material impact on our financialposition or results of operations. In addition, due to the revision ofmeasurement dates, certain stock options that we previously treated asincentive stock options do not actually qualify for such treatment and must betreated as non-statutory stock options. Accordingly, we may be subject to finesand/or penalties relating to the tax treatment of such stock options. However,we do not believe it is probable that we will incur any material additional taxliability as a result of the matters under review and any such amount is notexpected to have a material impact on our financial position or results ofoperations.

At the conclusion of theSEC’s informal inquiry, we could be subject to regulatory fines or penalties orother contingent liabilities.

**13.**          SubsequentEvent

In October 2006, the Internal Revenue Service, orIRS, commenced an audit of our 2004 U.S. Federal income tax return. Inconnection with the audit, the IRS has requested, among other things,information relating to our stock option grants and practices. The IRS has onlyrecently begun the audit, and it is not possible to predict its impact. However,we do not anticipate having to make a material tax payment, incurring amaterial liability or having our net operating loss carryforwards materiallyreduced, as a result of the audit.

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**ITEM2.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**Cautionary Statement Regarding Forward-LookingStatements**

This quarterly report on Form 10-Qcontains, in addition to historical information, forward-looking statementswithin the meaning of Section 21E of the Securities Exchange Act of 1934,as amended, which we refer to as the Exchange Act. These forward-lookingstatements involve risks and uncertainties and are not guarantees of futureperformance. Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,”“seek,” “estimate” and variations of these words and similar expressions areintended to identify forward-looking statements. Our actual results coulddiffer significantly from the results we discuss in these forward-lookingstatements. These forward-looking statements represent our expectationsas of the date of this report. Subsequent events will cause our expectations tochange. However, while we may elect to update these forward-lookingstatements, we specifically disclaim any obligation to do so. See the sectionentitled “Risk Factors” below for a discussion of important factors that couldcause our actual results to differ materially from the results we discuss inour forward-looking statements.

**Executive Overview**

We are a research-based pharmaceutical companyfocused on discovering, developing and commercializing differentiated productsthat address large and growing markets and unmet medical needs and can bemarketed to primary care physicians through our sales force.

We currently manufacture and sell three products,XOPENEX® (levalbuterol HCl) Inhalation Solution, ashort-acting bronchodilator, for the treatment or prevention ofbronchospasm in patients with reversible obstructive airway disease; XOPENEXHFA® (levalbuterol tartrate) Inhalation Aerosol, ahydrofluoroalkane, or HFA, metered-dose inhaler, or MDI, for the treatment orprevention of bronchospasm in adults, adolescents and children four years ofage and older with reversible obstructive airway disease; and LUNESTA® (eszopiclone) for the treatment of insomnia. InOctober 2006, we received approval from the United States Food and DrugAdministration, or FDA, for our New Drug Application, or NDA, for BROVANATM******(arformoterol tartrate) InhalationSolution 15 micrograms (mcg) as a long-term, twice-daily maintenance treatmentof bronchoconstriction in patients with chronic obstructive pulmonary disease,or COPD, including chronic bronchitis and emphysema.******Weexpect to commercially introduce BROVANA in the second quarter of 2007.

We market and sell XOPENEX Inhalation Solution,LUNESTA and XOPENEX HFA directly through our sales force, and we expect to sellBROVANA through our sales force as well. We have entered into out-licensingarrangements with respect to several other compounds. We expect tocommercialize any additional products that we may successfully develop throughour sales force, through co-promotion agreements and/or through out-licensingpartnerships.

**Restatementof Financial Statements Based on Review of Stock Option Practices**

In June 2006, we announced that the SEC hadinitiated an informal inquiry into our stock option practices, and we have beencooperating with such inquiry. We appointed a special committee of outsidedirectors in June 2006 to conduct an internal review relating to our stockoption grants and stock option practices. The special committee, with theassistance of legal counsel and accounting specialists, has reviewed the stockoption grants to our officers, directors and employees from 1996 to the presentunder our various stock option plans in effect during this period. We have beencooperating with this review and our finance department also reviewed the stockoption grants and stock option practices from 1996 to present. The specialcommittee has completed its stock option related review, but will remain inplace for the duration of the SEC’s inquiry. The aggregate amount of theadditional stock-based compensation expense that we have incurred as a resultof the stock option review is approximately $43.3 million, of 

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which$668,000 was recorded in the nine months ended September 30, 2006. Theimpact of additional stock-based compensation expense is approximately $1.0million, $1.3 million and $2.0 million for the years ended December 31,2005, 2004 and 2003, respectively. Our financial statements for the nine monthsended September 30, 2006 includes a restatement impact of $223,000 foradditional stock-based compensation in the period ended March 31, 2006 asreported in our Form 10-Q/A filed on September 12, 2006.

As a result of the review,we have restated our financial statements for the quarters ended March 31,June 30, September 30 and December 31, 2005, the quarter ended March 31,2006 and the fiscal years ended December 31, 2005 and 2004 and 2003. SeeNote 3 to our financial statements for additional information about the reviewand restatement.

**Significant 2006Developments**

***In October 2006,***we announced that the FDA approvedBROVANA (arformoterol tartrate) Inhalation Solution 15 mcg as a long-term,twice-daily (morning and evening), maintenance treatment of bronchoconstrictionin patients with COPD including chronic bronchitis and emphysema. BROVANA isfor use by nebulization only. We expect to commercially introduce BROVANAduring the second quarter of 2007.

In October 2006,the Internal Revenue Service, or IRS, commenced an audit of our 2004 U.S.Federal income tax return. In connection with the audit, the IRS has requested,among other things, information relating to our stock option grants andpractices. The IRS has only recently begun the audit and it is not possible topredict its impact. However, we do not anticipate having to make a material taxpayment, that we will be subject to material liability or that our netoperating loss carryforwards will be materially reduced, as a result of theaudit.

In September 2006, Tharos Laboratories, Inc.filed suit against us in the United States District Court, District of Utah,Central Division, alleging trademark infringement, dilution, unfaircompetition, false advertising, and false designation of origin arising out ofour use of our silk moth design in connection with LUNESTA. Tharos seeks unspecifiedmonetary damages and an injunction of our use of the silk moth design. In October 2006,we filed a motion to dismiss Tharos’ claims. We are unable to reasonablyestimate any possible range of loss related to this lawsuit due to itsuncertain resolution.

In June 2006,we re-introduced our XOPENEX Inhalation Solution Concentrate (1.25 mg/0.5 mL),for which we had announced a manufacturer-initiated voluntary recall in October 2004as a result of a packaging process validation issue relating to the automatedprocess of placing the finished vials into a foil pouch. XOPENEX InhalationSolution Concentrate is a premeasured, concentrated dose of 1.25 mg ofXOPENEX Inhalation Solution that is packaged in a 0.5 milliliter (mL) vial andis intended primarily for hospital use.

During the secondquarter of 2006, we completed the hiring and training of an additional 495sales representatives and managers. This expansion will focus on supportingexpected future sales growth of our marketed products.

In March 2006,the Medicare Durable Medical Equipment Program Safeguard Contractors, or DME-PSCs,issued a draft local coverage determination under which Medicare reimbursementfor XOPENEX Inhalation Solution would be reduced to the level of reimbursementfor generic albuterol inhalation solution under Medicare Part B, which issubstantially less than the current level of reimbursement for XOPENEXInhalation Solution. We estimate that approximately 25 to 30 percent of ourXOPENEX Inhalation Solution units sold are subject to reimbursement underMedicare Part B. If this local coverage determination is implemented,revenue from these sales of XOPENEX Inhalation Solution would be materiallyadversely affected.

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In February 2006,we announced that we entered into a licensing agreement with UCB S.A., or UCBrelating to levocetirizine. Under this agreement, we have exclusively licensedto UCB all of our patents and patent applications in the United Statesregarding levocetirizine and royalties will be payable to us on U.S. sales oflevocetirizine products. In July 2006, UCB announced it had submitted anNDA to the FDA seeking approval for XYZAL® (levocetirizine). In September 2006, UCBand sanofi-aventis announced they entered into an agreement to co-promote XYZALin the United States. We currently earn royalties from UCB on sales oflevocetirizine in European countries where the product is sold. Levocetirizineis currently marketed by UCB under the brand names XYZAL and XUSALTM in theEuropean Union, or E.U., for treatment of symptoms of seasonal and perennialallergic rhinitis, persistent allergic rhinitis and chronic idiopathicurticaria, or CIU, also known as hives of unknown cause, in adults and childrenaged six years and older.

In January 2006,we announced that we had completed the second $10 million purchase ofACADIA Pharmaceuticals Inc., or ACADIA, common stock in connection withour license, option and collaboration agreement, or collaboration, with ACADIAthat we entered into in January 2005. Our purchase was made at a price ofapproximately $12.29 per share, which represented a 25 percent premium tothe 30-day trailing average closing price on the NASDAQ Global Market asof the one-year anniversary of the collaboration, and resulted in the issuanceto us of 813,393 shares of ACADIA common stock. Our agreement with ACADIAincludes an option to select a preclinical candidate from ACADIA’s 5-HT2a program for use incombination with LUNESTA. We have decided not to exercise this option.

In January 2006,we announced that we had been notified that the FDA had received an abbreviatednew drug application, or ANDA, from Dey, L.P. for a generic version oflevalbuterol hydrochloride inhalation solution. Dey’s submission includes aParagraph IV certification alleging our patents listed in the FDApublication entitled “Approved Drug Products With Therapeutic EquivalenceEvaluations,” commonly referred to as the “Orange Book,” for XOPENEX InhalationSolution are invalid, unenforceable or not infringed by Dey’s proposed product.On September 7, 2005, we announced that the FDA had received an ANDA fromBreath Limited seeking marketing approval for generic copies of our 1.25 mg,0.63 mg and 0.31 mg XOPENEX Inhalation Solution (levalbuterol hydrochloride)unit-dose vial product. XOPENEX Inhalation Solution Concentrate is not subjectto the ANDA. Breath Limited’s submission includes a Paragraph IVcertification alleging that our patents listed in the Orange Book for XOPENEXInhalation Solution are invalid, unenforceable or not infringed by BreathLimited’s proposed product. We have filed civil actions against Breath Limitedand Dey, L.P. for patent infringement.

In April 2006, wewere notified of a third ANDA seeking approval of a generic version of our 1.25mg, 0.63 mg and 0.31 mg levalbuterol hydrochloride inhalation solutionincluding a Paragraph IV certification, which was submitted to the FDA byWatson Laboratories, Inc. Watson’s Paragraph IV certification was limitedto our patent that expires in 2021 and covers certain levalbuterolhydrochloride inhalation solutions, including XOPENEX Inhalation Solution. Wehave decided not to file a civil action against Watson Laboratories, Inc.for patent infringement at this time.

In August 2006, we received notification that theFDA had received an ANDA, including a Paragraph IV certification, from Dey, L.Pseeking approval of a generic version of our 1.25 mg/0.5 mL levalbuterolhydrochloride inhalation solution concentrate. We have filed a civil actionagainst Dey, L.P for patent infringement. If we successfully enforce ourpatents, the FDA will not approve the relevant ANDA until expiration ofthe applicable patents. Otherwise, the FDA will stay its approval of therelevant ANDA for 30 months following the date we received notice ofsuch ANDA or until a court decides that our patents are invalid,unenforceable or not infringed, whichever is earlier.

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**Three Month Periods ended September 30, 2006 and2005**

*Revenues*

Product sales were$280,086,000 and $193,357,000 for the three months ended September 30,2006 and 2005, respectively, an increase of approximately 45%.

Sales of LUNESTAwere $141,608,000 and $100,892,000 for the three months ended September 30,2006 and 2005, respectively, an increase of approximately 40%. The increase isprimarily the result of a 47% increase in the number of units sold, partiallyoffset by a 4% decrease in the net selling price per unit, which included a 9%increase in the gross selling price per unit. Adjustments recorded to grosssales are disclosed below under the heading “Analysis of gross sales to netsales.”

Sales of XOPENEXInhalation Solution were $125,379,000 and $92,466,000 for the three monthsended September 30, 2006 and 2005, an increase of approximately 36%. Thesales increase for XOPENEX Inhalation Solution for the three months ended September 30,2006 as compared with the same period in 2005 is due to: (i) a 14%increase in the net selling price per unit, which included an 8% increase inthe gross selling price per unit; and (ii) a 19% increase in the number ofunits sold. Adjustments recorded to gross sales are disclosed below under theheading “Analysis of gross sales to net sales.”

Salesof XOPENEX HFA were $13,099,000 for the three months ended September 30,2006, as compared to $0 for the sameperiod in 2005. We introduced XOPENEXHFA commercially in December 2005.

*Analysis of gross sales to net sales—**The*following tablepresents the adjustments deducted from gross sales to arrive at total netsales:

| ** **                                   | ** ** | **For the Three Months Ended September 30,** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                                   | ** ** | **% of  sales** | ** ** | **2005** | ** ** | **% of  sales** | ** ** | **$ Change** | ** ** | **%  Change** | ** ** |
| ** **                                   | ** ** | **(dollars in thousands)**                                       | ** ** |
| Gross sales                                  |       | $                                                                          | 349,015    |   | 100.0 | % | $ | 213,108 |   | 100.0 | % | $ | 135,907 |   |   | 64 | % |   |
| Adjustments to gross  sales:                 |       |                                                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Payment term discounts                       |       | 7,010                                                                      |       | 2.0 | % | 3,892 |   | 1.8 | % | 3,118 |   |   | 80 | % |   |
| Wholesaler fee for service                   |       | 11,487                                                                     |       | 3.3 | % | 2,585 |   | 1.2 | % | 8,902 |   |   | 344 | % |   |
| Government rebates and contractual discounts |       | 45,325                                                                     |       | 13.0 | % | 16,295 |   | 7.6 | % | 29,030 |   |   | 178 | % |   |
| Returns                                      |       | 4,141                                                                      |       | 1.2 | % | (1,184 | ) | (0.6 | %) | 5,325 |   |   | 450 | % |   |
| Other (includes product launch discounts)    |       | 966                                                                        |       | 0.3 | % | (1,837 | ) | (0.9 | %) | 2,803 |   |   | 153 | % |   |
| Sub-total  adjustments                       |       | 68,929                                                                     |       | 19.8 | % | 19,751 |   | 9.3 | % | 49,178 |   |   | 249 | % |   |
| Net sales                                    |       | $                                                                          | 280,086    |   | 80.2 | % | $ | 193,357 |   | 90.7 | % | $ | 86,729 |   |   | 45 | % |   |

 

The increase in  adjustments to gross sales as a percentage ofgross sales for the three months ended September 30, 2006 as compared tothe three months ended September 30, 2005 primarily reflects an increasein government rebates and contractual discounts as a result of an increase ini) government rebates and contractual discounts that we offered primarily onthe sales XOPENEX HFA, which was commercially introduced in December 2005;ii) discounts that we offered to managed care organizations; and iii) discountsgiven through Medicare and Medicaid programs; partially offset by a decrease in discounts including an $8.3 million reversal of reserves relating to rebates under theDepartment of Veterans Affairs, or VA, TRICARE Pharmacy Benefits Program , ofwhich $4.2 million related to XOPENEX brand levalbuterol product sales and $4.1million related to LUNESTA brand eszopiclone sales. The reversal was based on aU.S. Federal Court of Appeals ruling in September 2006 that 

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pharmaceuticalmanufacturers are not required to reimburse on drugs purchased through theTRICARE Program. Product sales allowances also increased as a result ofus offering more wholesaler discounts during the third quarter of 2006, ascompared to the same period in 2005. We also experienced a higher returnreserve as a percentage of gross sales in the third quarter of 2006 as comparedto the same period in 2005, which was due to the release of a reserve in thethree months ended September 30, 2005 relating to a potential productreturn caused by a packaging issue for our LUNESTA 1 milligram dose form, whichwas subsequently resolved, offset by a decrease in actual returns for the thirdquarter 2006 as compared to the same period in 2005.

Included in the deductions for government rebates andcontractual discounts is a reserve for Medicare Part B discounts relatedto XOPENEX Inhalation Solution sales. Medicare reimbursement rates for XOPENEXInhalation Solution have been favorable since January 2005, but we cannotbe certain these favorable rates will continue. In March 2006, the DME-PSCs issued a draft local coveragedetermination under which Medicare reimbursement for XOPENEX InhalationSolution would be reduced to the level of reimbursement for generic albuterolinhalation solution, which is substantially lower than the currentreimbursement rate. We estimate that approximately 25 to 30 percent of ourXOPENEX Inhalation Solution units sold are subject to reimbursement underMedicare Part B. If this local coverage determination is implemented,these sales of XOPENEX Inhalation Solution would be materially adverselyaffected.

Royalties were $9,210,000 and $12,363,000 for thethree months ended September 30, 2006 and 2005, respectively, a decreaseof approximately 26%. The decrease is primarily due to the decrease inroyalties earned on the sales of ALLEGRA® (fexofenadine HCl), under our agreement withsanofi-aventis, which were $3,032,000 for the three months ended September 30,2006 compared to $8,012,000 for the same period in 2005, with the majority of thedecrease resulting because we ceased to receive royalties on sales of ALLEGRAin the United States. Pursuant to the terms of our United States agreement withsanofi-aventis, our royalties on the sale of ALLEGRA in the United States,which have historically been between $15 and $20 million per year, terminatedbased on the introduction of a generic equivalent of this product in September 2005.We are still entitled to receive royalties on the sale of ALLEGRA outside ofthe United States in countries where we hold patents covering ALLEGRA and nogeneric equivalent product has been introduced. 

Royalties earned on salesof CLARINEX®,under our agreement with Schering-Plough Corporation, or Schering-Plough,increased to $4,085,000 from $2,300,000 for the three months ended September 30,2006 as compared to the same period in 2005. In August 2006, we were notifiedthat several ANDA’s containing Paragraph IV certifications had been received bythe FDA seeking approval of generic versions of certain of Schering-Plough’sCLARINEX products. If and while a generic version of a CLARINEX product ismarketed in the U.S. without Schering-Plough’s consent, Schering-Plough willhave no obligation to pay royalties to us on the U.S .sales of CLARINEXproducts.

*Costs of Revenues*

Cost of product sold was $24,554,000 and $15,491,000for the three months ended September 30, 2006 and 2005, respectively.

Cost of LUNESTA sold as a percentage of LUNESTA grosssales was approximately 5% and 7% for the three months ended September 30,2006 and 2005, respectively, with the largest portion being the royalty paid onnet sales of LUNESTA to a third party. The decrease in cost as a percentage ofgross sales in the third quarter of 2006 compared to the same period in 2005 isprimarily due to a gross sales price increase in 2006, however actual cost hasremained stable. In accordance with our accounting policies, we did not beginto capitalize product manufacturing costs associated with LUNESTA inventoryuntil the FDA approved the NDA for LUNESTA. Therefore, we expect costs ofLUNESTA sold as a percentage of 

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LUNESTAgross sales to increase after we have sold all of our product for which we havenot capitalized manufacturing costs. We expect this to occur by the end of2006.

Cost of XOPENEX Inhalation Solution sold as apercentage of XOPENEX Inhalation Solution gross sales was approximately 7% and8% for the three months ended September 30, 2006 and 2005,respectively.

Cost of XOPENEX HFA sold as a percentage of XOPENEXHFA gross sales was approximately 14% for the three months ended September 30,2006. Included in the costs of XOPENEX HFA sold is a royalty paid on net salesof XOPENEX HFA to 3M Company, or 3M, our third-party finished goodsmanufacturer of the product. We commercially introduced XOPENEX HFA in December 2005.

Cost of royalties earned was $327,000 and $224,000 forthe three months ended September 30, 2006 and 2005, respectively. The costof royalties in both periods relates to an obligation to a third party as aresult of royalties we earn from Schering-Plough Corporation based on itssales of CLARINEX. This increase in third-party obligations is due to theincrease in royalties earned in the three months ended September 30, 2006as compared with the same period in 2005.

*Research and Development*

Research and development expenses were $35,520,000 and$38,372,000 for the three months ended September 30, 2006 and 2005,respectively, a decrease of approximately 7%. The decrease is primarily due tolower spending on our XOPENEX HFA, BROVANA, LUNESTA and SEP-226330programs. The decrease was partially offset by: (i) increased spending onour SEP-227162 program, targeted for the treatment of depression; (ii) increaseddrug discovery efforts, and (iii) an increase in  personnel related expense which includesstock-based compensation expense of $2,616,000for the three months ended September 30, 2006, resulting from our January 1,2006 implementation of SFAS 123(R), as compared to $0 for the three monthsended September 30, 2005.

Drug development and approval in the United States isa multi-step process regulated by the FDA. The process begins with the filingof an investigational new drug application, or IND, which, if successful,allows the opportunity for study in humans, or clinical study, of the potentialnew drug. Clinical development typically involves three phases of study: PhaseI, II and III. The most significant costs in clinical development are inPhase III clinical trials, as they tend to be the longest and largest studiesin the drug development process. Following successful completion of Phase IIIclinical trials, an NDA must be submitted to, and accepted by, the FDA, and theFDA must approve the NDA prior to commercialization of the drug. We may electeither on our own, or at the request of the FDA, to conduct further studiesthat are referred to as Phase IIIB and IV studies, which if conducted, couldcause us to incur substantial costs. Phase IIIB studies are initiated andeither completed or substantially completed while the NDA is under FDA review.These studies are conducted under an IND. Phase IV studies, also referred to aspost-marketing studies, are studies that are initiated and conducted after theFDA has approved a product for marketing. Phase IV studies may be requested bythe FDA either before or after the FDA has approved an NDA. These studies mayalso be independently initiated by the company for which an NDA has beenapproved. The FDA and the companies conducting post-marketing studies use themto gather additional information about a product’s safety, efficacy or optimaluse.

Successful development of our product candidates ishighly uncertain. Completion dates and completion costs can vary significantlyfor each product candidate and are difficult to predict. The lengthy process ofseeking FDA approvals, and subsequent compliance with applicable statutes andregulations, require the expenditure of substantial resources. Any failure byus to obtain, or delay in obtaining, regulatory approvals could materiallyadversely affect our business. We cannot assure you that we will obtain anyapproval required by the FDA on a timely basis, if at all.

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For additional discussion of the risks anduncertainties associated with completing development of potential productcandidates, see “Risk Factors”.

Below is a summary ofdevelopment of our products and product candidates that represent 10% or moreof our direct project research and development spending for the three monthsended September 30, 2006. The “Estimate of Completion of Phase” columncontains forward-looking statements regarding expected timing ofcompletion of product development phases. Completion of product development, ifsuccessful, culminates in the submission of an NDA to the FDA; however, therecan be no assurance that the FDA will accept for filing, or approve, any NDA.The actual timing of completion of phases could differ materially from theestimates provided in the table. In the table below, the three FDA approvedproducts and the two product candidates listed accounted for approximately 94%of our direct project research and development spending for the three monthsended September 30, 2006. No other product candidate accounted for morethan 5% of our direct research and development spending in this period.

| **Product or Product Candidate** | ** ** | **Indication**     | ** ** | **Phase of  Development** | ** ** | **Estimate of  Completion of Phase** | ** ** |
|-------------------------------------------------|------------|--------------------|------------|--------------------------------|------------|-----------------------------------------------------|------------|
| XOPENEX HFA  (levalbuterol tartrate)            |       | Respiratory-Asthma |       | *                              |       |                                                | *          |   |   |
| LUNESTA  (eszopiclone)                          |       | Insomnia           |       | **                             |       |                                                | **         |   |   |
| BROVANA  (arformoterol tartrate)                |       | Respiratory-COPD   |       | NDA  Approved                  |       |                                                | ***        |   |   |
| SEP-225289                                      |       | Depression         |       | Phase  I                       |       |                                                | 2007       |   |   |
| SEP-227162                                      |       | Depression         |       | Phase I                        |       |                                                | 2007       |   |   |

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*                    Wecommercially introduced XOPENEX HFA in December 2005.

**             Wecommercially introduced LUNESTA in April 2005.

***      The FDA approved BROVANA in October 2006.We are targeting commercial introduction of the product in the second quarterof 2007.

Belowis a summary of expenditure information related to our products and productcandidates representing 10% or more of our direct project research and developmentspending during the three months ended September 30, 2006 and 2005, aswell as the costs incurred to date on these projects. The costs in thisanalysis include only direct costs and do not include certain indirect labor,overhead, share-based compensation or other costs that benefit multipleprojects. As a result, fully-loaded research and development cost summaries byproject are not presented.

| ** **                           | ** ** | **Project costs for  the three  months ended  September 30, 2006** | ** ** | **Project costs to  date through  September 30,  2006** | ** ** | **Project costs  for  the three  months ended  September 30, 2005** | ** ** | **Project costs to  date through  September 30,  2005** | ** ** |
|--------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                                                                          | ** ** |
| LUNESTA  (eszopiclone)               |       |                                                                                             | $          | 3,958                                                                       |       |                                                                                                   |       | $                                                                           | 214,502    |   |   |   | $ | 4,826 |   |   |   | $ | 194,541 |   |   |
| XOPENEX HFA  (levalbuterol tartrate) |       |                                                                                             | $          | 2,343                                                                       |       |                                                                                                   |       | $                                                                           | 167,547    |   |   |   | $ | 5,506 |   |   |   | $ | 151,498 |   |   |
| BROVANA  (arformoterol tartrate)     |       |                                                                                             | $          | 2,237                                                                       |       |                                                                                                   |       | $                                                                           | 169,465    |   |   |   | $ | 3,976 |   |   |   | $ | 155,932 |   |   |
| SEP-227162                           |       |                                                                                             | $          | 2,089                                                                       |       |                                                                                                   |       | $                                                                           | 6,462      |   |   |   | $ | 428 |   |   |   | $ | 791 |   |   |
| SEP-225289                           |       |                                                                                             | $          | 1,835                                                                       |       |                                                                                                   |       | $                                                                           | 11,105     |   |   |   | $ | 1,873 |   |   |   | $ | 3,032 |   |   |

 

Due to the length of time necessary to develop aproduct, uncertainties related to the ability to obtain governmental approvalfor commercialization, and difficulty in estimating costs of projects, it isdifficult to make accurate and meaningful estimates of the ultimate cost tobring our product candidates to FDA approved status. We do not believe it ispossible to estimate, with any degree of accuracy, the costs of productcandidates that are in stages earlier than Phase III. Accordingly, because allof our product candidates are in Phase I development, we have not provided anysuch estimates.

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*Selling, Marketingand Distribution*

Selling, marketing anddistribution expenses were $151,154,000 and $162,731,000 for the three monthsended September 30, 2006 and 2005, respectively, a decrease ofapproximately 7%. The decrease is primarily attributable to a decrease inmarketing, advertising and promotion costs to support LUNESTA, partially offsetby an increase in personnel-related expense, which includes stock-basedcompensation expense of $3,583,000for the three months ended September 30, 2006, of which $3,553,000resulted from our January 1, 2006 implementation of SFAS 123(R), ascompared to $35,000 for the three months ended September 30, 2005.

*General andAdministrative*

General and administrativecosts were $19,285,000 and $11,097,000 for the three months ended September 30,2006 and 2005, respectively, an increase of approximately 74%. The increase isprimarily the result of an increase in personnel-related expense, whichincludes stock-based compensation expense of $4,214,000for the three months ended September 30, 2006, of which $4,021,000resulted from our January 1, 2006 implementation of SFAS 123(R), ascompared to $226,000 for the three months ended September 30, 2005. The remainder of the increase isprimarily attributable to increased legal fees largely related to patent andshareholder litigation, as well as expense associated with responding to theSEC’s informal inquiry into our stock option practices and the related internalinvestigation.

*Other Income(Expense)*

Interest income was $12,319,000 and $7,776,000 for thethree months ended September 30, 2006 and 2005, respectively, an increaseof approximately 58%. The increase is due to higher average balances of cashand short- and long-term investments combined with an increase in theinterest rates earned on investments in 2006. Our monthly average cash andinvestment balance was approximately $968,798,000 and $906,548,000 for thethree months ended September 30, 2006 and 2005, respectively. For thethree months ended September 30, 2006 and 2005, the average annualizedinterest rate that we earned on our investments was 5.09% and 3.43%,respectively.

Interest expense was $5,538,000 and $5,847,000 for thethree months ended September 30, 2006 and 2005, respectively. The expensein both periods is primarily related to the interest we paid on our 5%convertible subordinated debentures.

Equity in investee losseswere $212,000 and $241,000 for the three months ended September 30, 2006and 2005, respectively, a decrease of approximately 12%. The loss representsour portion of BioSphere losses.

**Nine Month Periodsended September 30, 2006 and 2005**

*Revenues*

Product sales were $814,018,000 and $466,748,000 forthe nine months ended September 30, 2006 and 2005, respectively, anincrease of approximately 74%.

Sales of LUNESTA were $418,824,000 and $184,351,000for the nine months ended September 30, 2006 and 2005, respectively, anincrease of approximately 127%. The increase is primarily the result of a 108%increase in the number of units sold, which is principally attributable to afull nine months of sales in 2006 as compared to six months of sales in 2005,and a 9% increase in the net selling price per unit, which was primarily due toa 11% increase in the gross selling price per unit. Adjustments recorded togross sales are disclosed below under the heading “Analysis of gross sales tonet sales.”

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Sales of XOPENEXInhalation Solution were $375,149,000 and $282,398,000 for the nine monthsended September 30, 2006 and 2005, respectively, an increase of approximately33%. The increase is primarily due to a 14% increase in the number of unitssold and a 16% increase in the net selling price per unit, which included agross unit price increase of approximately 9%. Adjustments recorded to grosssales are disclosed below under the heading “Analysis of gross sales to netsales.”

Sales of XOPENEX HFA were$20,045,000 for the nine months ended September 30, 2006, as compared to$0 for the same period in 2005. We introduced XOPENEX HFA commercially in December 2005.

*Analysis of gross sales tonet sales—**The*following table presents theadjustments deducted from total gross sales to arrive at total net sales:

| ** **                                   | ** ** | **For the Nine months Ended September 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                                  | ** ** | **% of   sales** | ** ** | **2005** | ** ** | **% of  sales** | ** ** | **Change** | ** ** | **%  Change** | ** ** |
| ** **                                   | ** ** | **(dollars in thousands)**                                      | ** ** |
| Gross sales                                  |       | $                                                                         | 987,722    |   | 100.0 | % | $ | 563,718 |   | 100.0 | % | $ | 424,004 |   |   | 75 | % |   |
| Adjustments to gross  sales:                 |       |                                                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Payment term discounts                       |       | 20,309                                                                    |       | 2.1 | % | 11,145 |   | 2.0 | % | 9,164 |   |   | 82 | % |   |
| Wholesaler fee for service                   |       | 27,339                                                                    |       | 2.8 | % | 8,101 |   | 1.4 | % | 19,238 |   |   | 237 | % |   |
| Government rebates and contractual discounts |       | 108,930                                                                   |       | 11.0 | % | 54,416 |   | 9.7 | % | 54,514 |   |   | 100 | % |   |
| Returns                                      |       | 14,691                                                                    |       | 1.5 | % | 20,444 |   | 3.6 | % | (5,753 | ) |   | (28 | %) |   |
| Other (includes product launch discounts)    |       | 2,435                                                                     |       | 0.2 | % | 2,864 |   | 0.5 | % | (429 | ) |   | (15 | %) |   |
| Sub-total  adjustments                       |       | 173,704                                                                   |       | 17.6 | % | 96,970 |   | 17.2 | % | 76,734 |   |   | 79 | % |   |
| Net sales                                    |       | $                                                                         | 814,018    |   | 82.4 | % | $ | 466,748 |   | 82.8 | % | $ | 347,270 |   |   | 74 | % |   |

 

The increase inadjustments to gross sales as a percentage of gross sales for the nine monthsended September 30, 2006 as compared to the nine months ended September 30,2005 primarily reflects an increase in government rebates and contractualdiscounts as a result of i) an increase in discounts we offered primarily onthe sales XOPENEX HFA, which was commercially introduced in December 2005;ii) an increase in discounts offered to managed care organizations; iii) adecrease in discounts given through Medicare and Medicaid programs; iv) adecrease in discounts dueto a reversal of reserves relating to rebates under the Department of VATRICARE Pharmacy Benefits Program, which was based on a U.S. Federal Court ofAppeals ruling in September 2006 that pharmaceutical manufacturers are notrequired to reimburse on drugs purchased through the TRICARE Program.Product sales allowances also increased as a result of us offering morewholesaler discounts during the first nine months of 2006, as compared to thesame period in 2005, as these discounts did not commence until the secondquarter of 2005. Offsetting these increases to adjustment to gross sales was adecrease in sales returns primarily due to a decrease in actual returns forXOPENEX Inhalation Solution and the weighting of LUNESTA returns which are estimatedat a lower rate.

Included in the governmentrebates and contractual discounts is a reserve for Medicare Part Bdiscounts related to XOPENEX Inhalation Solution sales. Medicare reimbursementrates for XOPENEX Inhalation Solution have been favorable since January 2005,but we cannot be certain these favorable rates will continue. In March 2006, the DME-PSCs issued a draftlocal coverage determination under which Medicare reimbursement for XOPENEXInhalation Solution would be reduced to the level of reimbursement for genericalbuterol inhalation solution. We estimate that approximately 25 to 30 percentof our XOPENEX Inhalation Solution units sold are subject to reimbursementunder Medicare Part B. If this local coverage determination isimplemented, revenue from these sales of XOPENEX Inhalation Solution would bematerially adversely affected.

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Royalties were $25,362,000and $43,081,000 for the nine months ended September 30, 2006 and 2005,respectively, a decrease of approximately 41%. The decrease is primarily due tothe decrease in royalties earned on the sales of ALLEGRA under our agreementwith sanofi-aventis, which were $11,691,000 for the nine months ended September 30,2006 compared to $31,669,000 for the same period in 2005, with the majority ofthe decrease resulting as we ceased to received royalties on sales of ALLEGRAin the United States. Pursuant to the terms of our U.S. agreement withsanofi-aventis, our royalties on the sale of ALLEGRA in the United States,which have historically been between $15 and $20 million per year, terminatedbased on the introduction of a generic equivalent of this product in the UnitedStates in September 2005. We are still entitled to receive royalties onthe sale of ALLEGRA outside of the United States in countries where we holdpatents covering ALLEGRA and no generic equivalent product has been introduced.

Royalties earned on salesof CLARINEX, under our agreement with Schering-Plough Corporation, orSchering-Plough, increased to $9,613,000 from $7,366,000 for the nine monthsended September 30, 2006 as compared to the same period in 2005. In August2006, we were notified that several ANDA’s containing Paragraph IVcertifications had been received by the FDA seeking approval of genericversions of certain of Schering-Plough’s CLARINEX products. If and while ageneric version of a CLARINEX product is marketed in the U.S. withoutSchering-Plough’s consent, Schering-Plough will have no obligation to payroyalties to us on the U.S .sales of CLARINEX products.

*Costs of Revenues*

Cost of product sold was$70,780,000 and $39,981,000 for the nine months ended September 30, 2006and 2005, respectively.

Cost of LUNESTA sold as apercentage of LUNESTA gross sales was approximately 6% for the nine monthsended September 30, 2006 and 2005, with the largest portion being theroyalty paid on net sales of LUNESTA to a third party. In accordance with ouraccounting policies, we did not begin to capitalize product manufacturing costsassociated with LUNESTA inventory until the FDA approved the NDA for LUNESTA.Therefore, we expect costs of LUNESTA sold as a percentage of LUNESTA sales toincrease after we have sold all of our product for which we have notcapitalized manufacturing costs. We expect this to occur by the end of 2006.

Cost of XOPENEX InhalationSolution sold as a percentage of XOPENEX Inhalation Solution gross sales wasapproximately 8% for the nine months ended September 30, 2006 and 2005.

Cost of XOPENEX HFA soldas a percentage of XOPENEX HFA net sales was approximately 14% for the ninemonths ended September 30, 2006. Included in the costs of XOPENEX HFA soldis a royalty paid on net sales of XOPENEX HFA to 3M, our third party finishedgoods manufacturer of the product. We commercially introduced XOPENEX HFA in December 2005.

Cost of royalties earnedwas $769,000 and $629,000 for the nine months ended September 30, 2006 and2005, respectively. The cost of royalties in both periods relates to anobligation to a third party as a result of royalties we earn from Schering-PloughCorporation based on its sales of CLARINEX. This increase in third-partyobligations is due to the slight increase in royalties earned in the ninemonths ended September 30, 2006 as compared with the same period in 2005.

*Research and Development*

Research and developmentexpenses were $121,149,000 and $104,073,000 for the nine months ended September 30,2006 and 2005, respectively, an increase of approximately 16%. The increase isprimarily due to our increased spending on our LUNESTA Phase IIIB/IV program,as well as drug discovery efforts. We also incurred increased spending on twoof our early-stage programs, SEP-225289 and SEP-227162, bothtargeted for the treatment of depression. In addition, we experienced anincrease in personnel-related 

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expense,which includes stock-based compensation expense of $7,558,000 for the nine months ended September 30, 2006,resulting from our January 1, 2006 implementation of SFAS 123(R), ascompared to $0 for the nine months ended September 30, 2005.

Belowis a summary of development of our products and product candidates thatrepresent 10% or more of our direct project research and development spendingfor the nine months ended September 30, 2006. The “Estimate of Completionof Phase” column contains forward-looking statements regarding expectedtiming of completion of product development phases. Completion of productdevelopment, if successful, culminates in the submission of an NDA to the FDA;however, there can be no assurance that the FDA will accept for filing, orapprove, any NDA. The actual timing of completion of phases could differmaterially from the estimates provided in the table. In the table below, thethree FDA-approved products and two product candidates listed accounted forapproximately 94% of our direct project research and development spending forthe nine months ended September 30, 2006. No other product candidateaccounted for more than 4% of our direct research and development spending inthis period.

| **Product or Product Candidate** | ** ** | **Indication**          | ** ** | **Phase of  Development** | ** ** | **Estimate of  Completion of   Phase** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|--------------------------------|------------|-------------------------------------------------------|------------|
| LUNESTA  (eszopiclone)                          |       | Insomnia                |       | *                              |       |                                                  | *          |   |   |
| XOPENEX HFA  (levalbuterol tartrate)            |       | Respiratory—Asthma |       | **                             |       |                                                  | **         |   |   |
| BROVANA  (arformoterol tartrate)                |       | Respiratory—COPD   |       | NDA  Approved                  |       |                                                  | ***        |   |   |
| SEP-227162                                      |       | Depression              |       | Phase  I                       |       |                                                  | 2007       |   |   |
| SEP-225289                                      |       | Depression              |       | Phase I                        |       |                                                  | 2007       |   |   |

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*                    Wecommercially introduced LUNESTA in April 2005.

**             We commerciallyintroduced XOPENEX HFA in December 2005.

***      The FDA approved BROVANA in October 2006.We are targeting commercial introduction of the product in the second quarterof 2007.

Belowis a summary of expenditure information related to our products and productcandidates representing 10% or more of our direct project research anddevelopment spending during the nine months ended September 30, 2006, and2005, as well as the costs incurred to date on these projects. The costs inthis analysis include only direct costs and do not include certain indirectlabor, overhead, share-based compensation or other costs that benefit multipleprojects. As a result, fully-loaded research and development cost summaries byproject are not presented.

| ** **                           | ** ** | **Project costs for  the nine  months ended  September 30, 2006** | ** ** | **Project costs to  date through  September 30,  2006** | ** ** | **Project costs  for  the nine  months ended  September 30, 2005** | ** ** | **Project costs to  date through  September 30,  2005** | ** ** |
|--------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                                                                         | ** ** |
| LUNESTA  (eszopiclone)               |       |                                                                                            | $          | 14,780                                                                      |       |                                                                                                  |       | $                                                                           | 214,503    |   |   |   | $ | 10,978 |   |   |   | $ | 194,541 |   |   |
| XOPENEX HFA  (levalbuterol tartrate) |       |                                                                                            | $          | 10,756                                                                      |       |                                                                                                  |       | $                                                                           | 167,550    |   |   |   | $ | 18,801 |   |   |   | $ | 151,498 |   |   |
| BROVANA  (arformoterol tartrate)     |       |                                                                                            | $          | 7,887                                                                       |       |                                                                                                  |       | $                                                                           | 169,465    |   |   |   | $ | 12,413 |   |   |   | $ | 155,932 |   |   |
| SEP-225289                           |       |                                                                                            | $          | 7,036                                                                       |       |                                                                                                  |       | $                                                                           | 11,105     |   |   |   | $ | 3,032 |   |   |   | $ | 3,032 |   |   |

 

Due to the length of timenecessary to develop a product, uncertainties related to the ability to obtaingovernmental approval for commercialization, and difficulty in estimating costsof projects, it is difficult to make accurate and meaningful estimates of theultimate cost to bring our product candidates to FDA approved status. We do notbelieve it is possible to estimate, with any degree of accuracy, the costs ofproduct candidates that are in stages earlier than Phase III. Accordingly,because all of our product candidates are in Phase I development, we have notprovided any such estimates.

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*Selling, Marketing and Distribution*

Selling, marketing anddistribution expenses were $523,750,000 and $386,121,000 for the nine monthsended September 30, 2006 and 2005, respectively, an increase ofapproximately 36%. The increase is primarily related to an increase inmarketing, advertising and promotion costs in support of LUNESTA. Additionally,we incurred increased personnel-related expense, which is comprised of anincrease in salaries as a result of hiring additional sales representatives andmanagement to support marketed products, as well as an increase in stock-basedcompensation expense of $10,456,000for the nine months ended September 30, 2006, including $10,367,000resulting from our January 1, 2006 implementation of SFAS 123(R), ascompared to $105,000 of stock-based compensation expense for the nine monthsended September 30, 2005.

*General and Administrative*

General and administrativecosts were $51,880,000 and $29,878,000 for the nine months ended September 30,2006 and 2005, respectively, an increase of approximately 74%. The increase isprimarily due to an increase in personnel-related costs primarily as a resultof increased stock-based compensation expense, which was $12,960,000 for the nine months ended September 30,2006, including $12,382,000 resulting from our January 1, 2006implementation of SFAS 123(R), as compared to $678,000 of stock-basedcompensation expense for the nine months ended September 30, 2005. The remainder of the increase isprimarily attributable to increased legal fees related to patent support andlitigation and shareholder lawsuit-related cost, as well as expense associatedwith responding to the SEC’s informal inquiry into our stock option grants andpractices and the related internal investigation.

*Other Income (Expense)*

Interest income was$33,103,000 and $18,446,000 for the nine months ended September 30, 2006and 2005, respectively, an increase of approximately 79%. The increase is dueto higher average balances of cash and short- and long-term investmentscombined with an increase in the interest rates earned on investments in 2006.Our monthly average cash and investment balance was approximately $948,134,000and $836,663,000 for the nine months ended September 30, 2006 and 2005,respectively. For the nine months ended September 30, 2006 and 2005, theaverage annualized interest rate that we earned on our investments was 4.66%and 2.94%, respectively.

Interest expense was$16,632,000 and $17,528,000 for the nine months ended September 30, 2006and 2005, respectively. The expense in both periods is primarily related to theinterest we paid on our 5% convertible subordinated debentures.

Equity in investee losseswere $565,000 and $709,000 for the nine months ended September 30, 2006and 2005, respectively, a decrease of approximately 20%. The loss representsour portion of BioSphere losses.

**Liquidity and Capital Resources**

Our liquidity requirementshave historically consisted of research and development expenses, sales andmarketing expenses, capital expenditures, working capital, debt service andgeneral corporate expenses. We have funded these requirements and the growth ofour business primarily through convertible subordinated debt offerings, theissuance of common stock, including the exercise of stock options, sales of ourproducts and license agreements for our drug compounds. We now expect to fundour liquidity requirements primarily with revenue generated from product sales.We also believe we have the ability to meet our short-term liquidity needsthrough the use of our cash and short-term investments on hand at September 30,2006.

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Cash, cash equivalents and short- and long-terminvestments totaled $997,160,000, or 74% of total assets at September 30,2006, compared to $976,201,000, or 77% of total assets, at December 31,2005.

Net cash provided by operating activities for the ninemonths ended September 30, 2006 was $18,737,000, which includes net incomeof $85,511,000. Our net income includes non-cash charges of $47,058,000,consisting primarily of share-based compensation and depreciation andamortization expense. Accounts receivable increased by $47,292,000 primarilydue to LUNESTA and XOPENEX Inhalation Solution sales. Inventory increased by$9,312,000 in order to support anticipated sales increases. Other currentassets increased by $4,426,000, which is primarily attributable to an increasein prepaid expenses. Accounts payable increased by $6,288,000 primarily due totiming of vendor payments. Accrued expenses decreased by $82,945,000 primarilydue to the timing of payments relating to commissions and sales and marketingaccruals. Other current liabilities increased by $23,855,000 primarily due toan increase in accruals for product revenue rebates related to LUNESTA andXOPENEX HFA product sales, offset by a decrease in accruals for product revenuerebates related to XOPENEX Inhalation Solution.

Net cash used in investing activities for the ninemonths ended September 30, 2006 was $97,291,000. Cash used in netpurchases of short- and long-term investments was $76,573,000. We madepurchases of property and equipment of $11,929,000 and received proceeds fromsales of equipment of $150,000. We also made an investment in ACADIA of$8,939,000.

Net cash provided by financing activities for the ninemonths ended September 30, 2006 was $16,977,000. We received proceeds of$18,694,000 from issuing common stock upon the exercise of stock options issuedunder our stock option plans. We also used $1,717,000 to repay capital leaseobligations and long-term debt.

We believe ourexisting cash and the anticipated cash flow from operations and currentstrategic alliances will be sufficient to support existing operations throughat least 2007. In the longer term, we expect to continue to fund our operationswith revenue generated from product sales. Our actual future cash requirementsand our ability to generate revenue, however, will depend on many factors,including:

·       LUNESTA sales;

·       XOPENEX Inhalation Solutionand XOPENEX HFA sales;

·       successfulcommercialization of BROVANA;

·       acquisitions oftechnologies, product candidates, approved products and/or businesses;

·       our ability to establishand maintain additional strategic alliances and licensing arrangements;

·       achievement of milestonesunder our strategic alliance arrangements;

·       progress of our preclinicaland clinical research programs and the number and breadth of these programs;

·       progress of our developmentefforts and the development efforts of our strategic partners;

·       royalties from agreementswith parties to which we have licensed our technology; and

·       the outcome of pendinglitigation and/or the informal SEC inquiry.

If our assumptions underlying our beliefs regardingfuture revenues and expenses change, or if unexpected opportunities or needsarise, we may seek to raise additional cash by selling debt or equitysecurities or borrowing money from a bank. However, we may not be able to raisesuch funds on favorable terms, or at all.

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Based on our currentoperating plan, we believe that we will not be required to raise additionalcapital to fund the repayment of our outstanding convertible debt when due,however we may choose to do so. If we are not able to successfully continue togrow our revenue and properly manage our expenses, it is likely that ourbusiness would be materially and adversely affected and that we would berequired to raise additional funds in order to repay our outstandingconvertible debt. We cannot assure that, if required, we would be able to raisethe additional funds on favorable terms, if at all.

**Critical AccountingPolicies**

We identified critical accounting policies in ourannual report on Form 10-K/A for the year ended December 31,2005. These critical accounting policies relate to product revenue recognition,royalty revenue recognition, rebate and return reserves, patents, intangiblesand other assets, accounts receivable and bad debt, income taxes, inducedconversion of debt, inventory write-downs and stock-based compensation.These policies require us to make estimates in the preparation of our financialstatements as of a given date. Because of the uncertainty inherent in thesematters, our actual results could differ from the estimates we use in applyingthe critical accounting policies. Other than the adoption of SFAS 123(R), whichis described below, no changes to these critical accounting policies have takenplace since December 31, 2005; however, we have expanded the disclosure ofour accounting policies relating to product sale allowances and reserves.

***Product Sales Allowances and Reserves:****  *We record product sales net of thefollowing significant categories of product sales allowances: payment termdiscounts, wholesaler fee-for-service discounts, government rebates andcontractual discounts (includes Medicaid discounts, Medicare discounts, managedcare discounts, chargebacks and group purchasing organization, or GPO, contractdiscounts), returns and other discounts. Calculating each of these itemsinvolves significant estimates and judgments and requires us to use informationfrom external sources. Based on known market events and trends, internal andexternal historical trends, third party data, customer buying patterns andup-to-date knowledge of contractual and statutory requirements, we are able tomake reasonable estimates of sales discounts. Historically, our estimates havenot materially differed from our actual results.

1) *Payment TermDiscounts—*We offer our direct purchase customers a 2% prompt-paycash discount as an incentive to remit payment within the first thirty daysafter the date of the invoice. Prompt-pay discount calculations are based onthe gross amount of each invoice. We account for these discounts by reducingsales by the 2% discount amount when product is sold, and apply earned cashdiscounts at the time of payment. Since we began selling our productscommercially in 1999, our customers have routinely taken advantage of thisdiscount. Based on common industry practices and our customers’ overall paymentperformance, we accrue for cash discounts on product sales recorded during theperiod. We adjust the accrual to reflect actual experience as necessary, andhistorical adjustments have not been material. Based on our history ofestimating payment term discounts and the low dollar exposure, we do notanticipate that changes to estimates will have a material impact on net sales.

2) *Wholesaler Fee- for-Service Discounts—*Inthe second quarter of both 2006 and 2005, we entered into letter agreementswith certain wholesaler customers that provide these wholesalers with theopportunity to earn discounts in exchange for the performance of certainservices. These agreements are subject to termination upon thirty days priorwritten notice. Our effective rate of wholesaler fee-for-service discountsapplied across all product sales in the first nine months of 2006 wasapproximately 2.8% as compared to 1.4% in the first nine months of 2005. Ouraccruals for wholesaler fee-for-service discounts are based on actual data ofproduct sales made to wholesale customers with letter agreements and not onestimates. If the percentage of gross sales sold to wholesalers with letteragreements increases, our liability related to these discounts could increasematerially.

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***3)****  **Government Rebates and Contractual Discounts—*

*MedicaidDiscounts—**We*record accruals for rebates tobe provided through the Medicaid Drug Rebate Program as a reduction of saleswhen the product is sold. We rebate individual states for all eligible units purchasedunder the Medicaid program based on a rebate per unit calculation, which isdriven off our Average Manufacturer Price, or AMP. We estimate the expectedrebate per unit to be used and adjust our rebate accruals based on expectedchanges in rebate pricing. We also examine the historical rebate trends and thetrend of sales that become eligible for Medicaid programs and any changesexpected to these trends. In addition, certain states have supplemental rebateprograms, which provide such states with an additional rebate. Supplementalrebates, like rebates under the Medicaid Drug Rebate Program, are recorded as areduction of sales when the product is sold. Rebate amounts are generallyinvoiced quarterly in arrears and paid thirty days after they are invoiced. Asa result, our accrual consists of: (i) an estimate of the amount expectedto be incurred for the current quarter’s prescriptions; (ii) an accrualfor prior quarters’ unpaid rebates; and (iii) an accrual for estimatedinventory in the distribution channel.

We recorded a provision for Medicaid rebates of 4.9%and 7.1% of gross sales for the nine months ended September 30, 2006 and2005, respectively. The decrease is attributable to a change in the product mixwith the commercial introduction of LUNESTA in the second quarter of 2005,which has significantly lower Medicaid-eligible units than XOPENEX InhalationSolution. The decrease is also the result of a Medicaid reserve reversal in thesecond quarter of 2006 relating to a prior period estimate, in addition to ashift in patient coverage from Medicaid to Medicare Part D, as a result ofthe introduction of the Medicare Part D program in 2006. Actual Medicaiddiscounts could exceed historical experience and our estimates of expectedMedicaid activity and rebate-per-unit amounts. The most significant estimate wemake in connection with this accrual is the estimate of the number ofMedicaid-eligible units in the distribution channel. In recent quarters, ourestimates have been approximately 98% accurate. Although the actual Medicaidrebate may vary by more than 2% of the estimated eligible Medicaid units infuture periods, we believe, based on prior experience, a 2% variation in ourestimate is reasonably likely. A 2% understatement of Medicaid-eligible unitsat September 30, 2006 would have resulted in an additional provision ofapproximately $0.6 million.

*MedicareDiscounts—Part B—**We*record accruals for rebates tobe provided through Medicare Part B programs, as a reduction of sales whenthe product is sold. We established a Medicare Part B rebate program inorder to increase the access by Medicare Part B beneficiaries to ourXOPENEX Inhalation Solution 1.25 mg strength product through Medicare Part Bpharmacy providers, or MPPs. XOPENEX Inhalation Solution is covered under aMedicare Part B code for drugs used with durable medical equipment, in ourcase, nebulizers. We estimate the expected rebate using historical data and byexamining trends and expected changes in Medicare Part B codes. Medicare Part Bpayments are paid to MPPs primarily on a monthly basis. Accordingly, theprovision typically relates to the activity over a one-month period and, as aresult, the total provision consists of: (i) an estimate of the amountexpected to be incurred for the current month’s prescriptions; (ii) anaccrual for prior months’ unpaid rebates; and (iii) an accrual forestimated inventory in the distribution channel.

*MedicareDiscounts—Part D—**Effective*January 1, 2006,Medicare created a prescription drug benefit for its beneficiaries known asMedicare Part D. The Centers for Medicare and Medicaid Services, or CMS,contracted with numerous health plans and prescription drug benefit plans todesign and administer the drug benefit, including the development of aformulary (which defines which products are covered and at what co-pay level).We pay rebates to certain Medicare Part D health plans and prescriptiondrug plans on the sale of LUNESTA and XOPENEX HFA. XOPENEX Inhalation Solutionhas been, and we expect that it will remain, subject to reimbursement underMedicare Part B resulting in minimal Medicare Part D utilization. Ouraccruals for Medicare Part D are for rebates required for LUNESTA andXOPENEX HFA and are estimated based on projected sales volumes through thecontracted health and drug plans.

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The provision for both Medicare rebates was 1.2% ofgross sales for both the nine months ended September 30, 2006 and lessthan 1% for the nine months ended September 30, 2005. Actual Medicarediscounts could change significantly in the future based on future Medicarereimbursement classifications.

Medicare rebates at our current reimbursement levelsrepresent an immaterial amount of sales rebates. Based on the accuracy ofestimates and the small dollar amounts involved, we do not expect changes inestimates to have a material impact on net sales.

*ManagedCare Discounts—**We*have entered into agreementswith certain managed care organizations, or MCOs, whereby we provide agreedupon discounts to such entities based on the achievement of sales volume and/ormarket share purchasing targets. We record accruals for these discounts as areduction of sales when product is sold based on discount rates and expectedlevels of sales volumes of these MCOs during a period. We estimate eligiblesales based on historical amounts and sales trends and expected changes tothese trends. Discounts are generally invoiced and paid quarterly in arrears.Accordingly, our accrual consists of: (i) the amount expected to beincurred for the current quarter’s prescriptions, (ii) an accrual forprior quarters unpaid discounts; and (iii) an accrual for estimatedinventory in the distribution channel.

The provision for MCO rebates was approximately 1.2%and 0.7% of gross sales in the nine months ended September 30, 2006 and2005, respectively. Actual MCO discounts could exceed historical experience andour estimates of expected future participation in these programs. However, inpart due to the fact that only a few organizations currently account forapproximately 90% of our MCO discounts, our MCO discount estimates havehistorically been very similar to the actual MCO discounts. We expect that asmall number of organizations will continue to account for substantially all ofour MCO discounts for the foreseeable future and, therefore, do not expectsignificant changes to our MCO discount estimates in future periods.

*Chargebacksand GPO Contract Discounts—**We have entered into agreements withcertain group purchasing organizations, or GPOs, in which its members canpurchase product from our wholesalers at a specified price. GPOs areorganizations that represent a group of end buyers in the purchase of goods.These agreements involve the wholesalers who receive a stated margin on salesto GPOs. When the difference between the wholesaler’s purchase price and theGPO’s price creates a margin less than the amount agreed between us and thewholesaler, the wholesaler requests a credit, which is referred to as achargeback. We record accruals for these discounts as a reduction of sales whenproduct is sold. We estimate eligible sales based on a history of the averageactual chargebacks and an average of the chargeback cycle time, which is thetime from when a wholesaler sells to a GPO until we issue a credit to thewholesaler. We examine the history of sales which qualify for chargebacks andmonitor sales trends and contractual changes. Our accrual consists of theamount expected to be incurred for the current sales in the calculatedchargeback cycle, plus an accrual for estimated inventory in the distributionchannel.*

*The provision for chargebacks and GPO contract credits wasapproximately 4.4% and 1.1% of gross sales* in the ninemonths ended September 30, 2006 and 2005, respectively.*Actual chargeback and GPO contractcredits could exceed historical experience and our estimates of futureparticipation in these programs. However, over the past few years, chargebackactivity has been fairly stable with the exception of XOPENEX HFA, whichcurrently has low sales volumes and a limited number of chargeback contracts.In addition, the dollar value of our chargebacks and GPO contract credits arerelatively low. Therefore, we do not expect significant variation betweenactual chargeback and GPO credits and our estimates.*

4) *Return*s—Customerscan return short-dated or expired product that meets the guidelines set forthin our returned goods policy. Product shelf-life from the date of manufacturefor XOPENEX Inhalation Solution is 15 months, XOPENEX HFA is 21 months andLUNESTA is 15-24 months. Returns are accepted from wholesalers and retailpharmacies. Customers can return product with six months or less of shelf liferemaining and expired product within twelve months following the expirationdate. We record an 

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estimate for returns asreductions of revenue at the time product sales are recorded. We base ourestimates of product returns on the percentage of returns that we haveexperienced historically and on a historical aging of the average time a returnoccurs from the time the product was sold. For products with insufficientreturn history, we estimate by examining data of similar drugs. For example,with LUNESTA, we researched industry data on return patterns of widelyprescribed insomnia drugs. We may adjust our estimate of product returns if weare aware of other factors that we believe could significantly impact ourexpected return percentages. These factors include our estimate of inventorylevels of our products in the distribution channel, the product shelf-life of theproduct we have shipped, competitive issues such as new product entrants andother known changes in sales trends.

The provision for returns was approximately 1.5% and3.6% for the nine months ended September 30, 2006 and 2005, respectively.The decrease in return percentage provision in 2006 from 2005 is due to theintroduction of LUNESTA in the second quarter of 2005, which has asignificantly lower return percentage than XOPENEX Inhalation Solution, inaddition to a decrease in actual returns for XOPENEX Inhalation Solution in thefirst nine months of 2006 compared to the same period in 2005. Actual returnscould exceed historical experience and our estimates of expected future returnsdue to factors such as wholesaler and retailer stocking patterns and inventorylevels and/or competitive changes. Based on these factors, and as a result offluctuations observed in prior periods, we believe it is reasonably likely thatthe actual returns provision percentage could vary from the estimatedpercentage within a range of 0.25% to 0.5%. If the returns provision percentagefor each of these products had increased by 0.25% to 0.5% of gross sales forthe nine months ended September 30, 2006, an additional provision ofbetween $2.5 million and $4.9 million would have been necessary.

Many of ouraccruals include an estimate of inventory in the distribution pipeline. At September 30,2006, we believe a reasonable estimate of the value of our pipeline inventoryin sales dollars is approximately $66 million for XOPENEX Inhalation Solution,$22 million for XOPENEX HFA and $84 million for LUNESTA.

5) *Other Discounts—*Attimes we offer special programs and discounts. In 2005, we implemented discountprograms related to the commercial introduction of LUNESTA and XOPENEX HFA MDI tosupport the goal of making the products widely available. These programsinclude discounts for auto-shipments to pharmacies, coupons, and vouchers,including the LUNESTA 7-Night Challenge introduced in September 2006.Under the auto-shipments to pharmacies program, we offer a discount duringcommercial introduction of new products to wholesalers that provide evidencethat they have delivered product to an agreed upon number of pharmacies in atimely manner. Under the coupon program, physicians give patients coupons topurchase the prescribed drug at a discount from any retail pharmacy. Wereimburse retail pharmacies for these discounts through a third-partyadministrator. Under the voucher and LUNESTA 7-Night Challenge programs,physicians give patients vouchers to obtain free samples of the prescribed drugfrom any retail pharmacy. We reimburse retail pharmacies for the cost of theseproducts through a third-party administrator. We use the voucher programprimarily in states where samples cannot be shipped directly to physicians.

In each case mentioned above, we estimate the cost ofreimbursement as a reduction of gross sales when the product is sold. Inaddition, we maintain an accrual for unused coupons and vouchers based onoutstanding total coupons and vouchers and their historical usage rates andadjust this accrual whenever changes in such historical usage rate occurs. Eachof these programs has a defined expiration date.

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Thefollowing table summarizes activity in each of the above product sales allowances and reservecategories for the nine-month period from December 31, 2005 to September 30,2006:

| ** **                              | ** ** | **Payment  Terms  Discount** | ** ** | **Wholesaler  Fee  for Service** | ** ** | **Government  Rebates and  Contractual  Discounts** | ** ** | **Returns** | ** ** | **Other  Discounts** | ** ** | **Total** | ** ** |
|-----------------------------------------|------------|------------------------------|------------|---------------------------------------|------------|----------------------------------------------------------|------------|-------------|------------|----------------------|------------|-----------|------------|
| ** **                              | ** ** | **(in thousands)**      | ** ** |
| **Balance  at December 31, 2005**  |       | $                            | (2,632     | )                                     |       | $                                                        | (9,503     | )           |       |                 | $          | (47,462   | )          |   | $ | (16,269 | ) |   | $ | (553 | ) |   | $ | (76,419 | ) |
| Current provision:                      |       |                         |       |                                  |       |                                                     |       |        |       |                 |       |      |       |   |   |   |   |   |   |
| Current year                            |       | (20,309                      | )          |                                  | (27,339    | )                                                        |       |        | (118,515   | )                    |       | (14,690   | )          |   | (2,425 | ) |   | (183,278 | ) |
| Prior year                              |       | —                       |       |                                  | —     |                                                     |       |        | 9,585      |                 |       | —    |       |   | 20 |   |   | 9,605 |   |
| Total                                   |       | (20,309                      | )          |                                  | (27,339    | )                                                        |       |        | (108,930   | )                    |       | (14,690   | )          |   | (2,405 | ) |   | (173,673 | ) |
| Actual:                                 |       |                         |       |                                  |       |                                                     |       |        |       |                 |       |      |       |   |   |   |   |   |   |
| Current year                            |       | 15,982                       |       |                                  | 7,151      |                                                     |       |        | 63,839     |                 |       | —    |       |   | 933 |   |   | 87,905 |   |
| Prior year                              |       | 2,958                        |       |                                  | 9,315      |                                                     |       |        | 38,142     |                 |       | 9,557     |       |   | 597 |   |   | 60,569 |   |
| Total                                   |       | 18,940                       |       |                                  | 16,466     |                                                     |       |        | 101,981    |                 |       | 9,557     |       |   | 1,530 |   |   | 148,474 |   |
| **Balance at September 30,  2006** |       | $                            | (4,001     | )                                     |       | $                                                        | (20,376    | )           |       |                 | $          | (54,411   | )          |   | $ | (21,402 | ) |   | $ | (1,428 | ) |   | $ | (101,618 | ) |

 

***Share-BasedCompensation—******Effective***January 1,2006, we adopted the provisions of SFAS 123(R), which resulted in changesto our financial statements as detailed in Note 5 to the financialstatements. Determining the amount and distribution of expense for stock-basedcompensation, as well as the associated impact to the balance sheets andstatements of cash flows, requires us to develop estimates of the fair value ofstock-based compensation expense.

We estimate the fair valueof stock options using the Black-Scholes valuation model. This valuation modeltakes into account the exercise price of the award, as well as a variety ofassumptions. These assumptions used to estimate the fair value of stock optionsinclude the expected term, the expected volatility of our stock over theexpected term, the risk-free interest rate over the expected term, and ourexpected annual dividend yield. As required by SFAS 123(R), management has alsomade an estimate of expected forfeitures in determining the amount of expenseto be recorded, and is recognizing compensation expense only for those equityawards expected to vest. We believe that the valuation technique and theapproach utilized to develop the underlying assumptions are appropriate incalculating the fair value of stock-based compensation expenses. Theseestimates are not intended to predict actual future events or the valueultimately realized by persons who receive equity awards.

**ContractualObligations**

As of September 30,2006, our contractual obligations disclosure in our annual report on Form 10-K/Afor the year ended December 31, 2005 has not materially changed.

**ITEM3.****                QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

**Market Risk**

We are exposed to marketrisk from changes in interest rates and equity prices, which could affect ourfuture results of operations and financial condition. These risks are describedin our annual report on Form 10-K/A for the year ended December 31,2005. As of November 9, 2006, there have been no material changes to themarket risks described in our annual report on Form 10-K/A for theyear ended December 31, 2005. Additionally, we do not anticipate anynear-term changes in the nature of our market risk exposures or in ourmanagement’s objectives and strategies with respect to managing such exposures.

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**ITEM 4.**                CONTROLSAND PROCEDURES

**Evaluation ofDisclosure Controls and Procedures**

Our management, with theparticipation of our chief executive officer and chief financial officer,evaluated the effectiveness of our disclosure controls and procedures as of September 30,2006. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act, means controls and otherprocedures of a company that are designed to ensure that information requiredto be disclosed by a company in the reports that it files or submits under theExchange Act is recorded, processed, summarized and reported, within the timeperiods specified in the SEC’s rules and forms. Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed by a company in the reportsthat it files or submits under the Exchange Act is accumulated and communicatedto the company’s management, including its principal executive and principalfinancial officers, as appropriate to allow timely decisions regarding requireddisclosure. Our management recognizes that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving their objectives and our management necessarily applies its judgmentin evaluating the cost-benefit relationship of possible controls andprocedures. Based on the evaluation of our disclosure controls and proceduresas of September 30, 2006, our chief executive officer and chief financialofficer concluded that, as of such date, our disclosure controls and procedureswere effective at the reasonable assurance level.

**Change in andEvaluation of Internal Control Over Financial Reporting**

There has been no change in our internal control overfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) during our quarter ended September 30, 2006 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

In light of the conclusions of our special committee’sreview of our stock option granting practices, we have re-evaluated the Reportof Management on Internal Control Over Financial Reporting as of December 31,2005 as set forth in our Annual Report on Form 10-K/A for the fiscalyear ended December 31, 2005. Based on this analysis, we have determinedthat there is no material weakness in our internal controls over financial reportingrelating to the matters under review.

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**PART II**

**OTHER INFORMATION**

**ITEM 1.**                LEGALPROCEEDINGS

**Stock OptionInquiry and Derivative Stockholder Complaints**

In June 2006, we announced that we had received aletter of inquiry from the SEC requesting documents related to our stock optiongrants and stock option practices, and we have been cooperating with suchinquiry. We appointed a special committee of outside directors to conduct aninternal review relating to our stock option grants and stock option practices.The special committee, with the assistance of legal counsel and accountingspecialists, has reviewed stock option grants to our officers, directors andemployees from 1996 to present under our various stock option plans in effectduring this period. We cooperated with the review, and our finance departmentalso reviewed our stock option grants and stock option practices. The specialcommittee has completed its stock option related review but will remain inplace for the duration of the SEC’s inquiry. See Note 3 to our financialstatements for additional information concerning these reviews.

We have accepted service of three stockholderderivative complaints relating to certain of our stock option grants that werefiled in the Superior Court, Middlesex County, Commonwealth of Massachusetts,naming Sepracor as nominal defendant and also naming as defendants certaincurrent members of our board of directors and certain of our current and formeremployees. The complaints allege purported breaches of fiduciary duties andunjust enrichment in connection with certain stock option grants made by usbetween June 1998 and May 2001. The complaints seek monetary damagesin unspecified amounts, equitable and injunctive relief, including disgorgementof profits obtained by certain defendants and other relief as determined by theCourt. On September 12, 2006, the three complaints were consolidated intoone action, and on September 22, 2006, the action was transferred to theBusiness Litigation Session of the Superior Court, Suffolk County, Commonwealthof Massachusetts. Plaintiffs filed a consolidated complaint on October 19,2006.

Three stockholder derivative complaints relating tothe same subject matter were filed against Sepracor, certain current members ofour board of directors and certain of our current and former employees in theUnited States District Court for the District of Massachusetts on September 28,2006, October 3, 2006 and October 12, 2006. We have not been servedwith these complaints.

We are unable toreasonably estimate any possible range of loss or liability associated with thestock option inquiry and/or derivative suits due to their uncertain resolution.

**Tecastemizole Class ActionComplaints**

We and several of ourcurrent and former officers and a current director are named as defendants inseveral class action complaints which have been filed on behalf of certainpersons who purchased our common stock and/or debt securities during differenttime periods, beginning on various dates, the earliest being May 17, 1999,and all ending on March 6, 2002. These complaints allege violations of theSecurities Exchange Act of 1934, as amended, and the rules and regulationspromulgated thereunder by the SEC. Primarily, they allege that the defendantsmade certain materially false and misleading statements relating to thetesting, safety and likelihood of approval of tecastemizole by the FDA. In boththe debt purchasers’ action and equity purchasers’ action, the court hasgranted the plaintiffs’ motion for class certification. In late February 2006,two corrected and amended consolidated complaints were filed, one on behalf ofthe purchasers of our common stock and the other on behalf of the purchasers ofour debt securities. These corrected and amended consolidated complaintsreiterate the allegations contained in the previously filed complaints anddefine the alleged class periods as May 17, 1999 through March 6,2002. The parties are currently engaged in discovery. We are unable toreasonably estimate any possible range of loss related to 

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thelawsuits due to their uncertain resolution. However, any conclusion of thesematters in a manner adverse to us would have a material adverse effect on ourfinancial position and results of operations.

**LevalbuterolHydrochloride Inhalation Solution ANDAs**

In September 2005, we received notification thatthe FDA had received an ANDA from Breath Limited seeking approval of a genericversion of our 1.25 mg, 0.63 mg and 0.31 mg levalbuterol hydrochlorideinhalation solution. Breath Limited’s submission includes a Paragraph IV certificationalleging that our patents listed in the FDA publication entitled “Approved DrugProducts With Therapeutic Equivalence Evaluations,” commonly referred to as the“Orange Book,” for XOPENEX Inhalation Solution are invalid, unenforceable ornot infringed by Breath Limited’s proposed product. We have filed a civilaction against Breath Limited for patent infringement. We were notified in January 2006of a second ANDA seeking approval of a generic version of our 1.25 mg, 0.63 mgand 0.31 mg levalbuterol hydrochloride inhalation solution including aParagraph IV certification, which was submitted to the FDA by Dey, L.P. We havefiled a civil action against Dey, L.P. for patent infringement.

In April 2006, we were notified of a third ANDAseeking approval of a generic version of our 1.25 mg, 0.63 mg and 0.31 mglevalbuterol hydrochloride inhalation solution including a Paragraph IVcertification, which was submitted to the FDA by Watson Laboratories, Inc.Watson’s Paragraph IV certification was limited to our patent that expires in2021 and covers certain levalbuterol hydrochloride inhalation solutions,including XOPENEX Inhalation Solution. We have decided not to file a civilaction against Watson Laboratories, Inc. for patent infringement.

In August 2006, we received notification that theFDA had received an ANDA, including a Paragraph IV certification, from Dey, L.Pseeking approval of a generic version of our 1.25 mg/0.5 mL levalbuterolhydrochloride inhalation solution concentrate. We have filed a civil actionagainst Dey, L.P for patent infringement.

Should we successfully enforce our patents, ANDAapproval will not occur until the expiration of the applicable patents.Otherwise, the FDA will stay its approval of the relevant ANDA until 30 monthsfollowing the date we received notice of such ANDA or until a court decidesthat our patents are invalid, unenforceable or not infringed, whichever isearlier.

Patent litigation involvescomplex legal and factual questions. We can provide no assurance concerning theoutcome or the duration of the lawsuit. If we are not successful in enforcingour patents, we will not be able to exclude the generic company, for the fullterm of our patents, from marketing their generic version of XOPENEX InhalationSolution. Introduction of a generic copy of XOPENEX Inhalation Solution beforethe expiration of our patents would have a material adverse effect on ourbusiness.

**Fexofenadine PatentClaim**

In June 2006, we werenotified that Teva Pharmaceutical Industries Limited and Teva UK Limited havefiled a claim naming us as defendant in the United Kingdom’s High Court ofJustice, Chancery Division, Patents Court. The claim alleges that our twopatents relating to fexofenandine, which we have licensed to sanofi-aventis inconnection with its sale of ALLEGRA, are invalid, and seeks to have theminvalidated. Sanofi-aventis is defending this action. If patent-basedexclusivity for ALLEGRA is lost in the United Kingdom or in any otherjurisdiction where a similar action is brought, our rights to receive royaltyrevenue in any such jurisdiction will terminate.

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**LUNESTA TrademarkClaim**

In September 2006,Tharos Laboratories, Inc. filed suit against us in the United StatesDistrict Court, District of Utah, Central Division, alleging trademarkinfringement, dilution, unfair competition, false advertising, and falsedesignation of origin arising out of our use of our silk moth design inconnection with LUNESTA. Tharos seeks unspecified monetary damages and aninjunction of our use of the silk moth design. In October 2006, we filed amotion to dismiss Tharos’ claims. We are unable to reasonably estimate anypossible range of loss related to this lawsuit due to its uncertain resolution.

**ITEM 1A. RISKFACTORS**

You should carefully consider the risks describedbelow in addition to the other information contained in this report, beforemaking an investment decision. Our business, financial condition or results ofoperations could be harmed by any of these risks. The risks and uncertaintiesdescribed below are not the only ones we face. Additional risks not currentlyknown to us or other factors not perceived by us to present significant risksto our business at this time also may impair our business operations. We havenot made any material changes in the risk factors previously disclosed in ourquarterly report on Form 10-Q for the three-month period ended June 30,2006.

**Risks Related toOur Financial Results**

**We have a historyof net losses and we may not be able to generate revenues sufficient to achieveand maintainprofitability on a quarterly and annual basis.**

Except for our four mostrecent fiscal quarters, we have incurred net losses each quarter since ourinception. It is possible we will not be able to achieve profitability again ormaintain profitability on a quarterly or annual basis. We expect to continue toincur significant operating expenditures to further develop and commercializeour products and product candidates. As a result, we will need to generatesignificant revenues in future periods to achieve and maintain profitability.We cannot assure you that we will achieve significant revenues or that we willever achieve profitability again. Even if we do achieve profitability again, wemay not be able to maintain profitability for any substantial period of time.If revenues grow more slowly than we anticipate or if operating expenses exceedour expectations or cannot be adjusted accordingly, our business, results ofoperations and financial condition will be materially and adversely affected.In addition, if we are unable to achieve or maintain profitability on aquarterly or annual basis, the market price of our common stock may decline.

**Almost all of our revenues are derived from sales ofLUNESTA and XOPENEX Inhalation Solution and our future successdepends on the continued commercial success of these products.**

Approximately 95% of our total revenues for the ninemonths ended September 30, 2006 resulted from sales of LUNESTA and XOPENEXInhalation Solution and we expect that sales from these two products willcontinue to represent a significant majority of our revenues for the comingyear. In April 2005, we commercially introduced LUNESTA as a new productin a highly and increasingly competitive market and we cannot be certain thatit will achieve continued commercial success. In addition, we do not havelong-term sales contracts with our customers, and we rely on purchase ordersfor sales of LUNESTA and XOPENEX Inhalation Solution. Reductions, delays orcancellations of orders for LUNESTA or XOPENEX Inhalation Solution couldadversely affect our operating results. If sales of LUNESTA and XOPENEXInhalation Solution do not continue to increase, we may not have sufficientrevenues to achieve our business plan or repay our outstanding debt, and ourbusiness will not be successful. In December 2005, we commerciallyintroduced XOPENEX HFA. In October 2006, we received FDA approval tomarket BROVANA, which we expect to commercially introduce in the second quarterof 2007. We cannot be certain that either XOPENEX HFA or BROVANA will achievecommercial success.

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With respect to XOPENEX Inhalation Solution, threecompanies have filed ANDAs with the FDA seeking to market a generic version oflevalbuterol hydrochloride inhalation solution. We have commenced patentlitigation against two of these companies and we have decided not to commencelitigation against the third at this time. A finding that the products thesecompanies wish to market do not infringe our patents or that our patents are invalidor unenforceable will likely lead to the introduction of generic levalbuterolinhalation solution. If this occurs, sales of XOPENEX Inhalation Solution willbe adversely affected.

We cannot becertain that we will be able to continue to successfully commercialize ourproducts or that any of our products will continue to be accepted in theirmarkets. Specifically, the following factors, among others, could affect thelevel of success and market acceptance of LUNESTA, XOPENEX Inhalation Solution,XOPENEX HFA and/or BROVANA, which we expect to commercially introduce in thesecond quarter of 2007:

·       a change in the perceptionof the health care community of their safety and/or efficacy, both in anabsolute sense and relative to that of competing products;

·       the introduction of newproducts into the sleep or respiratory markets;

·       the level and effectivenessof our sales and marketing efforts;

·       any unfavorable publicityregarding these products or similar products;

·       litigation or threats oflitigation with respect to these products;

·       the price of the productrelative to other competing drugs or treatments;

·       any changes in governmentand other third-party payor reimbursement policies and practices; and

·       regulatory developmentsaffecting the manufacture, marketing or use of these products.

Any adverse developmentswith respect to the sale of LUNESTA or XOPENEX Inhalation Solution couldsignificantly reduce revenues and have a material adverse effect on our abilityto maintain profitability and achieve our business plan.

**We have significantdebt and we may not be able to make principal payments when due.**

As of September 30, 2006, our total debt wasapproximately $1.2 billion and our stockholders’ equity (deficit) was($33.0) million. None of our 5% debentures due February 2007, our 0% Series Anotes due December 2008, our 0% Series B notes due December 2010nor our 0% notes due October 2024 restricts us or our subsidiaries’ability to incur additional indebtedness, including debt that ranks senior tothe notes. The 0% notes due 2024 are senior to the Series A notes due 2008and Series B notes due 2010, which are senior to the 5% debentures due2007. Additional indebtedness that we incur may in certain circumstances ranksenior to or on parity with this debt. Our ability to satisfy our obligationswill depend upon our future performance, which is subject to many factors,including factors beyond our control. The conversion prices for the 5%debentures due 2007, 0% Series A notes due 2008 and 0% Series B notesdue 2010 are $92.38, $31.89 and $29.84, respectively. On July 31, 2006,the closing sale price of our common stock was $49.40. If the market price forour common stock does not exceed the conversion price, the holders of ouroutstanding convertible debt may not convert their securities into commonstock. Our 0% notes due 2024 are convertible into cash and, if applicable,shares of our common stock at a conversion price of approximately $67.20, atthe option of the holders under certain circumstances. We may not be able tomake the required cash payments upon conversion of the 0% notes due 2024.

Historically, we have hadnegative cash flow from operations. For the nine months ended September 30,2006, net cash provided by operating activities was approximately $18.7 million.Our annual debt service through 2006, assuming no additional interest-bearingdebt is incurred and no additional 5% 

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debenturesdue 2007 are converted, redeemed, repurchased or exchanged, is approximately$22.0 million. Unless we have sufficient cash or are able to generatesufficient operating cash flow to pay off the principal of our outstandingdebt, we will be required to raise additional funds or default on ourobligations under the debentures and notes. If revenue generated from sales ofLUNESTA and XOPENEX Inhalation Solution do not meet expected levels, it isunlikely that we would have sufficient cash flow to repay our outstandingconvertible debt and/or make cash payments upon conversion of the 0% notes due2024. There can be no assurance that, if required, we would be able to raisethe additional funds on favorable terms, if at all.

**If we exchange debt for shares of common stock, therewill be additional dilution to holders of our common stock.**

As of September 30,2006, we had approximately $1.2 billion of outstanding debt. In order toreduce future cash interest payments, as well as future payments due atmaturity, we may, from time to time, depending on market conditions, repurchaseadditional outstanding convertible debt for cash; exchange debt for shares ofour common stock, warrants, preferred stock, debt or other consideration; or acombination of any of the foregoing. If we exchange shares of our capitalstock, or securities convertible into or exercisable for our capital stock, foroutstanding convertible debt or use proceeds from the issuance of convertibledebt to fund redemption of outstanding convertible debt with a higherconversion ratio, the number of shares that we might issue as a result of suchexchanges would significantly exceed the number of shares originally issuableupon conversion of such debt and, accordingly, such exchanges would result inmaterial dilution to holders of our common stock. We cannot assure you that wewill repurchase or exchange any additional outstanding convertible debt.

**If the estimates we make, or the assumptions on whichwe rely, in preparing our financial statements prove inaccurate, our actualresults may vary from those reflected in our projections and accruals.**

Our financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States. The preparation of these financial statements requires usto make estimates and judgments that affect the reported amounts of our assets,liabilities, net revenues and expenses, the amounts of charges accrued by usand related disclosure of contingent assets and liabilities. We base ourestimates on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances. We cannot assure you,however, that our estimates, or the assumptions underlying them will not bematerially different from actual results. For example, our royalty revenue isrecognized based upon our estimates of our collaboration partners’ sales duringthe period and, if these sales estimates are greater than the actual sales thatoccur during the period, our net income would be reduced. This, in turn, couldadversely affect our stock price.

**If sufficient funds to finance our business are notavailable to us when needed or on acceptable terms, then we may be required todelay, scale back, eliminate or alter our strategy for our programs.**

We may require additional funds for our research andproduct development programs, operating expenses, repayment of debt, thepursuit of regulatory approvals, license or acquisition opportunities and theexpansion of our production, sales and marketing capabilities. Historically, wehave satisfied our funding needs through collaboration arrangements withcorporate partners, sales of product, and equity and debt financings. Thesefunding sources may not be available to us when needed in the future, and, ifavailable, they may not be on terms acceptable to us. Insufficient funds couldrequire us to delay, scale back or eliminate certain of our research andproduct development programs or to enter into license agreements with thirdparties to commercialize products or technologies that we would otherwisedevelop or commercialize ourselves. Our cash requirements may vary materiallyfrom those now planned because of factors including:

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·       patent developments;

·       licensing or acquisitionopportunities;

·       relationships withcollaboration partners;

·       the FDA regulatory process;

·       litigation and governmentinquiries and investigations;

·       our capital requirements;and

·       selling,marketing and manufacturing expenses in connection with commercialization ofproducts.

**Several class action lawsuits have been filed againstus which may result in litigation that is costly to defend and the outcome ofwhich is uncertain and may harm our business.**

We and several of our current and former officers anda current director are named as defendants in several class action complaintswhich have been filed on behalf of certain persons who purchased our commonstock and/or debt securities during different time periods, beginning onvarious dates, the earliest being May 17, 1999, and all ending on March 6,2002. These complaints allege violations of the Exchange Act and the rules andregulations promulgated thereunder by the SEC. Primarily they allege that thedefendants made certain materially false and misleading statements relating tothe testing, safety and likelihood of FDA approval of tecastemizole. On September 8,2005, in both the debt purchasers’ action and the equity purchasers’ action,the district court granted the plaintiff’s motion for class certification. Inlate February 2006, two corrected and amended consolidated complaints werefiled, one on behalf of the purchasers of our equity securities and the otheron behalf the purchasers of our debt securities. These corrected and amendedconsolidated complaints reiterate the allegations contained in the previouslyfiled complaints and define the alleged class periods as May 17, 1999through March 6, 2002. The parties are currently engaged in discovery.

We can provide noassurance as to the outcome of these lawsuits. Any conclusion of these mattersin a manner adverse to us would have a material adverse effect on our financialcondition and business. In addition, the costs to us of defending anylitigation or other proceeding, even if resolved in our favor, could besubstantial. Such litigation could also substantially divert the attention ofour management and our resources in general. Uncertainties resulting from theinitiation and continuation of any litigation or other proceedings could harmour ability to compete in the marketplace.

**Our stock option granting practices are the subject ofan informal inquiry by the Securities and Exchange Commission.**

As we announced on June 2, 2006, the SEC isconducting an informal inquiry into our stock option grants and stock optionpractices and a special committee of our outside directors oversaw a review ofour stock option granting practices and the documentation relating to suchgrants. We cannot assure you that we will not be subject to regulatory fines orpenalties or other contingent liabilities at the conclusion of the SEC’sinformal inquiry.

Based on the results ofthe special committee’s review, we have restated our financial statements forthe quarters ended March 31, June 30, and September 30, 2005,the quarter ended March 31, 2006 and the fiscal years ended December 31,2005, 2004 and 2003, and revised the financial information contained in ourearnings release for the period ended June 30, 2006.

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**We have civil litigation pending that relates to ourstock option granting practices, and we cannot predict the ultimateoutcome of this litigation.**

We and our directors andofficers are defendants in several derivative actions relating to our stockoption granting practices. The complaints allege purported breaches offiduciary duties and unjust enrichment in connection with certain stock optiongrants made by us between June 1998 and May 2001. The complaints seekmonetary damages in unspecified amounts, equitable and injunctive relief,including disgorgement of profits obtained by certain defendants and otherrelief as determined by the Court. These actions are in preliminary stages andwe cannot predict the ultimate outcome or impact of this litigation.

**Fluctuations in the demand for products, the successand timing of clinical trials, regulatory approvals, product launches,collaboration arrangements and any termination ofdevelopment efforts will cause fluctuations in our quarterly operating results,which could cause volatility in our stock price.**

Our quarterlyoperating results are likely to fluctuate significantly, which could cause ourstock price to be volatile. These fluctuations will depend on many factors,including:

·       timing and extent ofproduct sales and market penetration;

·       timing and extent ofoperating expenses, including selling and marketing expenses and the costs ofexpanding and maintaining a direct sales force;

·       success and timing ofregulatory filings and approvals for products developed by us or our licensingpartners or for collaborative agreements;

·       timing and success ofproduct launches;

·       introduction of competitiveproducts into the market;

·       results of clinical trialswith respect to products under development;

·       the initiation of, oradverse developments in, any judicial litigation proceedings or governmentalinvestigations in which we are involved;

·       a change in the perceptionof the health care and/or investor communities with respect to our products;

·       success and timing ofcollaboration agreements for development of our pharmaceutical candidates anddevelopment costs for those pharmaceuticals;

·       timing of receipt ofupfront, milestone or royalty payments under collaboration agreements;

·       termination of developmentefforts of any product under development or any collaboration agreement; and

·       timingof expenses we may incur with respect to any license or acquisition of productsor technologies.

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**We have various mechanisms in place to discouragetakeover attempts, which may reduce or eliminate our stockholders’ ability tosell their shares for a premium in a change of control transaction.**

Various provisionsof our certificate of incorporation and by-laws and of Delaware corporate lawmay discourage, delay or prevent a change in control or takeover attempt of ourcompany by a third party that is opposed by our management and board ofdirectors. Public stockholders who might desire to participate in such atransaction may not have the opportunity to do so. These anti-takeoverprovisions could substantially impede the ability of public stockholders tobenefit from a change of control or change in our management and board ofdirectors. These provisions include:

·       preferred stock that couldbe issued by our board of directors to make it more difficult for a third partyto acquire, or to discourage a third party from acquiring, a majority of ouroutstanding voting stock;

·       classification of ourdirectors into three classes with respect to the time for which they holdoffice;

·       non-cumulative voting for directors;

·       control by our board ofdirectors of the size of our board of directors;

·       limitations on the abilityof stockholders to call special meetings of stockholders;

·       inability of ourstockholders to take any action by written consent; and

·       advance notice requirementsfor nominations of candidates for election to our board of directors or forproposing matters that can be acted upon by our stockholders at stockholdermeetings.

In addition, inJune 2002, our board of directors adopted a shareholder rights plan, theprovisions of which could make it more difficult for a potential acquirer ofSepracor to consummate an acquisition transaction.

**The price of our common stock historically has beenvolatile, which could cause you to lose part or all of your investment.**

The market price of ourcommon stock, like that of the common stock of many other pharmaceutical andbiotechnology companies, may be highly volatile. In addition, the stock markethas experienced extreme price and volume fluctuations. This volatility hassignificantly affected the market prices of securities of many pharmaceuticaland biotechnology companies for reasons frequently unrelated to ordisproportionate to the operating performance of the specific companies. Thesebroad market fluctuations may adversely affect the market price of our commonstock. Prices for our common stock will be determined in the marketplace andmay be influenced by many factors, including variations in our financialresults and investors’ perceptions of us, and changes in recommendations bysecurities analysts as well as their perceptions of general economic, industryand market conditions.

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**Risks Related toCommercialization**

**We face intensecompetition and our competitors have greater resources and capabilities than wehave.**

We face intense competition in the sale of our currentproducts, and expect to face intense competition in the sale of any futureproducts we sell. If we are unable to compete effectively, our financialcondition and results of operations could be materially adversely affectedbecause we may not achieve our product revenue objectives and because we mayuse our financial resources to seek to differentiate ourselves from ourcompetition. Large and small companies, academic institutions, governmentalagencies and other public and private organizations conduct research, seekpatent protection, develop products, establish collaborative arrangements forproduct development and sell products in competition with us. Many of ourcompetitors and potential competitors have substantially greater resources,manufacturing and sales and marketing capabilities, research and development staffand production facilities than we have. The fields in which we compete aresubject to rapid and substantial technological change. Our competitors may beable to respond more quickly to new or emerging technologies or to devotegreater resources to the development, manufacture and marketing of new productsand/or technologies than we can. As a result, any products and/or technologiesthat we develop may become obsolete or noncompetitive before we can recoverexpenses incurred in connection with their development.

With our XOPENEX franchise, we compete primarilyagainst albuterol. XOPENEX Inhalation Solution and generic albuterol inhalationsolution currently account for the majority of short-acting beta-agonistinhalation solution prescriptions in the market. Albuterol has been marketedfor many years, is well established and sells at prices substantially lowerthan XOPENEX Inhalation Solution. With XOPENEX HFA, we compete with genericchlorofluorocarbon-based albuterol metered-dose inhalers and brand-name HFAalbuterol metered-dose inhalers. Generic chlorofluorocarbon MDIs sell atsubstantially lower prices than XOPENEX HFA. To continue successfully marketingour XOPENEX products, we must continue to demonstrate that the efficacy andsafety features of our drug outweigh their higher cost.

In the sleep disorder market, we face intensecompetition from established products, such as AMBIEN® and SONATA®. We also face competition from the newly approved sleepagents ROZEREMÔ and AMBIEN CRÔ.There are also other potentially competitive therapies that are in late-stagedevelopment for the treatment of insomnia. For all of our products, we need todemonstrate to physicians, patients and third-party payors that the costof our product is reasonable and appropriate in light of its safety andefficacy, its price and the health care benefits, each as compared to othercompeting products.

With BROVANA, we expect tocompete primarily against established dry-powder inhalers and inexpensivegeneric nebulized therapies for COPD. To successfully market BROVANA, we mustdemonstrate that its safety and efficacy outweigh the convenience of dry-powderinhalers and the lower cost of generic nebulized COPD treatments.

**We may be unable tocommercialize products for which we receive approval from the FDA.**

Commercialization of aproduct for which we have received an approval letter from the FDA could bedelayed for a number of reasons, some of which are outside of our control,including delays in delivery of the product due to importation regulationsand/or problems with our distribution channels or delays in the issuance ofapprovals from, or the completion of required procedures by agencies other thanthe FDA, such as the United States Drug Enforcement Administration. Inaddition, commercialization of FDA-approved products may be delayed by ourfailure to timely finalize distribution arrangements, manufacturing processesand arrangements, produce sufficient inventory and/or properly prepare oursales force. If we are unable to commercialize a product promptly after receiptof an approval letter, our business and financial position may be materiallyadversely affected due to reduced revenue from product 

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salesduring the period or periods that commercialization is delayed and the shorteningof any lead time to market we may have had over our competitors. In addition,the exclusivity period, which is the time during which the FDA will preventgeneric pharmaceutical companies from introducing a generic copy of theproduct, begins to run upon FDA approval and, therefore, to the extent we areunable to commercialize a product promptly after receipt of an approval letter,our long-term product sales and revenues could be adversely affected. In October 2006,we received FDA approval to market BROVANA, which we expect to commerciallyintroduce in the second quarter of 2007. Even if the FDA or similar foreignagencies grant us regulatory approval of a product, if we fail to comply withthe applicable regulatory requirements, we may be subject to fines, suspensionor withdrawal of regulatory approvals, product recalls, seizures of products,operating restrictions and criminal prosecution. In any such event, our productsales and revenues could be adversely affected.

**We sell our products primarily through a direct salesforce and if we are not successful in attracting and retaining qualifiedsales personnel, we may not be successful in commercializing our products.**

We have established a sales force to market XOPENEXInhalation Solution, LUNESTA and XOPENEX HFA. We also plan to market BROVANAthrough our sales force. We have incurred significant expense in expanding oursales force and we may incur additional expense if we further expand. If wesuccessfully develop and obtain regulatory approval for the products we aredeveloping, we may (1) market and sell them through our sales force, (2) licensesome of them to large pharmaceutical companies or (3) market and sell themthrough other arrangements, including co-promotion arrangements. We may incursignificant costs in expanding our sales force before the products underdevelopment have been approved for marketing. For example, we expanded oursales force in 2004 in anticipation of marketing and selling LUNESTA and in2005 in anticipation of marketing and selling XOPENEX HFA. In addition, wehave, and may continue to, expand our sales force in anticipation of salesgrowth that may never occur. In addition, if we enter into co-promotionarrangements or market and sell additional products directly, we may need tosignificantly expand our sales force.

Our ability to realizesignificant revenues from direct marketing and sales activities depends on ourability to attract and retain qualified sales personnel. Competition for thesepersons is intense. If we are unable to attract and retain qualified salespersonnel, we will not be able to successfully expand our marketing and directsales force on a timely or cost effective basis. We may also need to enter intoadditional co-promotion arrangements with third parties, for example where ourown direct sales force is not large enough or sufficiently well aligned toachieve maximum penetration in the market. We may not be successful in enteringinto any co-promotion arrangements, and the terms of any co-promotion arrangementsmay not be favorable to us.

**If we or our third-party manufacturers do notcomply with current Good Manufacturing Practices regulations, then the FDAcould refuse to approve marketing applications or force us to recall orwithdraw our products.**

The FDA and other regulatory authorities require thatour products be manufactured according to their Good Manufacturing Practices,or GMP, regulations. The failure by us, our collaborative development partnersor third-party manufacturers to comply with current GMP regulations couldlead to delay in our development programs or refusal by the FDA to approvemarketing applications. Failure in either respect could also be the basis foraction by the FDA to withdraw approvals previously granted, to recall productsand for other regulatory action.

On October 22, 2004,we commenced notifying drug wholesalers, hospitals and pharmacies of amanufacturer-initiated voluntary Class III recall of one componentof our XOPENEX Inhalation Solution product line, XOPENEX Inhalation SolutionConcentrate (1.25mg/0.5mL), which we introduced in August 2004. Therecall, which affected only XOPENEX Inhalation Solution Concentrate and noother 

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componentsof our XOPENEX Inhalation Solution product line, was necessitated by packagingprocess validation issues relating to the automated process of placing finishedvials into a foil pouch. We suspended manufacture and sale of XOPENEXInhalation Solution Concentrate until the issues giving rise to the recall werefully addressed. We re-introduced XOPENEX Inhalation Solution Concentrate in June 2006.If these or similar deficiencies are found to extend to other components or ourXOPENEX Inhalation Solution product line, our ability to supply product to themarket may be limited or interrupted indefinitely, which could have a materialadverse effect on our busines**s.**

**We could be exposed to significant liability claimsthat could prevent or interfere with our product commercialization efforts.**

We may be subject toproduct liability claims that arise through testing, manufacturing, marketing,sale and use of pharmaceutical products. Product liability claims coulddistract our management and key personnel from our core business, require us tospend significant time and money in litigation or to pay significant damages,which could prevent or interfere with our product commercialization efforts andcould adversely affect our business. Claims of this nature could also adverselyaffect our reputation, which could damage our position in the market and subjectus to product recalls. Although we maintain product liability insurancecoverage for both the clinical trials and commercialization of our products, itis possible that we will not be able to obtain further product liabilityinsurance on acceptable terms, if at all, and that our insurance coverage maynot provide adequate coverage against all potential claims.

**Risks Related tothe Regulatory Environment**

**If our products donot receive government approval, we will not be able to commercialize them.**

The FDA and similarforeign agencies must approve for commercialization any pharmaceutical productsdeveloped by us or our development partners. These agencies impose substantialrequirements on drug manufacturing and marketing. Any unanticipated preclinicaland clinical studies we are required to undertake could result in a significantincrease in the cost of advancing our products to commercialization. Inaddition, failure by us or our collaborative development partners to obtainregulatory approval on a timely basis, or at all, or the attempt by us or ourcollaborative development partners to receive regulatory approval to achievelabeling objectives, could prevent or adversely affect the timing of commercialintroduction of, or our ability to market and sell, our products.

**If we fail to successfully develop and receiveregulatory approval for product candidates, we will be unable to commercializethe product candidates and future sales and earnings growth will besubstantially hampered.**

Our ability to maintain profitability will depend inlarge part on successful development and commercialization of additionalproducts. All of our product candidates are in the early stages of development.We cannot assure you that we will be able to develop or acquire and commerciallyintroduce new products in a timely manner or that new products, if developed,will be approved for the indications and/or with the labeling we expect, orthat they will achieve market acceptance. Before we commercialize any otherproduct candidate, we will need to successfully develop the product candidateby completing successful clinical trials, submitting an NDA for the productcandidate that is accepted by the FDA and receiving FDA approval to market thecandidate. If we fail to successfully develop a product candidate and/or theFDA delays or denies approval of any submitted NDA or any NDA that we submit inthe future, then commercialization of our products under development may bedelayed or terminated, which could have a material adverse effect on ourbusiness.

A number ofproblems may arise during the development of our product candidates:

·       results of clinical trialsmay not be consistent with preclinical study results;

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·       results from later phasesof clinical trials may not be consistent with results from earlier phases;

·       results from clinicaltrials may not demonstrate that the product candidate is safe and efficacious;

·       we may not receiveregulatory approval for our product candidates;

·       the product candidate maynot offer therapeutic or other improvements over comparable drugs;

·       we may elect not tocontinue funding the development of our product candidates; or

·       funds may not be availableto develop all of our product candidates.

In addition, our growth isdependent on our continued ability to penetrate new markets where we havelimited experience and competition is intense. We cannot assure you that themarkets we serve will grow in the future, that our existing and new productswill meet the requirements of these markets, that our products will achievecustomer acceptance in these markets, that competitors will not force prices toan unacceptably low level or take market share from us, or that we can achieveor maintain profits in these markets.

**If the FDA delays or denies approval of any NDA thatwe file in the future, then commercialization of the product subject to the NDAwill be delayed or terminated, which could have a material adverse effect on our business.**

The regulatoryprocess to obtain marketing approval requires clinical trials of a product toestablish its safety and efficacy. Problems that may arise during clinicaltrials include:

·       results of clinical trialsmay not be consistent with preclinical study results;

·       results from later phasesof clinical trials may not be consistent with results from earlier phases; and

·       products may not be shownto be safe and efficacious.

Even if the FDA or similarforeign agencies grant us regulatory approval of a product, the approval maytake longer than we anticipate and may be subject to limitations on theindicated uses for which the product may be marketed or contain requirementsfor costly post-marketing follow-up studies. Moreover, if we fail to complywith applicable regulatory requirements, we may be subject to fines, suspensionor withdrawal of regulatory approvals, product recalls, seizure of products,operating restrictions and criminal prosecution.

**Our sales depend on payment and reimbursement fromthird-party payors, and a reduction in payment rate orreimbursement could result in decreased use or sales of our products.**

Sales of our products are dependent, in part, on theavailability of reimbursement from third-party payors such as state andFederal governments under programs such as Medicare and Medicaid, and privateinsurance plans. Third-party payors continually attempt to contain orreduce the cost of health care by challenging the prices charged for medicalproducts and services. We may not be able to sell our products profitably ifreimbursement is unavailable or limited in scope or amount.

There have been, there are, and we expect there willcontinue to be, state and Federal legislative and/or administrative proposalsthat could limit the amount that state or Federal governments will pay toreimburse the cost of pharmaceutical products. The Medicare Prescription DrugImprovement and Modernization Act of 2003, or the MMA, which was signed intolaw in December 2003, contains provisions that permit reductions ingovernment reimbursement for drugs. We are not able to predict the full impactof the MMA and its regulatory requirements on our business. However, we believethat legislative or administrative acts that reduce reimbursement for ourproducts could adversely affect our business. In addition, private insurers,such as managed care organizations, may adopt their own reimbursement 

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reductions in response tolegislation. Reduction in reimbursement for our products could have a materialadverse effect on our results of operations. Also, the increasing emphasis onmanaged care in the U.S. may put increasing pressure on the price and usage ofour products, which may adversely affect product sales. Further, when a newdrug product is approved, governmental and/or private reimbursement for thatproduct is uncertain, as is the amount for which that product will bereimbursed. We cannot predict availability or amount of reimbursement for our approvedproducts or product candidates, including those at a late stage of development,and current reimbursement policies for marketed products may change at anytime.

The MMA also established a prescription drug benefitbeginning in 2006 for all Medicare beneficiaries. We do not know the extent towhich our products will continue to be included in the Medicare prescriptiondrug benefit, and we may be required to provide significant discounts orrebates to drug plans participating in the Medicare drug benefit. Moreover, theFederal government may acquire the ability to negotiate price and demanddiscounts on pharmaceutical products that may implicitly create price controlson prescription drugs. In addition, Managed Care Organizations, or MCOs, HealthMaintenance Organizations, or HMOs, Preferred Provider Organizations, or PPOs,health care institutions and other government agencies continue to seek pricediscounts. MCOs, HMOs, PPOs and private health plans will administer theMedicare drug benefit, leading to managed care and private health plansinfluencing prescription decisions for a larger segment of the population. Inaddition, certain states have proposed and certain other states have adoptedvarious programs to control prices for their seniors’ and low-income drugprograms, including price or patient reimbursement constraints, restrictions onaccess to certain products, importation from other countries, such as Canada,and bulk purchasing of drugs.

In March 2006, the Medicare Durable MedicalEquipment Program Safeguard Contractors, or DME-PSCs, issued a draft localcoverage determination under which Medicare reimbursement for XOPENEXInhalation Solution would be reduced to the level of reimbursement for genericalbuterol under Medicare Part B, which is substantially less than thecurrent level of reimbursement for XOPENEX Inhalation Solution. We estimatethat approximately 25 to 30 percent of our XOPENEX Inhalation Solution units soldare subject to reimbursement under Medicare Part B. If this local coveragedetermination is implemented, our sales of XOPENEX Inhalation Solution would bematerially adversely affected.

Some states have adopted preferred drug lists, orPDLs, for their Medicaid programs and more states may adopt this practice.Medicaid PDLs indicate which drugs a provider is permitted under the Medicaidprogram to prescribe without first seeking prior authorization from the stateMedicaid agency. If our drugs are not included on Medicaid PDLs, use of ourdrugs in the Medicaid program may be adversely affected. In some states thathave adopted PDLs, we have been, and may continue to be, required to providesubstantial supplemental rebates to state Medicaid authorities in order for ourdrugs to be included on the PDL.

If reimbursement for ourmarketed products changes adversely or if we fail to obtain adequatereimbursement for our other current or future products, health care providersmay limit how much or under what circumstances they will prescribe oradminister them, which could reduce use of our products or cause us to reducethe price of our products.

**We will spend considerable time and money complyingwith Federal and state laws and regulations and, if we are unable to fullycomply with such laws and regulations, we could face substantial penalties.**

We are subject toextensive regulation by Federal and state governments. The laws that directlyor indirectly affect our business include, but are not limited to, thefollowing:

·       Federal Medicare andMedicaid Anti-Kickback laws, which prohibit persons from knowingly andwillfully soliciting, offering, receiving or providing remuneration, directlyor indirectly, in cash or in 

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kind, to induce eitherreferral of an individual, or furnishing or arranging for a good or service,for which payment may be made under Federal health care programs such as theMedicare and Medicaid programs;

·       other Medicare laws andregulations that establish requirements for coverage and payment for our products,including the amount of such payments;

·       the Federal False ClaimsAct, which imposes civil and criminal liability on individuals and entities whosubmit, or cause to be submitted, false or fraudulent claims for payment to thegovernment;

·       the Federal HealthInsurance Portability and Accountability Act of 1996, or HIPAA, which prohibitsexecuting a scheme to defraud any health care benefit program, includingprivate payors and, further, requires us to comply with standards regardingprivacy and security of individually identifiable health information andconduct certain electronic transactions using standardized code sets;

·       the Federal FalseStatements Statute, which prohibits knowingly and willfully falsifying,concealing or covering up a material fact or making any materially falsestatement in connection with the delivery of or payment for health carebenefits, items or services;

·       the Federal Food, Drug andCosmetic Act, which regulates manufacturing, labeling, marketing, distributionand sale of prescription drugs and medical devices;

·       the Controlled SubstancesAct, which regulates handling of controlled substances such as LUNESTA;

·       state and foreign lawequivalents of the foregoing;

·       state food and drug laws,pharmacy acts and state pharmacy board regulations, which govern sale,distribution, use, administration and prescribing of prescription drugs; and

·       state laws that prohibitpractice of medicine by non-physicians and fee-splitting arrangements betweenphysicians and non-physicians, as well as state law equivalents to the FederalMedicare and Medicaid Anti-Kickback Laws, which may not be limited togovernment reimbursed items or services.

If our past or presentoperations are found to be in violation of any of the laws described above orother governmental regulations to which we or our customers are subject, we maybe subject to the applicable penalty associated with the violation, includingcivil and criminal penalties, damages, fines, exclusion from Medicare andMedicaid programs and curtailment or restructuring of our operations.Similarly, if our customers are found non-compliant with applicable laws, theymay be subject to sanctions, which could also have a negative impact on us. Inaddition, if we are required to obtain permits or licenses under these lawsthat we do not already possess, we may become subject to substantial additionalregulation or incur significant expense. Any penalties, damages, fines,curtailment or restructuring of our operations would adversely affect ourability to operate our business and our financial results. The risk of ourbeing found in violation of these laws is increased by the fact that many ofthem have not been fully interpreted by the regulatory authorities or thecourts and their provisions are open to a variety of interpretations. Anyaction against us for violation of these laws, even if we successfully defendagainst it, could cause us to incur significant legal expenses, divert ourmanagement’s attention from operating our business and damage our reputation.

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**If our Medicaid rebate program practices areinvestigated, the costs could be substantial and could divert the attention ofmanagement.**

We are a participant inthe Medicaid rebate program established by the Omnibus Budget ReconciliationAct of 1990. Under the Medicaid rebate program, we pay a rebate for each unitof our product reimbursed by Medicaid. The amount of the rebate for eachproduct is set by law. We are also required to pay certain statutorily definedrebates on Medicaid purchases for reimbursement on prescription drugs understate Medicaid plans. Both the Federal government and state governments haveinitiated investigations into the rebate practices of many pharmaceuticalcompanies to ensure compliance with these rebate programs. Any investigation ofour rebate practices could be costly, could divert the attention of ourmanagement from our core business and could damage our reputation.

**The approval ofsale of certain medications without a prescription may adversely affect ourbusiness.**

In May 2001, anadvisory panel to the FDA recommended that the FDA allow certain popularallergy medications to be sold without a prescription. In November 2002,the FDA approved CLARITIN®, an allergy medication, to be sold without aprescription. In the future, the FDA may also allow sale of other allergymedications without a prescription. The sale of CLARITIN and /or, if allowed,the sale of other allergy medications without a prescription, may have amaterial adverse effect on our business because the market for prescriptiondrugs, including CLARINEX, for which we receive royalties on sales, has beenand may continue to be adversely affected.

**Risks Related toOur Intellectual Property**

**If we fail to adequately protect or enforce ourintellectual property rights, then we could lose revenue under our licensingagreements or lose sales to generic copies of our products.**

Our success depends in part on our ability to obtain,maintain and enforce patents, and protect trade secrets. Our ability tocommercialize any drug successfully will largely depend upon our ability toobtain and maintain patents of sufficient scope to prevent third parties fromdeveloping substantially equivalent products. In the absence of patent andtrade secret protection, competitors may adversely affect our business byindependently developing and marketing substantially equivalent products. It isalso possible that we could incur substantial costs if we are required to initiatelitigation against others to protect or enforce our intellectual propertyrights.

We have filed patent applications covering compositionof, methods of making, and/or methods of using our drugs and drug candidates.Our revenues under collaboration agreements with pharmaceutical companiesdepend in part on the existence and scope of issued patents. We may not beissued patents based on patent applications already filed or that we file inthe future and if patents are issued, they may be insufficient in scope tocover the products licensed under these collaboration agreements. Generally, wedo not receive royalty revenue from sales of products licensed undercollaboration agreements in countries where we do not have a patent for suchproducts. The issuance of a patent in one country does not ensure the issuanceof a patent in any other country. Furthermore, the patent position of companiesin the pharmaceutical industry generally involves complex legal and factualquestions, and has been and remains the subject of much litigation. Legalstandards relating to scope and validity of patent claims are evolving. Anypatents we have obtained, or obtain in the future, may be challenged,invalidated or circumvented. Moreover, the United States Patent and TrademarkOffice may commence interference proceedings involving our patents or patentapplications. Any challenge to, or invalidation or circumvention of, ourpatents or patent applications would be costly, would require significant timeand attention of our management and could have a material adverse effect on ourbusiness.

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The FDA has received ANDAsfrom Breath Limited, Dey, L.P. and Watson Laboratories, Inc. seekingmarketing approval for generic copies of our XOPENEX brand levalbuterol HClInhalation Solution products. These submissions include Paragraph IVcertifications alleging that our patents listed in the Orange Book for XOPENEXInhalation Solution are invalid, unenforceable or not infringed by thesubmitter’s proposed product. We have filed civil actions against BreathLimited and Dey, L.P. for patent infringement.

Should  we successfully enforce our patents, the FDAwill not approve the ANDA until expiration of the applicable patents.Otherwise, the FDA will stay its approval of the relevant ANDA until30 months following the date we received notice of such ANDA or until acourt decides that our patents are invalid, unenforceable or not infringed,whichever is earlier. Patent litigation involves complex legal and factualquestions. We can provide no assurance concerning the outcome or the durationof the lawsuits. Any conclusion of these matters in a manner adverse to uswould have a material adverse effect on our financial condition and business.If we are not successful in enforcing our patents, we will not be able toprevent the generic company, for the full term of our patents, from marketingtheir generic version of XOPENEX Inhalation Solution. Introduction of a genericcopy of XOPENEX Inhalation Solution before the expiration of our patents wouldhave a material adverse effect on our business.

In June 2006, we werenotified that Teva Pharmaceutical Industries Limited and Teva UK Limited havefiled a claim naming us as defendant in the United Kingdom’s High Court ofJustice, Chancery Division, Patents Court. The claim alleges that our twopatents relating to fexofenandine, which we have licensed to sanofi-aventis inconnection with its sale of ALLEGRA, are invalid, and seeks to have theminvalidated. Sanofi-aventis is defending this action. If patent-basedexclusivity for ALLEGRA is lost in the United Kingdom or in any otherjurisdiction where a similar action is brought our rights to receive royaltyrevenue in any such jurisdiction will terminate.

The costs to us of theseproceedings, even if resolved in our favor, could be substantial. Suchlitigation could also substantially divert the attention of our management andother key personnel from our core business and our resources in general.Uncertainties resulting from the initiation and continuation of any litigationor other proceedings could harm our ability to compete in the marketplace.

In August 2006, we werenotified that several ANDA’s containing Paragraph IV certifications had beenreceived by the FDA seeking approval of generic versions of certain ofSchering-Plough Corporation’s, or Schering-Plough’s,  CLARINEX products.  If and while a generic version of a CLARINEXproduct is marketed in the U.S. without Schering-Plough’s consent,Schering-Plough will have no obligation to pay royalties to us on the U.S. salesof CLARINEX products.

**If weface a claim of intellectual property infringement by a third party, then wecould be liable forsignificant damages or be prevented from commercializing our products.**

Our success depends inpart on our ability to operate without infringing upon proprietary rights ofothers, including patent and trademark rights. Third parties, typically drugcompanies, hold patents or patent applications covering compositions, methodsof making and uses, covering the composition of matter for some of the drugcandidates for which we have patents or patent applications. Third parties alsohold patents relating to drug delivery technology that may be necessary fordevelopment or commercialization of some of our drug candidates. In each ofthese cases, unless we have or obtain a license agreement, we generally may notcommercialize the drug candidates until these third-party patents expireor are declared invalid or unenforceable by the courts. Licenses may not beavailable to us on acceptable terms, if at all. In addition, it would be costlyfor us to contest validity of a third-party patent or defend any claimthat we infringe a third-party patent. Moreover, litigation involvingthird-party patents may not be resolved in our favor. Such contests andlitigation would be costly, would require significant time and attention of ourmanagement, could prevent us from commercializing our products, could require 

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us topay significant damages and could have a material adverse effect on ourbusiness. If any of our trademarks, or our use of any of our trademarks on ourproducts, is challenged, we may be forced to rename the affected product orproduct candidate, which could be costly and time consuming, and would resultin the loss of any brand equity associated with the product name.

In September 2006,Tharos Laboratories, Inc. filed suit against us in the United StatesDistrict Court, District of Utah, Central Division, alleging trademarkinfringement, dilution, unfair competition, false advertising, and falsedesignation of origin arising out of our use of our silk moth design inconnection with LUNESTA. Tharos seeks unspecified monetary damages and aninjunction of our use of the silk moth design. In October 2006, we filed amotion to dismiss Tharos’ claims. We are unable to reasonably estimate anypossible range of loss related to this lawsuit due to its uncertain resolution.

**Risks Related to Our Dependence on Third Parties**

**Ifany third-party collaborator is not successful in development of ourproduct candidates, we may not realize the potential commercial benefits of thearrangement and our results of operations could be adversely affected.**

We have entered into acollaboration agreement with 3M for the scale-up and manufacturing of XOPENEXHFA and we may enter into additional collaboration agreements in the future.Under our agreement with 3M, 3M is responsible for manufacturing an MDIformulation of XOPENEX. We commercially introduced XOPENEX HFA in December 2005.If 3M, or any future development or commercialization collaborator, does notdevote sufficient time and resources to its collaboration arrangement with us,breaches or terminates its agreement with us, fails to perform its obligationto us in a timely manner or is unsuccessful in its development and/orcommercialization efforts, we may not realize the potential commercial benefitsof the arrangement and our results of operations may be adversely affected. Inaddition, if regulatory approval or commercialization of any product candidateunder development by or in collaboration with a partner is delayed or limited,we may not realize, or may be delayed in realizing, the potential commercialbenefits of the arrangement.

**Theroyalties we receive under licensing arrangements could be delayed, reduced orterminated if ourlicensing partners terminate, or fail to perform their obligations under, theiragreements with us, or if our licensing partners are unsuccessful in theirsales efforts.**

We have entered intolicensing arrangements pursuant to which we license patents to pharmaceuticalcompanies and our revenues under these licensing arrangements consist primarilyof royalties on sales of products. Payments and royalties under thesearrangements depend in large part on the commercialization efforts of ourlicensing partners in countries where we hold patents, including sales effortsand enforcement of patents, which we cannot control. If any of our licensingpartners does not devote sufficient time and resources to its licensingarrangement with us or focuses its efforts in countries where we do not holdpatents, we may not realize the potential commercial benefits of thearrangement, our revenues under these arrangements may be less than anticipatedand our results of operations may be adversely affected. If any of ourlicensing partners was to breach or terminate its agreement with us or fail toperform its obligations to us in a timely manner, the royalties we receiveunder the licensing agreement could decrease or cease. If we are unable or failto perform, or breach in our performance of, our obligations under a licensingagreement, the royalties and benefits to which we are otherwise entitled underthe agreement could be reduced or eliminated. Any delay or termination of thistype could have a material adverse effect on our financial condition and resultsof operations because we may lose technology rights and milestone or royaltypayments from licensing partners and/or revenues from product sales, if any,could be delayed, reduced or terminated.

In June 2006, we werenotified that Teva Pharmaceutical Industries Limited and Teva UK Limited havefiled a claim naming us as defendant in the United Kingdom’s High Court ofJustice, Chancery 

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Division,Patents Court. The claim alleges that our two patents relating tofexofenandine, which we have licensed to sanofi-aventis in connection with itssale of ALLEGRA, are invalid, and seeks to have them invalidated. Sanofi-aventisis defending this action. If patent-based exclusivity for ALLEGRA is lost inthe United Kingdom or in any other jurisdiction where a similar action isbrought our rights to receive royalty revenue in any such jurisdiction willterminate.

In August 2006, we werenotified that several ANDA’s containing Paragraph IV certifications had beenreceived by the FDA seeking approval of generic versions of certain ofSchering-Plough Corporation’s, or Schering-Plough’s,  CLARINEX products.  If and while a generic version of a CLARINEXproduct is marketed in the U.S. without Schering-Plough’s consent,Schering-Plough will have no obligation to pay royalties to us on the U.S. salesof CLARINEX products.

**Werely on third-party manufacturers, and this reliance could adverselyaffect our ability to meet ourcustomers’ demands.**

Wecurrently operate a manufacturing plant that we believe can meet our commercialrequirements of the active pharmaceutical ingredient for XOPENEX InhalationSolution and XOPENEX HFA, partially fulfill our commercial requirements of theactive pharmaceutical ingredient for LUNESTA, and support production of ourproduct candidates in amounts needed for our clinical trials. We do not,however, have the capability to manufacture at our manufacturing facility allof our requirements for the active ingredients of our currently approvedproducts, and we have no facilities for manufacturing pharmaceutical dosageforms or finished drug products. Developing and obtaining this capability wouldbe time consuming and expensive. Unless and until we develop this capability,we will rely substantially, and in some cases, entirely, on third-partymanufacturers. Cardinal Health, Inc. is currently the sole finished goodsmanufacturer of our XOPENEX Inhalation Solution, Patheon Inc. is the solemanufacturer of LUNESTA and 3M is the sole manufacturer and supplier of XOPENEXHFA. Certain components of XOPENEX HFA are available from only a single source.If Cardinal Health, Patheon, 3M, or any of our sole-source component suppliersexperiences delays or difficulties in producing, packaging or deliveringXOPENEX Inhalation Solution, LUNESTA, or XOPENEX HFA, as the case may be, wecould be unable to meet our customers’ demands for such products, which couldlead to customer dissatisfaction and damage to our reputation. Furthermore, ifwe are required to change manufacturers, we will be required to verify that thenew manufacturer maintains facilities and procedures that comply with qualitystandards and with all applicable regulations and guidelines, including FDAguidelines. The delays associated with the verification of a new manufacturerfor XOPENEX Inhalation Solution, LUNESTA or XOPENEX HFA could negatively affectour ability to produce such products in a timely manner or within budget.

3M owns certainproprietary technology required to manufacture our XOPENEX HFA. If 3M is unableor unwilling to fulfill its obligations to us under our agreement, we may beunable to manufacture XOPENEX HFA on terms that are acceptable to us, if atall. Our other current contract manufacturers, as well as any future contractmanufacturers, may also independently own technology related to manufacturingof our products. If so, we would be heavily dependent on such manufacturer andsuch manufacturer could require us to obtain a license in order to have anotherparty manufacture our products.

**Risks Related to Growth of Our Business**

**If wefail to acquire and develop additional product candidates or approved products,our ability to grow willbe impaired.**

We are currentlycommercializing three products and expect to begin commercializing a fourthproduct during the second quarter of 2007. However, all of our productcandidates are in the early stages of development. In order to increase thelikelihood that we will be able to successfully develop and/or 

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commercializeadditional drugs, we intend to acquire and develop additional product candidatesand /or approved products. The success of this growth strategy depends upon ourability to correctly establish criteria for such acquisitions and successfullyidentify, select and acquire product candidates and/or products that meet suchcriteria. We will be required to integrate any acquired product candidates intoour research and development operations and any acquired products into oursales and marketing operations. Managing the development and/orcommercialization of a new product involves numerous financial and operationalrisks, including difficulties allocating resources between existing andacquired assets and attracting and retaining qualified employees to developand/or sell the product.

Any product candidate weacquire may require additional research and development efforts prior tocommercial sale, including extensive pre-clinical and/or clinical testing andapproval by the FDA and corresponding foreign regulatory authorities. Allproduct candidates are prone to the risks of failure inherent in pharmaceuticalproduct development, including the possibility that the product candidate will notbe safe and effective or approved by regulatory authorities.

Inaddition, we cannot assure you that any products that we develop or acquirewill be:

·       manufacturedor produced economically;

·       successfullycommercialized;

·       complementaryto our existing product portfolio; or

·       widelyaccepted in the marketplace.

Proposing, negotiating andimplementing an economically viable acquisition is a lengthy and complexprocess. Other companies, including those with substantially greater financial,marketing and sales resources, may compete with us for the acquisition ofproduct candidates and approved products. We may not be able to acquire therights to additional product candidates and approved products on terms that wefind acceptable, or at all.

**Wemay undertake strategic acquisitions in the future and any difficulties fromintegrating suchacquisitions could adversely affect our stock price, operating results andresults of operations.**

We may acquire additionalbusinesses and products that complement or augment our existing business. Wemay not be able to integrate any acquired business or product successfully oroperate any acquired business profitably. Integrating any newly acquiredbusiness or product could be expensive and time-consuming. Integration effortsoften take a significant amount of time, place a significant strain onmanagerial, operational and financial resources and could prove to be more difficultor expensive than we predict. The diversion of our management’s attention andany delay or difficulties encountered in connection with any futureacquisitions we may consummate could result in the disruption of our on-goingbusiness or inconsistencies in standards, controls, procedures and policiesthat could negatively affect our ability to maintain relationships withcustomers, suppliers, collaborators, employees and others with whom we havebusiness dealings. Moreover, we may need to raise additional funds throughpublic or private debt or equity financing to acquire any businesses orproducts, which may result in dilution for stockholders or the incurrence ofindebtedness.

As part of our efforts toacquire businesses or product candidates or to enter into other significanttransactions, we conduct business, legal and financial due diligence with thegoal of identifying and evaluating material risks involved in the transaction.Despite our efforts, we ultimately may be unsuccessful in ascertaining or evaluatingall such risks and, as a result, might not realize the intended advantages ofthe transaction. If we fail to realize the expected benefits from acquisitionswe may consummate in the future, whether as a result of unidentified risks,integration difficulties, regulatory setbacks and other events, our business,results of operations and financial condition could be adversely affected. Ifwe acquire product candidates, we will also need to make certain assumptionsabout, among other things, development costs, 

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thelikelihood of receiving regulatory approval and the market for such productcandidates. Our assumptions may prove to be incorrect, which could cause us tofail to realize the anticipated benefits of these transactions.

In addition, we will likelyexperience significant charges to earnings in connection with our efforts, ifany, to consummate acquisitions. For transactions that are ultimately notconsummated, these charges may include fees and expenses for investmentbankers, attorneys, accountants and other advisers in connection with ourefforts. Even if our efforts are successful, we may incur as part of atransaction substantial charges for closure costs associated with eliminationof duplicate operations and facilities and acquired in-process research anddevelopment charges. In either case, the incurrence of these charges couldadversely affect our results of operations for particular quarterly or annualperiods.

**Developmentand commercialization of our product candidates could be delayed or terminatedif we are unable to enter into collaboration agreements in the future or if anyfuture collaboration agreement is subject to lengthy government review.**

Developmentand commercialization of some of our product candidates may depend on our abilityto enter into additional collaboration agreements with pharmaceutical companiesto fund all or part of the costs of development and commercialization of theseproduct candidates. We may not be able to enter into collaboration agreementsand the terms of the collaboration agreements, if any, may not be favorable tous. Inability to enter into collaboration agreements could delay or precludedevelopment, manufacture and/or marketing of some of our drugs and could have amaterial adverse effect on our financial condition and results of operationsbecause:

·       wemay be required to expend additional funds to advance the drugs tocommercialization;

·       revenuefrom product sales could be delayed; or

·       wemay elect not to commercialize the drugs.

We are required tofile a notice under the Hart-Scott-Rodino Antitrust Improvements Actof 1976, as amended, which we refer to as the HSR Act, for certain agreementscontaining exclusive license grants and to delay the effectiveness of any suchexclusive license until expiration or earlier termination of the notice and waitingperiod under the HSR Act. If expiration or termination of the notice andwaiting period under the HSR Act is delayed because of lengthy governmentreview, or if the Federal Trade Commission or Department of Justicesuccessfully challenges such a license, development and commercialization couldbe delayed or precluded and our business could be adversely affected.

**ITEMS 2-5.**                              NONE

**ITEM 6.**                EXHIBITS

| 31.1 |   | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a)/Rule 15d-14(a) of the Securities  Exchange Act of 1934, as amended.        |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a)/Rule 15d-14(a) of the Securities  Exchange Act of 1934, as amended.        |
| 32.1 |   | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2 |   | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

|                              | ** ** | **SEPRACOR INC.** |
|------------------------------|------------|-------------------|
| Date: November 9,  2006 |       | By:               |   | /s/  TIMOTHY J. BARBERICH |
|                         |       |              |   | Timothy J.  Barberich |
|                         | * *   | * *          | * * | *Chairman  and Chief Executive Officer (Principal Executive Officer)* |
| Date: November 9,  2006 |       | By:               |   | /s/  ROBERT F. SCUMACI |
|                         |       |              |   | Robert F. Scumaci |
|                         | * *   | * *          | * * | *Executive  Vice President, Finance and Administration, and Treasurer  (Principal Accounting Officer)* |

 

 

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**Exhibit Index**

| Exhibit No. | ** ** | **Description**                                                                                                                                                |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1             |       | Certification of Chief Executive Officer pursuant to  Rule 13a-14(a)/Rule 15d-14(a) of the Securities  Exchange Act of 1934, as amended.        |
| 31.2             |       | Certification of Chief Financial Officer pursuant to  Rule 13a-14(a)/Rule 15d-14(a) of the Securities  Exchange Act of 1934, as amended.        |
| 32.1             |       | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2             |       | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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