**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

**(Mark One)**

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

 

**Forthe Quarterly Period Ended March 31, 2006**

**or**

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

 

**For the 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 telephonenumber, including area code: **(508) 481-6700**

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Indicate by check markwhether the registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports) and (2) has been subject to such filing requirementsfor the past 90 days. Yes x  No o

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

Large accelerated file x    Accelerated filer o    Non-acceleratedfiler o

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

Thenumber of shares outstanding of the registrant’s class of Common Stock as of May 1,2006 was: 108,749,416 shares.

 

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**SEPRACOR INC.**

**INDEX**

| **Part I—Financial Information** |                                                                                                                 |
|--------------------------------------------|----------------------------------------------------------------------------------------------------------------------|
| Item 1.                                    | Condensed Consolidated Financial Statements  (Unaudited)                                                             |   |
|                                       | Consolidated  Balance Sheets as of March 31, 2006 and December 31, 2005  (Unaudited)                       | 3 |
|                                       | Consolidated Statements of Operations for the Three  Months Ended  March 31, 2006 and 2005 (Unaudited)     | 4 |
|                                       | Consolidated Statements of Cash Flows for the Three  Months Ended March 31, 2006 and 2005 (Unaudited) | 5 |
|                                       | Notes to Condensed Consolidated Interim Financial  Statements                                                        | 6 |
| Item 2.                                    | Management’s Discussion and Analysis of Financial  Condition and Results  of Operations                         | 14 |
| Item 3.                                    | Quantitative and Qualitative Disclosures About Market  Risk                                                          | 25 |
| Item  4.                                   | Controls  and Procedures                                                                                             | 25 |
| **Part II—Other Information**    |                                                                                                                 |
| Item 1.                                    | Legal Proceedings                                                                                                    | 26 |
| Item 1A.                                   | Risk Factors                                                                                                         | 26 |
| Item 6.                                    | Exhibits                                                                                                             | 42 |
|                                       | Signatures                                                                                                           | 43 |
|                                       | Exhibit Index                                                                                                   | 44 |

 

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**SEPRACOR INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

**(InThousands)**

| ** **                                                                                                                                                                                                                                                             | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                                                                                             |       |                     |       |                        |       |
| Current assets:                                                                                                                                                                                                                                                        |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                                                              |       | $                        | 119,335    |                        | $          | 178,144 |   |
| Short-term investments                                                                                                                                                                                                                                                 |       | 685,697                  |       | 666,615                     |       |
| Accounts receivable, net                                                                                                                                                                                                                                               |       | 150,602                  |       | 140,465                     |       |
| Inventories                                                                                                                                                                                                                                                            |       | 42,779                   |       | 38,951                      |       |
| Other assets                                                                                                                                                                                                                                                           |       | 33,355                   |       | 22,370                      |       |
| Total current  assets                                                                                                                                                                                                                                                  |       | 1,031,768                |       | 1,046,545                   |       |
| Long-term investments                                                                                                                                                                                                                                                  |       | 155,169                  |       | 131,442                     |       |
| Property and equipment, net                                                                                                                                                                                                                                            |       | 74,667                   |       | 72,467                      |       |
| Investment in affiliate                                                                                                                                                                                                                                                |       | 5,460                    |       | 5,829                       |       |
| Deferred financing costs and patents, net                                                                                                                                                                                                                              |       | 16,606                   |       | 18,097                      |       |
| Other assets                                                                                                                                                                                                                                                           |       | 117                      |       | 117                         |       |
| Total assets                                                                                                                                                                                                                                                           |       | $                        | 1,283,787  |                        | $          | 1,274,497 |   |
| **Liabilities  and Stockholders’ Equity (Deficit)**                                                                                                                                                                                                               | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                   |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                       |       | $                        | 26,685     |                        | $          | 11,544 |   |
| Accrued expenses                                                                                                                                                                                                                                                       |       | 116,218                  |       | 187,409                     |       |
| Current portion of notes payable and capital lease  obligation                                                                                                                                                                                                         |       | 1,539                    |       | 2,030                       |       |
| Other current liabilities                                                                                                                                                                                                                                              |       | 105,014                  |       | 76,923                      |       |
| Total current  liabilities                                                                                                                                                                                                                                             |       | 249,456                  |       | 277,906                     |       |
| Notes payable and capital lease obligation                                                                                                                                                                                                                             |       | 1,164                    |       | 1,260                       |       |
| Convertible subordinated debt                                                                                                                                                                                                                                          |       | 1,160,820                |       | 1,160,820                   |       |
| Total liabilities                                                                                                                                                                                                                                                      |       | 1,411,440                |       | 1,439,986                   |       |
| Stockholders’  equity (deficit):                                                                                                                                                                                                                                  |       |                     |       |                        |       |
| Preferred stock, $1.00 par value, 1,000 shares  authorized; none outstanding at March 31, 2006 and December 31,  2005                                                                                                                                        |       | —                   |       | —                      |       |
| Common stock, $.10 par value, 240,000 shares  authorized at March 31, 2006 and December 31, 2005, respectively;  108,729 and 108,354 shares issued, 104,468 and 104,093 shares outstanding, at  March 31, 2006 and December 31, 2005, respectively |       | 10,873                   |       | 10,835                      |       |
| Treasury stock, at cost (4,261 and 4,261 shares at  March 31, 2006 and December 31, 2005, respectively)                                                                                                                                                 |       | (232,028                 | )          | (232,028                    | )          |
| Additional paid-in capital                                                                                                                                                                                                                                             |       | 1,686,315                |       | 1,669,541                   |       |
| Accumulated deficit                                                                                                                                                                                                                                                    |       | (1,610,256               | )          | (1,620,515                  | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                 |       | 17,443                   |       | 6,678                       |       |
| Total  stockholders’ equity (deficit)                                                                                                                                                                                                                             |       | (127,653                 | )          | (165,489                    | )          |
| Total liabilities and  stockholders’ equity (deficit)                                                                                                                                                                                                             |       | $                        | 1,283,787  |                        | $          | 1,274,497 |   |

 

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

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**SEPRACOR INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

**(InThousands, Except Per Share Amounts)**

| ** **                                                                      | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                      | ** ** | **March 31,  2006**         | ** ** | **March 31,   2005** | ** ** |
| Revenues:                                                                       |       |                             |       |   |   |
| Product sales                                                                   |       | $                                | 277,505    |   | $ | 106,648 |   |
| Royalties                                                                       |       | 8,173                            |       | 12,397 |   |
| Total revenues                                                                  |       | 285,678                          |       | 119,045 |   |
| Costs and expenses:                                                             |       |                             |       |   |   |
| Cost of product sold                                                            |       | 25,533                           |       | 10,037 |   |
| Cost of royalties                                                               |       | 159                              |       | 203 |   |
| Research and development                                                        |       | 49,269                           |       | 28,569 |   |
| Selling, marketing and distribution                                             |       | 189,961                          |       | 93,172 |   |
| General and administrative                                                      |       | 14,315                           |       | 8,481 |   |
| Total costs and expenses                                                        |       | 279,237                          |       | 140,462 |   |
| Income (loss) from operations                                                   |       | 6,441                            |       | (21,417 | ) |
| Other income (expense):                                                         |       |                             |       |   |   |
| Interest income                                                                 |       | 9,794                            |       | 5,248 |   |
| Interest expense                                                                |       | (5,551                           | )          | (5,842 | ) |
| Equity in investee losses                                                       |       | (258                             | )          | (168 | ) |
| Other expense                                                                   |       | (56                              | )          | (394 | ) |
| Income (loss) before income taxes                                               |       | 10,370                           |       | (22,573 | ) |
| Income taxes                                                                    |       | 111                              |       | — |   |
| Net income (loss) after income taxes                                            |       | $                                | 10,259     |   | $ | (22,573 | ) |
| Basic net income (loss) per common share                                        |       | $                                | 0.10       |   | $ | (0.22 | ) |
| Diluted net income (loss) per common share                                      |       | $                                | 0.09       |   | $ | (0.22 | ) |
| Shares used in computing  basic and diluted net income (loss) per common share: |       |                             |       |   |   |
| Basic                                                                           |       | 104,292                          |       | 103,593 |   |
| Diluted                                                                         |       | 115,470                          |       | 103,593 |   |

 

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

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**SEPRACOR INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(In Thousands)**

| ** **                                                                            | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                            | ** ** | **March 31,  2006**         | ** ** | **March 31,  2005** | ** ** |
| Cash flows from  operating activities:                                                |       |                             |       |   |   |
| Net income (loss)                                                                     |       | $                                | 10,259     |   | $ | (22,573 | ) |
| Adjustments to reconcile  net income (loss) to net cash used in operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                                         |       | 4,968                            |       | 4,256 |   |
| Equity in investee losses                                                             |       | 258                              |       | 168 |   |
| Stock compensation                                                                    |       | 9,825                            |       | — |   |
| Changes in operating  assets and liabilities:                                         |       |                             |       |   |   |
| Accounts receivable                                                                   |       | (10,137                          | )          | 6,657 |   |
| Inventories                                                                           |       | (3,836                           | )          | (2,888 | ) |
| Other current assets                                                                  |       | (10,976                          | )          | (2,537 | ) |
| Accounts payable                                                                      |       | 15,138                           |       | (1,095 | ) |
| Accrued expenses                                                                      |       | (71,196                          | )          | (40,389 | ) |
| Other current liabilities                                                             |       | 28,130                           |       | (2,850 | ) |
| Net cash used in  operating activities                                                |       | (27,567                          | )          | (61,251 | ) |
| Cash flows from  investing activities:                                                |       |                             |       |   |   |
| Purchases of short and long-term investments                                          |       | (333,674                         | )          | (278,090 | ) |
| Sales and maturities of short and long-term  investments                              |       | 310,825                          |       | 84,881 |   |
| Additions to property and equipment                                                   |       | (5,833                           | )          | (2,636 | ) |
| Investment in non-affiliate                                                           |       | (8,939                           | )          | (7,143 | ) |
| Net cash used in  investing activities                                                |       | (37,621                          | )          | (202,988 | ) |
| Cash flows from  financing activities:                                                |       |                             |       |   |   |
| Net proceeds from issuance of common stock                                            |       | 6,987                            |       | 4,074 |   |
| Repayments of long-term debt and capital  leases                                      |       | (588                             | )          | (463 | ) |
| Net cash provided  by financing activities                                            |       | 6,399                            |       | 3,611 |   |
| Effect of  exchange rate changes on cash and cash equivalents                         |       | (20                              | )          | (15 | ) |
| Net decrease in  cash and cash equivalents                                            |       | (58,809                          | )          | (260,643 | ) |
| Cash and cash  equivalents at beginning of period                                     |       | $                                | 178,144    |   | $ | 435,905 |   |
| Cash and cash  equivalents at end of period                                           |       | $                                | 119,335    |   | $ | 175,262 |   |

 

 

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

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**NOTES TO CONDENSEDCONSOLIDATED INTERIM FINANCIAL STATEMENTS**

**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 year-end consolidated balancesheet data was derived from audited financial statements but does not include alldisclosures required by generally accepted accounting principles. Theconsolidated interim financial statements, in the opinion of our management,reflect all adjustments (consisting of normal recurring accruals) necessary fora fair presentation of the results for the interim periods ended March 31,2006 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 inour annual report on Form 10-K 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 December 2004, theFinancial Accounting Standards Board, or FASB, issued Statement of FinancialAccounting Standards, or SFAS, No. 123(R) (revised 2004), “Share-Based Payment”. SFAS 123(R) isa revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”, supersedesAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, and amends FASBStatement No. 95, “Statement ofCash Flows”. SFAS 123(R) requires all share-based payments toemployees, including grants of employee stock options and stock purchases underemployee stock purchase plans, to be recognized in the financial statementsbased on their fair values. We adopted SFAS 123(R) using the modifiedprospective method during the quarter ended March 31, 2006. As noted infootnote 4 below, the adoption of SFAS 123(R) had a material impact on ourcondensed consolidated statements of operations and net income per share.

**3.**   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 periodending March 31, 2005 because 

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including them would beanti-dilutive. There were no outstanding purchased call options as of March 31,2006.

For the three months ended March 31, 2006, basicand diluted net income per common share is computed based on the weighted-averagenumber of common shares outstanding during the period; however, diluted netincome for that period also includes the dilutive effect of potential common shares.For the three months ended March 31, 2005 basic and diluted net loss percommon share is computed based on the weighted-average number of commonshares outstanding during the period because the effect of potential commonshares would be anti-dilutive. Certain securities were not included in thecomputation of diluted earnings per share because they would have ananti-dilutive effect due to exercise price or net losses for such periods.These securities include the following:

a.   Optionsto purchase shares of common stock:

| ** **            | ** ** | **March 31, 2006**                                                  | ** **      | **March 31, 2005** | ** ** |
|-----------------------|------------|-------------------------------------------------------------------------------|-----------------|------------------------------|------------|
| ** **            | ** ** | **(in thousands, except price per share data)** | ** **      |
| Number of options     |       | 7,853                                                                         |            | 13,048                       |       |
| Price range per share |       | $                                                                             | 44.15 to $87.50 |                         | $          | 5.00 to $87.50 |   |
|                       |            |                                                                               |                 |                              |            |  |  |

 

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

| ** **                                                            | ** ** | **March 31,  2006** | ** ** | **March 31,  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 March 31,2006 and 2005 or at any time during the three months ended March 31, 2006and 2005. Once these notes become convertible, shares of common stock will bereserved under the conversion formula for issuance upon conversion if and whenour common stock price exceeds $67.20 per share on the Nasdaq National Market.Prior to such occurrence, the notes are only convertible into cash.

**4.**   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), stock-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 Form 10-Q have not been restated toreflect the fair value method of expensing stock-based compensation.

Our stock option plans were adopted in 1997, 1999,2000 and 2002 (“option plans”). Options granted under the option plans aregenerally non-qualified stock options but the option plans permit some optionsgranted to qualify as “incentive stock options” under the U.S. Internal RevenueCode. The exercise price of a stock option generally is equal to the fairmarket value of our common stock on the option grant date. The contractual termof options granted is generally 10 years.

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Under the option plans, in addition to options, wegranted certain employees restricted stock awards. Restricted stock awards arenon-vested stock awards. Restricted stock awards are independent of option grantsand are subject to forfeiture if employment terminates prior to the release ofthe restrictions. Such awards generally vest annually over a two to five yearperiod from the date of grant. Ownership of restricted stock typically cannotbe transferred until the shares have vested. In connection with restrictedstock grants, we record compensation expense based on the fair value of the sharesgranted. This stock compensation is being amortized on a straight-line basisover the vesting periods.

The 1998 Employee Stock Purchase Plan, or 1998 ESPP,permits an aggregate of 900,000 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.

As required by SFAS 123(R), management has made anestimate of expected forfeitures and is recognizing compensation costs only forthose equity awards expected to vest.

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

| ** **                           | ** ** | **Three Months Ended  March 31, 2006** | ** ** |
|--------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                                    | ** ** |
| Cost of products  sold               |       |                                                       | $          | 134 |   |   |
| Research and  development            |       |                                                       | 2,425      |   |   |
| Selling,  marketing and distribution |       |                                                       | 3,274      |   |   |
| General and  administrative          |       |                                                       | 3,992      |   |   |
| Stock-based compensation  expense    |       |                                                       | $          | 9,825 |   |   |

 

As a result of adopting SFAS 123(R), our netincome for the quarter ended March 31, 2006, is $9,825,000 less than if wehad continued to account for stock-based compensation under APB 25. Basicand diluted income per share for the quarter ended March 31, 2006 were alsoless by $0.09 and $0.08, respectively, due to the adoption of SFAS 123(R).

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

| ** **                        | ** ** | **Three Months Ended  March 31, 2006** | ** ** |
|-----------------------------------|------------|------------------------------------------------------------|------------|
| ** **                        | ** ** | **(in thousands)**                                    | ** ** |
| Employee stock  options           |       |                                                       | $          | 9,039 |   |   |
| Restricted shares  .              |       |                                                       | 302        |   |   |
| Employee stock  purchase plan     |       |                                                       | 484        |   |   |
| Stock-based compensation  expense |       |                                                       | $          | 9,825 |   |   |

 

We estimate the fair value of stock options using theBlack-Scholes valuation model. This valuation model takes into account theexercise price of the award, as well as a variety of assumptions. Theseassumptions used to estimate the fair value of stock options include theexpected term, the expected volatility of our stock over the expected term, therisk-free interest rate over the expected term, and our expected annualdividend yield. We believe that the valuation technique and the approachutilized to develop the underlying assumptions are appropriate in calculatingthe fair values of the stock options granted in the three months ended March 31,2006. 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 options granted during the three monthsended March 31, 2006, using the Black-Scholes valuation model were:

| ** **                      | ** ** | **Three Months Ended  March 31, 2006** | ** ** |
|---------------------------------|------------|------------------------------------------------------------|------------|
| ** **                      | ** ** | **Employee Stock  Option Plans**                 | ** ** | **Employee Stock   Purchase Plan** | ** ** |
| Expected term                   |       |                                                       | 5.7 years  |   |   |   | 0.5 years |   |   |
| Expected  volatility factor     |       |                                                       | 28.6       | % |   |   | 28.6 | % |   |
| Risk-free  interest rate        |       |                                                       | 4.6        | % |   |   | 4.3 | % |   |
| 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 threemonths ended March 31, 2005 as if we had applied the fair valuerecognition provisions of SFAS 123 to stock-based employee awards.

| ** **                                                                                     | ** ** | **Three Months Ended  March 31, 2005**                | ** ** |
|------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                                                     | ** ** | **(in thousands, except  price per share data)** | ** ** |
| Net loss as  reported                                                                          |       |                                                                      | $          | (22,573 | ) |   |
| Less: Total  stock-based employee compensation expense determined under the fair value  method |       |                                                                      | (11,853    | ) |   |
| Pro forma net  loss                                                                            |       |                                                                      | $          | (34,426 | ) |   |
| Net loss per  share:                                                                           |       |                                                                      |       |   |   |
| Basic and  Diluted—as reported                                                       |       |                                                                      | $          | (0.22 | ) |   |
| Basic and  Diluted—pro-forma                                                              |       |                                                                      | $          | (0.33 | ) |   |

 

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 set ofassumptions for our valuation model, including the utilization of a forfeiturerate. Assumptions used to determine the fair value of options granted underSFAS 123 during the three months ended March 31, 2005 were:

| ** **               | ** ** | **Three Months Ended March 31, 2005** | ** **     |
|--------------------------|------------|----------------------------------------------------------------|----------------|
| ** **               | ** ** | **Employee Stock   Option Plans**               | ** **     | **1998 Employee Stock   Purchase Plan** | ** ** |
| Expected term            |       |                                                           | 5.0 years |   |   |   | 0.5 years |   |   |
| Volatility               |       |                                                           | 80.0%          |   |   |   | 36.0% |   |   |
| Risk-free  interest rate |       |                                                           | 3.9%           |   |   |   | 2.4% |   |   |
| Dividend yield           |       |                                                           | —         |   |   |   | — |   |   |

 

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

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Asummary of our stock option activity for the three months ended March 31,2006 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                              |       |                                             | 1,393      |                                       |       |                                                                       | $          | 55.54 |   |   |   |   |   |   |
| Exercised                            |       |                                             | (375       | )                                          |       |                                                                       | $          | 18.63 |   |   |   |   |   |   |
| Cancelled                            |       |                                             | (90        | )                                          |       |                                                                       | $          | 43.41 |   |   |   |   |   |   |
| Outstanding,  March 31, 2006    |       |                                             | 11,787     |                                       |       |                                                                       | $          | 35.83 |   |   |   | 6.2 |   |   |
| Exercisable at  March 31, 2006  |       |                                             | 6,475      |                                       |       |                                                                       | $          | 26.80 |   |   |   | 2.9 |   |   |

 

All options granted during the three months ended March 31,2006 and 2005 were granted with exercise prices equal to the fair market valueof our common stock on the grant date and had weighted average grant date fairvalues of $20.50 and $42.85, respectively.

At March 31, 2006, the aggregate intrinsic valueof options outstanding and options exercisable was $201,139,000 and$172,822,000, respectively. The intrinsic value of a stock option is the amountby which the market value of the underlying stock exceeds the exercise price ofthe option.

The aggregate intrinsic value of options exercisedduring the three months ended March 31, 2006 was $13,973,000.

Thefollowing table summarizes the stock options outstanding at March 31,2006:

| ** **                         | ** ** | **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** | ** ** |
| $5.75-  $8.31                      |       |                            | 738        |                                   |       |   | $ | 6.31 |   |   |   | 6.4 |   |   |   | 719 |   |   |   | $ | 6.27 |   |   |
| $11.25-  $16.78                    |       |                            | 2,199      |                                   |       |   | $ | 13.06 |   |   |   | 4.7 |   |   |   | 1,627 |   |   |   | $ | 12.70 |   |   |
| $18.38-  $27.15                    |       |                            | 2,561      |                                   |       |   | $ | 21.25 |   |   |   | 4.8 |   |   |   | 1,840 |   |   |   | $ | 20.60 |   |   |
| $27.70-  $39.07                    |       |                            | 1,098      |                                   |       |   | $ | 34.43 |   |   |   | 4.4 |   |   |   | 966 |   |   |   | $ | 35.30 |   |   |
| $42.38-  $59.45                    |       |                            | 4,032      |                                   |       |   | $ | 52.26 |   |   |   | 8.2 |   |   |   | 1,053 |   |   |   | $ | 53.15 |   |   |
| $64.50-  $87.50                    |       |                            | 1,159      |                                   |       |   | $ | 74.31 |   |   |   | 6.8 |   |   |   | 270 |   |   |   | $ | 75.43 |   |   |
| $5.75-$87.50                       |       |                            | 11,787     |                                   |       |   | $ | 35.83 |   |   |   | 6.2 |   |   |   | 6,475 |   |   |   | $ | 26.80 |   |   |

 

Ournon-vested share activity for the three months ended March 31, 2006 was asfollows:

| ** **                            | ** ** | **Stock Options**                          | ** ** | **Restricted Stock**                                   | ** ** |
|---------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                            | ** ** | **Number of  Shares  (in thousands)** | ** ** | **Weighted  Average  grant date**

**Fair Value** | ** ** | **Number of  Shares  (in thousands)** | ** ** | **Weighted  Average  grant date  Fair Value** | ** ** |
| Non-vested at  December 31, 2005 |       |                                            | 4,563      |                                                        |       |   | $ | 42.38 |   |   |   | — |   |   |   | $ | — |   |   |
| Granted                               |       |                                            | 1,393      |                                                        |       |   | $ | 55.54 |   |   |   | 174 |   |   |   | $ | 55.54 |   |   |
| Vested                                |       |                                            | (554       | )                                                           |       |   | $ | 32.44 |   |   |   | — |   |   |   | — |   |   |
| Forfeited                             |       |                                            | (90        | )                                                           |       |   | $ | 43.40 |   |   |   | — |   |   |   | — |   |   |
| Non-vested at  March 31, 2006    |       |                                            | 5,312      |                                                        |       |   | $ | 46.85 |   |   |   | 174 |   |   |   | $ | 55.54 |   |   |

 

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At March 31, 2006, unrecognized compensationexpense related to non-vested stock options and restricted stock was$111,132,000, and $8,974,000 respectively, which are expected to be recognizedover weighted average periods of 3.75 years and 4.34 years, respectively.

The fair market value ofthe December 1, 2005 offering period of the 1998 ESPP, which concludes on May 31,2006, was determined to be $968,000, or approximately $11.91 per share. Theassociated expense is amortized on a straight-line basis over the offeringperiod. For the three months ended March 31, 2006, we recorded $484,000 ofexpense related to an ongoing ESPP offering period. No offering periodsconcluded during the three months ended March 31, 2006.

**5.**   Inventories

Inventoriesconsist of the following:

| ** **     | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **     | ** ** | **(in thousands)**  | ** ** |
| Raw materials  |       |                     | $          | 23,012                      |       |   |   | $ | 21,780 |   |   |
| Finished goods |       |                     | 19,767     |                        |       |   | 17,171 |   |   |
| Total          |       |                     | $          | 42,779                      |       |   |   | $ | 38,951 |   |   |

 

**6.**   DeferredFinancing and Patents Costs

Thefollowing schedule details the carrying value of our patents and deferredfinancing costs:

| ** **                       | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                       | ** ** | **(in thousands)**  | ** ** |
| Deferred  financing costs, gross |       | $                        | 34,440     |                        |       | $ | 34,440 |   |   |
| Accumulated  amortization        |       | (18,909                  | )          |                        | (17,474    | ) |   |
| Deferred financing  costs, net   |       | $                        | 15,531     |                        |       | $ | 16,966 |   |   |
| Patents, gross                   |       | $                        | 2,785      |                        |       | $ | 2,785 |   |   |
| Accumulated  amortization        |       | (1,710                   | )          |                        | (1,654     | ) |   |
| Patents, net                     |       | $                        | 1,075      |                        |       | $ | 1,131 |   |   |

 

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

| ** **                                | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **March 31,  2006**         | ** ** | **March 31,  2005** | ** ** |
| ** **                                | ** ** | **(in thousands)**          | ** ** |
| Amortization of  deferred financing costs |       |                             | $          | 1,435 |   |   |   | $ | 903 |   |   |
| Amortization of  patents                  |       |                             | 56         |   |   |   | 153 |   |   |
| Total                                     |       |                             | $          | 1,491 |   |   |   | $ | 1,056 |   |   |

 

We currently estimate thatour amortization expense will be $4,482,000,$4,344,000, $3,994,000, $2,861,000 and $729,000 for the remainder of 2006 andfor the years ending December 31, 2007, 2008, 2009 and 2010,respectively.

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**7.**   ConvertibleSubordinated Debt

Convertiblesubordinated debt consists of the following:

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

 

**8.**   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** | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                               | ** ** | **March 31,  2006**         | ** ** | **March 31,  2005** | ** ** |
| ** **                                               | ** ** | **(in thousands)**          | ** ** |
| Comprehensive  income (loss):                            |       |                             |       |   |   |   |   |
| Net income (loss)                                        |       |                             | $          | 10,259 |   |   | $ | (22,573 | ) |
| Net foreign  currency translation adjustment             |       |                             | (41        | ) |   | (82 | ) |
| Unrealized gain  (loss) on available-for-sale securities |       |                             | 10,806     |   |   | (1,485 | ) |
| Total comprehensive  income (loss)                       |       |                             | $          | 21,024 |   |   | $ | (24,140 | ) |

 

**9.**   LegalProceedings

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 Securities Exchange Act of1934, as amended, and the rules and regulations promulgated thereunder by theSecurities and Exchange Commission. 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 are currentlyengaged in discovery. We are unable to reasonably estimate any possible rangeof loss related to the lawsuits due to their uncertain resolution. However, anyconclusion of these matters in a manner adverse to us would have a materialadverse effect on our financial position and results of operations.

In September 2005, we received notification that theFDA 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 

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January 2006 of a secondANDA seeking 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 Dey, L.P. We have filed acivil action against Dey, L.P. for patent infringement. In April 2006, we werenotified of a third ANDA seeking approval of a generic version of our 1.25 mg,0.63 mg and 0.31 mg levalbuterol hydrochloride inhalation solution including aParagraph IV certification, which was submitted to the FDA by WatsonLaboratories, Inc. We have yet to decide whether we will file a civil actionagainst Watson Laboratories, Inc. for patent infringement. 

Should we successfullyenforce our patents, ANDA approval will not occur until the expiration of theapplicable patents. Otherwise, the FDA will stay its approval of the relevantANDA until 30 months following the date we received notice of such ANDA oruntil a court decides that our patents are invalid, unenforceable or notinfringed, whichever is earlier.

**10.   Investmentin ACADIA**

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 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 National Market andresulted in the issuance to us of 813,393 shares of ACADIA common stock. We recordedthe premium 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 in connectionwith the collaboration. Our purchase was made at a price of approximately $9.28per share, which represented a 40 percent premium over the 30-daytrailing average closing price of ACADIA’s common stock on the Nasdaq NationalMarket and resulted in the issuance to us of 1,077,029 shares of ACADIA commonstock. We recorded the premium amount of $2,857,000 as research and developmentexpense and the remaining amount of $7,143,000 as an investment in ACADIA.

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**ITEM 2.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**CautionaryStatement Regarding Forward-Looking Statements**

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, a short-actingbronchodilator, for the treatment or prevention of bronchospasm in patientswith reversible obstructive airway disease; XOPENEX HFAÔ(levalbuterol tartrate) Inhalation Aerosol, a hydrofluoroalkane, or HFA,metered-dose inhaler, or MDI, for the treatment or prevention of bronchospasmin adults, adolescents and children four years of age and older with reversibleobstructive airway disease; and LUNESTAÔ(eszopiclone) for the treatment of insomnia.

We market and sell XOPENEXInhalation Solution, LUNESTA and XOPENEX HFA directly through our sales force. Wehave entered into out-licensing arrangements with respect to several othercompounds. We expect to commercialize products that we successfully developthrough our sales force, through co-promotion agreements and throughout-licensing partnerships.

**Significant 2006Developments**

On February 23, 2006, we announced that we enteredinto a licensing agreement with UCB, relating to levocetirizine, which is an antihistaminebeing developed by UCB. Under this agreement, we have exclusively licensed toUCB all of our patents and patent applications in the U.S. regardinglevocetirizine and royalties will be payable to us on U.S. sales oflevocetirizine products. Under a separate agreement, we currently earnroyalties from UCB on sales of levocetirizine in European countries where theproduct is sold. Levocetirizine is marketed by UCB under the brand names XYZAL®and XUSALÔ in the EuropeanUnion, or E.U., for treatment of symptoms of seasonal and perennial allergicrhinitis, persistent allergic rhinitis, and chronic idiopathic urticaria, orCIU, also known as hives of unknown cause, in adults and children aged6 years and older.

On January 17, 2006, we announced that we hadcompleted the second $10 million purchase of ACADIAPharmaceuticals Inc., or ACADIA, common stock in connection with ourlicense, option and collaboration agreement, or collaboration, with ACADIA thatwe 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 National Marketas of the one-year anniversary of the collaboration, and resulted in theissuance to us, of 813,393 shares of ACADIA common stock.

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On January 12, 2006,we announced that we had been notified that the United States Food and DrugAdministration, or FDA had received an abbreviated new drug application, or ANDA,from Dey, L.P. for a generic version of levalbuterol hydrochloride inhalationsolution. Dey’s submission includes a Paragraph IV certification allegingour patents listed in the FDA publication entitled “Approved Drug Products WithTherapeutic Equivalence Evaluations,” commonly referred to as the “Orange Book,”for XOPENEX Inhalation Solution are invalid, unenforceable or not infringed byDey’s proposed product. On September 7, 2005, we announced that the FDAhad received an ANDA from Breath Limited seeking marketing approval for genericcopies of our 1.25 mg, 0.63 mg and 0.31 mg XOPENEX Inhalation Solution(levalbuterol hydrochloride) unit-dose vial product. XOPENEX InhalationSolution Concentrate is not subject to the ANDA. Breath Limited’s submissionincludes a Paragraph IV certification alleging that our patents listed inthe Orange Book for XOPENEX Inhalation Solution are invalid, unenforceable ornot infringed by Breath Limited’s proposed product. We have filed civil actionsagainst Breath Limited and Dey, L.P. for patent infringement. In April2006, we were notified of a third ANDA seeking approval of a generic version ofour 1.25 mg, 0.63 mg and 0.31 mg levalbuterol hydrochloride inhalation solutionincluding a Paragraph IV certification, which was submitted to the FDA byWatson Laboratories, Inc. We have yet to decide whether we will file a civilaction against Watson Laboratories, Inc. for patent infringement.

Should we successfullyenforce our patents, the FDA will not approve the relevant ANDA untilexpiration of the applicable patents. Otherwise, the FDA will stay its approvalof the relevant ANDA for 30 months following the date we receivednotice of such ANDA or until a court decides that our patents are invalid,unenforceable or not infringed, whichever is earlier.

**Critical AccountingPolicies**

We identified critical accounting policies in ourannual report on Form 10-K 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 Statement ofFinancial Accounting Standards No. 123(R), “Share-Based Payment,” or SFAS123(R), no changes to these critical accounting policies have taken place sinceDecember 31, 2005; however, we have expanded the disclosure of ouraccounting policies relating to product sale allowances and reserves.

***Product SalesAllowances and Reserves:****  *We record product sales net of the followingsignificant categories of product sales allowances: payment term discounts,wholesaler fee for service discounts, government rebates and contractualdiscounts (includes Medicaid discounts, Medicare discounts, managed carediscounts, 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 Term Discounts—*We offer ourwholesaler customers a 2% prompt-pay cash discount as an incentive to remitpayment within the first thirty days after the date of the invoice. Prompt-paydiscount calculations are based on the gross amount of each invoice. We accountfor these discounts by reducing sales by the 2% discount amount when product issold, and apply earned cash discounts at the time of payment. Since we beganselling our products commercially in 1999, our customers have routinely taken 

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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.

2)   *Wholesaler Fee for Service Discounts—*Inthe second quarter of 2005, we entered into letter agreements with certainwholesaler customers that provide these wholesalers with the opportunity toearn discounts in exchange for the performance of certain services. Theseagreements are subject to termination upon thirty days prior written notice.Our effective rate of wholesaler discounts applied across all product sales inthe first quarter of 2006 was approximately 2.5%. If the percentage of grosssales sold to wholesalers with letter agreements increases, our liabilityrelated to wholesaler discounts could increase materially. For example, a 0.5%increase in the effective rate of wholesaler discounts on the first quarter of2006 gross sales from our three marketed products would result in a salesreduction of approximately $1.7 million.

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

*Medicaid Discounts—We***record accruals forrebates to be provided through the Medicaid Drug Rebate Program as a reductionof sales when the product is sold. We rebate individual states for all eligibleunits purchased under the Medicaid program based on a rebate per unitcalculation driven off our Average Manufacturer Price, or AMP. We estimate theexpected rebate per unit to be used and adjust our rebate accruals based onexpected changes in rebate pricing. We also examine the historical rebatetrends and the trend of sales that become eligible for Medicaid programs andany changes expected to these trends. In addition, certain states havesupplemental rebate programs, which provide such states with an additionalrebate. Supplemental rebates, like rebates under the Medicaid Drug RebateProgram, are recorded as a reduction of sales when the product is sold. Rebateamounts are generally invoiced quarterly in arrears and paid thirty days afterthey are invoiced. As a result, our accrual consists of (i) an estimate ofthe amount we expect to be incurred for the current quarter’s prescriptions, (ii) anaccrual for prior quarters’ unpaid rebates and (iii) an accrual forestimated inventory in the distribution channel.

We recorded a provision for Medicaid rebates of 6.0%and 8.7% of gross sales for the three months ended March 31 2006 and 2005,respectively. The reduction was principally due to a change in product mix,with LUNESTA, which we commercially introduced in 2005, having significantlylower Medicaid eligible units than XOPENEX Inhalation Solution. Actual Medicaiddiscounts could exceed historical experience and our estimates of expectedMedicaid activity and rebate per unit amounts. If the Medicaid discountprovision percentage were to increase by 0.5% of first quarter 2006 gross salesfrom our marketed products, an additional provision of $1.7 million wouldresult.

*MedicareDiscounts—Part B—**We*record accruals for rebates tobe provided through Medicare programs as a reduction of sales when the productis sold. We provide rebates to medicare pharmacy providers, or MPPs, on XOPENEXInhalation Solution that is dispensed to Medicare beneficiaries. XOPENEX iscovered under a Medicare code for drugs used with durable medical equipment, inour case, nebulizers. We estimate the expected rebate using historical data andby examining trends and expected changes in Medicare codes. Medicare paymentsare paid to MPPs primarily on a monthly basis. Accordingly, the provisiontypically relates to the activity over a one-month period and, as a result, thetotal provision consists of (i) an estimate of the amount expected to beincurred for the current month’s prescriptions, (ii) an accrual for priormonths’ unpaid rebates and (iii) an accrual for estimated inventory in thedistribution channel.

*Medicare Discounts—Part D—**Effective*January 1,2006, Medicare created a prescription drug benefit for its beneficiaries knownas Medicare Part D. CMS, the Centers for Medicare and Medicaid Services,contracted with numerous health plans and prescription drug benefit plans todesign and administer the drug benefit, including the development of a formulary(which defines which products are covered and at 

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what co-pay level).We pay rebates to certain Part D health plans and prescription drug plans onthe sale of Lunesta and Xopenex HFA. Xopenex UDV has been and will remaincovered as a Part B product, resulting in minimal Part D utilization.Our accruals for Part D are for rebates required for Lunesta and XopenexHFA and are estimated based on projected sales volumes through the contactedhealth and drug plans.

The provision for Medicare rebates was less than 1% ofgross sales for both the three months ended March 31, 2006 and 2005.Actual Medicare discounts could change significantly in the future based onfuture Medicare reimbursement classifications. If the Medicare discountprovision percentage were to increase by 0.5% of first quarter 2006 gross salesof our marketed products, we would incur an additional provision ofapproximately $1.7 million.

*Managed Care Discounts**—We*have entered intoagreements with certain managed care organizations, or MCOs, whereby we provideagreed upon discounts to such entities based on the achievement of sales volumeand/or market share purchasing targets. We record accruals for these discountsas a reduction of sales when product is sold based on discount rates andexpected levels of sales volumes of these MCOs during a period. We estimateeligible sales based on historical amounts and sales trends and expectedchanges to these trends. Discounts are generally invoiced and paid quarterly inarrears. Accordingly, our accrual consists of (i) the amount expected tobe incurred 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 1.6%and 1.1% of gross sales in the three months ended March 31, 2006 and 2005,respectively. Actual MCO discounts could exceed historical experience and ourestimates of expected future participation in these programs. If the MCOdiscount provision percentage were to increase by 0.5% of first quarter 2006gross sales of our marketed products, an additional provision of approximately$1.7 million would result.

*Chargebacks and GPO Contract Discounts**—We*have entered intoagreements with certain group purchasing organizations, or GPOs, in which itsmembers can purchase product from our wholesalers at a specified price. GPOsare organizations that represent a group of end buyers in the purchase ofgoods. These agreements involve the wholesalers who receive a stated margin onsales to GPOs. When the difference between the wholesaler’s purchase price andthe GPO’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 that qualify for chargebacks andmonitor sales trends and contractual changes. Our accrual consists of theamount we expect 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 creditswas approximately 3.5% and 1.8% of gross sales in the three months ended March 31,2006 and 2005, respectively. The increase in the three months ended March 31,2006 as compared to March 31, 2005 is mainly due to chargebacks related tosales discounts on XOPENEX HFA units that were ultimately sold to the VeteransAdministration, or VA. Actual chargeback and GPO contract credits could exceedhistorical experience and our estimates of expected future participation inthese programs. Additionally our estimate of the average chargeback cycle timecould vary. If the provision for chargeback and GPO contract credits was toincrease by 0.5% of first quarter 2006 gross sales of our marketed products,then an additional provision of approximately $1.7 million would result.

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4)   *Return*s—Customers can return short-datedor expired product that meets the guidelines set forth in our returns goodpolicy. Product shelf life from the date of manufacture for XOPENEX InhalationSolution is 15 months, XOPENEX HFA is 21 months and LUNESTA is 15-24months. Returns are accepted from wholesalers and retail pharmacies. Customerscan return product with six months or less of shelf life remaining and expiredproduct within twelve months following the expiration date. We record anestimate for returns as reductions of revenue at the time product sales arerecorded. We base our estimates of product returns on the percentage of returnsthat we have experienced historically and on a historical aging of the averagetime a return occurs from the time the product was sold. For products withinsufficient return history, we estimate by examining data of similar drugs.For example, with LUNESTA we researched industry data on return patterns ofwidely prescribed insomnia drugs. We may adjust our estimate of productreturns if we are aware of other factors that we believe could significantlyimpact our expected return percentages. These factors include our estimate ofinventory levels of our products in the distribution channel, competitiveissues such as new product entrants and other known changes in sales trends.

The provision for returns was approximately 1.9% and2.5% for the three months ended March 31, 2006 and 2005, respectively. Thedecrease 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. Actualreturns could exceed historical experience and, accordingly, our estimates ofexpected future returns due to factors such as wholesaler and retailer stockingpatterns and inventory levels and/or competitive changes. If the returnsprovision percentage were to increase by 0.5% of first quarter 2006 gross salesfor each of these products, then an additional provision of $1.7 million wouldbe necessary.

Many of our accruals include an estimate of inventoryin the distribution pipeline. At March 31, 2006, we believe a reasonableestimate of the value of our pipeline inventory is approximately $63.0 millionfor XOPENEX Inhalation Solution, $11.0 million for XOPENEX HFA and $74.0million for LUNESTA.

5)   *Other Discounts—*At times we offer specialprograms and discounts. In 2005, we implemented discount programs related tothe launch of LUNESTA and XOPENEX HFA to support the goal of making theproducts widely available. These programs include discounts for auto-shipmentsto pharmacies, coupons and vouchers. Under the auto-shipments to pharmaciesprogram, we give a discount to wholesalers that provide evidence that they havedelivered product to an agreed upon number of pharmacies in a timely manner. Underthe coupon program, physicians give patients coupons to purchase the prescribeddrug at a discount from any retail pharmacy. We reimburse retail pharmacies forthese discounts through a third party administrator. Under the voucher program,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 occur. 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 period ended December 31, 2005 and the three monthsended March 31, 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:                    |       |                             | (6,885     | )                                         |       |                                                     | (8,561     | )           |       |                 | (40,192    | )         |       | (6,282 | ) |   | (990 | ) |   | (62,910 | ) |
| Actual:                                |       |                             |       |                                      |       |                                                     |       |        |       |                 |       |      |       |   |   |   |   |   |   |   |   |
| Current periods                        |       |                             | 3,577      |                                      |       |                                                     | —     |        |       |                 | 572        |      |       | — |   |   | 267 |   |   | 4,416 |   |
| Prior periods                          |       |                             | 2,958      |                                      |       |                                                     | 1,953      |        |       |                 | 21,384     |      |       | 3,185 |   |   | 597 |   |   | 30,077 |   |
| Total                                  |       |                             | 6,535      |                                      |       |                                                     | 1,953      |        |       |                 | 21,956     |      |       | 3,185 |   |   | 864 |   |   | 34,493 |   |
| **Balance  at March 31, 2006**    |       |                             | $          | (2,982                                    | )          |                                                     |       | $           | (16,111    | )                    |       |      | $          | (65,698 | ) |   | $ | (19,366 | ) |   | $ | (679 | ) |   | $ | (104,836 | ) |

 

*Stock-Based Compensation—*EffectiveJanuary 1, 2006, we adopted the provisions of SFAS 123(R), whichresulted in changes to our financial statements as detailed in Note 4 to thefinancial statements. Determining the amount and distribution of expense forstock-based compensation, as well as the associated impact to the balancesheets and statements of cash flows, requires us to develop estimates of thefair value of stock-based compensation expenses.

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.

**Three Month Periodsended March 31, 2006 and 2005**

*Revenues*

Product sales were $277,505,000 and $106,648,000 forthe three months ended March 31, 2006 and 2005, respectively, an increaseof approximately 160%. This increase is primarily a result of the commercialintroduction of LUNESTA in April 2005, a significant increase in XOPENEXInhalation Solution revenue and the commercial introduction of XOPENEX HFA in December 2005.

Sales of LUNESTA were $138,085,000 for the threemonths ended March 31, 2006 as compared to $0 for the same period in 2005.LUNESTA was commercially introduced in April 2005.

Sales of XOPENEX Inhalation Solution were $134,065,000for the three months ended March 31, 2006 as compared to $106,648,000 forthe same period in 2005, an increase of approximately 26%. The sales increasefor XOPENEX Inhalation Solution for the three months ended March 31, 2006as compared with the same period in 2005 is due to a 16% increase in the numberof units sold and an 8% increase in the net selling price per unit, which isdue to a gross unit price increase of approximately 8%. Adjustments recorded togross sales remained relatively unchanged as disclosed in the table below.

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Sales of XOPENEX HFA were$5,355,000 for the three months ended March 31, 2006, as compared to $0 for the same period in2005. XOPENEX HFA was commerciallyintroduced in December 2005.

*Analysisof gross sales to net sales*—The following table presents theadjustments deducted from gross sales to arrive at a net sales figure:

| ** **                                   | ** ** | **For the three months ended March 31,** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                               | ** ** | **% of  sales** | ** ** | **2005** | ** ** | **% of  sales** | ** ** | **Change** | ** ** | **%  Change** | ** ** |
| ** **                                   | ** ** | **(dollars in thousands)**                                   | ** ** |
| Gross sales                                  |       | $                                                                      | 340,415    |   | 100 | % | $ | 129,030 |   | 100 | % | $ | 211,385 |   |   | 164 |   |   |
| Adjustments to  gross sales:                 |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Payment term discounts                       |       | 6,885                                                                  |       | 2.0 | % | 2,750 |   | 2.1 | % | 4,135 |   |   | 150 | % |   |
| Wholesaler fee for service                   |       | 8,561                                                                  |       | 2.5 | % | — |   | 0.0 | % | 8,561 |   |   | 100 | % |   |
| Government rebates and contractual discounts |       | 40,192                                                                 |       | 11.8 | % | 16,284 |   | 12.6 | % | 23,908 |   |   | 147 | % |   |
| Returns                                      |       | 6,282                                                                  |       | 1.9 | % | 3,276 |   | 2.5 | % | 3,006 |   |   | 92 | % |   |
| Other (includes product launch discounts)    |       | 990                                                                    |       | 0.3 | % | 72 |   | 0.1 | % | 918 |   |   | 1,275 | % |   |
| Sub-total  adjustments                       |       | 62,910                                                                 |       | 18.5 | % | 22,382 |   | 17.3 | % | 40,528 |   |   | 181 | % |   |
| Net sales                                    |       | $                                                                      | 277,505    |   | 81.5 | % | $ | 106,648 |   | 82.7 | % | $ | 170,857 |   |   | 160 | % |   |

 

Increases in the adjustments to gross sales as apercentage of gross sales from the quarter ended March 31, 2005 to thequarter ended March 31, 2006 primarily reflect the establishment ofwholesaler fee for service discount arrangements in 2006 to provide for feesconsistent with the terms of the wholesaler service agreements we executed inthe second quarter of 2005, offset by, lower returns reserve as a percentage ofgross sales due to LUNESTA being accrued at a lower rate than XOPENEXInhalation Solution and an overall decrease in government rebates and contractualdiscounts as a percentage of gross sales. Part of the decrease is associated with lower Medicare Part Bdiscounts resulting from favorable Medicare reimbursement rates for XOPENEXInhalation Solution. We cannot be certain these favorable rates will continue. 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. If this local coverage determination is implemented, our sales ofXOPENEX Inhalation Solutions would be material adversely affected.

Royalties were $8,173,000and $12,397,000 for the three months ended March 31, 2006 and 2005,respectively, a decrease of approximately 34%. The decrease is primarily due tothe decrease in royalties earned on the sales of ALLEGRA under our agreementwith sanofi-aventis, which were $5,439,000 for the three months ended March 31,2006 compared to $9,277,000 for the same period in 2005, with the majority ofthe decrease occurring in the United States. Pursuant to the terms of our U.S.agreement with sanofi-aventis, our royalties on the sale of ALLEGRA in theUnited States, which have historically been $15 to $20 million per year,terminated based on the introduction of a generic equivalent of this product inSeptember 2005. We are still entitled to receive royalties on the sale ofALLEGRA outside of the United States in countries where we hold patentscovering ALLEGRA and no generic equivalent product has been introduced. Royaltiesearned on sales of CLARINEX®, under our agreement with Schering-PloughCorporation, decreased to $1,981,000 from $2,340,000 for the three months endedMarch 31, 2006 versus the same period in 2005.

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*Costs of Revenues*

Cost of product sold was$25,533,000 and $10,037,000 for the three months ended March 31, 2006 and2005, respectively.

Cost of LUNESTA sold as apercentage of LUNESTA sales was approximately 6% for the three months ended March 31,2006, with the largest portion being the royalty paid on net sales of LUNESTAto a third party. In accordance with our accounting policies, we did not beginto capitalize product manufacturing costs associated with LUNESTA inventoryuntil the FDA approved the new drug application, or 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 around mid to late2006.

Cost of XOPENEX InhalationSolution sold as a percentage of XOPENEX Inhalation Solution sales wasapproximately 9% for the three months ended March 31, 2006 and for thesame period in 2005.

Cost of XOPENEX HFA soldas a percentage of XOPENEX HFA sales was approximately 14% for the three monthsended March 31, 2006. Included in the costs of XOPENEX HFA sold is aroyalty paid on net sales of XOPENEX HFA to 3M Company, or 3M, our third-partyfinished goods manufacturer of the product.

Cost of royalties earnedwas $159,000 and $203,000 for the three months ended March 31, 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 upon its sales of CLARINEX. This decrease in third-partyobligations is due to the decrease in royalties earned in the three monthsended March 31, 2006 as compared with the same period in 2005.

*Research and Development*

Research and developmentexpenses were $49,269,000 and $28,569,000 for the three months ended March 31,2006 and 2005, respectively, an increase of approximately 72%. The increase isprimarily due to our increased spending on our LUNESTA Phase IIIB/IV program aswell as drug discovery efforts. We also incurred increased spending on one ofour early-stage programs, SEP-225289, targeted for the treatment ofdepression. In addition, stock compensation expense resulting from the January 1,2006 implementation of FAS123(R) was$2,425,000 for the period ended March 31, 2006 as compared to $0 for theperiod ended March 31, 2005.

Drug development andapproval in the United States is a multi-step process regulated by the FDA. Theprocess begins with the filing of an investigational new drug application, orIND, which, if successful, allows the opportunity for study in humans, or clinicalstudy, of the potential new drug. Clinical development typically involves threephases of study: Phase I, II and III. The most significant costs inclinical development are in Phase III clinical trials, as they tend to be thelongest and largest studies in the drug development process. Followingsuccessful completion of Phase III clinical trials, an NDA must be submittedto, and accepted by, the FDA, and the FDA must approve the NDA prior tocommercialization of the drug. We may elect either on our own, or at therequest of the FDA, to conduct further studies that are referred to as PhaseIIIB and IV studies. Phase IIIB studies are initiated and either completed orsubstantially completed while the NDA is under FDA review. These studies areconducted under an IND. Phase IV studies, also referred to as post-marketingstudies, are studies that are initiated and conducted after the FDA hasapproved a product for marketing. Phase IV studies may be requested by the FDAeither before or after the FDA has approved an NDA. These studies may also beindependently initiated by the company whose NDA has been approved. The FDAuses post-marketing studies to gather additional information about a product’ssafety, efficacy or optimal use.

Successful development ofour product candidates is highly uncertain. Completion dates and completioncosts can vary significantly for each product candidate and are difficult topredict. The lengthy 

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processof seeking FDA approvals, and subsequent compliance with applicable statutesand regulations, require the expenditure of substantial resources. Any failureby us 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.

For additional discussionof the risks and uncertainties associated with completing development ofpotential product candidates, see “Risk Factors”.

Belowis a summary of development of our products and product candidates thatrepresent 10% or more of our direct project research and development spendingfor the three months ended March 31, 2006. The “Estimate of Completion ofStage” 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.The actual timing of completion of phases could differ materially from theestimates provided in the table. The table is sorted by highest to lowestspending amounts, and the three product candidates listed accounted forapproximately 89% of our direct project research and development spending forthe three months ended March 31, 2006. No other product candidateaccounted for more than 6% 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 |       |           | **         |                           |       |                                                | **         |   |   |
| Arformoterol                                    |       | Respiratory—COPD   |       |           | ***        |                           |       |                                                | ***        |   |   |
| SEP-225289                                      |       | Depression              |       |           | Phase I    |                           |       |                                                | 2007       |   |   |

 

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*                    Wecommercially launched LUNESTA in April 2005.

**             Wecommercially launched XOPENEX HFA in December 2005.

***      Wesubmitted an NDA to the FDA in December 2005. The Prescription Drug UserFee Act, or PDUFA, date is October 12, 2006.

Belowis a summary of expenditure information related to our product candidatesrepresenting 10% or more of our direct project research and developmentspending during the three months ended March 31, 2006, and 2005, as wellas the costs incurred to date on these projects. The costs in this analysisinclude only direct costs and do not include certain indirect labor, overhead,stock based compensation, or other costs which benefit multiple projects. As aresult, fully loaded research and development cost summaries by project are notpresented.

| ** **                           | ** ** | **Project costs for  the three  months ended  March 31, 2006** | ** ** | **Project costs to  date through  March 31,  2006** | ** ** | **Project costs for  the three  months ended  March 31, 2005** | ** ** | **Project costs to  date through  March 31,  2005** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                                                                      | ** ** |
| LUNESTA  (eszopiclone)               |       |                                                                                         | $          | 7,981                                                                   |       |                                                                                         |       | $                                                                       | 207,703    |   |   |   | $ | — |   |   |   | $ | 183,369 |   |   |
| XOPENEX HFA  (levalbuterol tartrate) |       |                                                                                         | $          | 5,287                                                                   |       |                                                                                         |       | $                                                                       | 162,078    |   |   |   | $ | 5,246 |   |   |   | $ | 137,943 |   |   |
| Arformoterol                         |       |                                                                                         | $          | 3,643                                                                   |       |                                                                                         |       | $                                                                       | 165,221    |   |   |   | $ | 3,796 |   |   |   | $ | 147,315 |   |   |
| SEP-225289                           |       |                                                                                         | $          | 2,799                                                                   |       |                                                                                         |       | $                                                                       | 6,750      |   |   |   | $ | 493 |   |   |   | $ | 493 |   |   |

 

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.

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*Selling, Marketingand Distribution*

Selling, marketing and distribution expenses were$189,961,000 and $93,172,000 for the three months ended March 31, 2006 and2005, respectively, an increase of approximately 104%. Of this increase,approximately 65% is due to an increase in marketing, advertising and promotioncosts in support of the commercial launch of LUNESTA, which took place inApril 2005. Additionally, we incurred increased payroll and relatedexpense as a result of hiring additional sales representatives and management tosupport the commercialization of LUNESTA and XOPENEX HFA. We also experiencedincreased sales training costs for the three months ended March 31, 2006compared to the same period last year as a result of sales training for oursales force expansion in 2006. In addition, stock compensation expenseresulting from the January 1, 2006 implementation of FAS123(R) was $3,274,000 for the period ended March 31,2006 as compared to $0 for the period ended March 31, 2006.

*General andAdministrative*

General and administrativecosts were $14,315,000 and $8,481,000 for the three months ended March 31,2006 and 2005, respectively, an increase of approximately 69%. Of thisincrease, approximately $3,992,000 or 68% relates to stock compensation expenseresulting from the January 1, 2006 implementation of FAS123(R).

*Other Income(Expense)*

Interest income was $9,794,000 and $5,248,000 for thethree months ended March 31, 2006 and 2005, respectively, an increase ofapproximately 87%. The increase is due to higher average balances of cash andshort- and long-term investments combined with an increase in theinterest rates earned on investments in 2006. Our monthly average cash andinvestment balance was approximately $978,657,000 and $813,591,000 for thethree months ended March 31, 2006 and 2005, respectively. For the threemonths ended March 31, 2006 and 2005 the average annualized interest ratethat we earned on our investments was 4.00% and 2.58%, respectively.

Interest expense was $5,551,000 and $5,842,000 for thethree months ended March 31, 2006 and 2005, respectively. The expense inboth periods is primarily related to the interest we paid on our 5% convertiblesubordinated debentures.

Equity in investee losseswere $258,000 and $168,000 for the three months ended March 31, 2006 and2005, respectively, an increase of approximately 54%. The loss represents ourportion of BioSphere losses.

**Liquidity andCapital Resources**

Our liquidity requirements have historically consistedof research and development expenses, sales and marketing expenses, capitalexpenditures, working capital, debt service and general corporate expenses. Wehave funded these requirements and the growth of our business primarily throughconvertible subordinated debt offerings, the issuance of common stock,including the exercise of stock options, and sales of product and licenseagreements for our drug compounds. We now expect to fund our liquidityrequirements primarily through the generation of positive cash flow from ouroperations. We also believe we have the ability to meet our short-termliquidity needs through the use of our cash and short-term investments on handat March 31, 2006.

Cash, cash equivalents and short- and long-terminvestments totaled $960,201,000, or 75% of total assests at March 31,2006, compared to $976,201,000, or 77% of total assets at December 31,2005.

Net cash used in operating activities for the threemonths ended March 31, 2006 was $27,567,000 which includes net income of$10,259,000, which includes non-cash charges of $15,051,000, consistingprimarily of stock compensation and depreciation and amortization expense.Accounts receivable and 

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inventory increased by$10,137,000 and $3,836,000, respectively due primarily to LUNESTA and XOPENEXInhalation Solution sales. Other current assets increased by $10,976,000, whichis primarily attributable to an increase in prepaid expenses as well as anincrease in interest receivable on our investments. Accounts payable increasedby $15,138,000 primarily due to timing of vendor payments. Accrued expensesdecreased by $71,196,000 primarily due to the timing of payments relating tocommissions, interest and sales and marketing accruals as well as a decrease inmanufacturing accruals due to the production timing of LUNESTA and XOPENEX HFA.Other current liabilities increased by $28,130,000 primarily due to an increasein accruals for product revenue rebates related to LUNESTA and XOPENEX HFAproduct sales.

Net cash used in investing activities for the threemonths ended March 31, 2006 was $37,621,000. Cash used in net purchases ofshort- and long-term investments was $22,849,000. We made purchases ofproperty and equipment of $5,833,000. We also made an investment in ACADIA of$8,939,000.

Net cash provided by financing activities for thethree months ended March 31, 2006 was $6,399,000. We received proceeds of$6,987,000 from issuing common stock upon the exercise of stock options issuedunder our stock option plans. We also used $588,000 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 through2007. In the longer term, we expect to continue to fund our operations withrevenue generated from product sales. Our actual future cash requirements andour ability to generate revenue, however, will depend on many factors,including:

·       LUNESTAsales;

·       XOPENEXInhalation Solution sales;

·       successfulcommercialization of XOPENEX HFA;

·       FDAapproval of our arformoterol NDA;

·       acquisitionsof technologies, product candidates, approved products and/or businesses;

·       ourability to establish and maintain additional strategic alliances and licensingarrangements;

·       achievementof milestones under our strategic alliance arrangements;

·       progressof our preclinical, clinical and research programs and the number and breadthof these programs; and

·       progressof our development efforts and the development efforts of our strategicpartners.

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.

Based on our current operatingplan, we believe that we will not be required to raise additional capital tofund the repayment of our outstanding convertible debt when due. If we are notable to successfully continue to grow our revenue and properly manage ourexpenses, it is likely that our business would be materially and adverselyaffected and that we would be required to raise additional funds in order torepay our outstanding convertible debt. We cannot assure that, if required, wewould be able to raise the additional funds on favorable terms, if at all.

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**Off-Balance SheetArrangements**

We do not have anyoff-balance sheet arrangements, other than operating leases in the normalcourse of business, or variable interest entities or activities that includenon-exchange traded contracts accounted for at fair value.

**ContractualObligations**

As of March 31, 2006, our contractualobligations disclosure in our annual report on Form 10-K for theyear 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 for the year ended December 31,2005. As of May 9, 2006, there have been no material changes to the marketrisks described in our annual report on Form 10-K for the year endedDecember 31, 2005. Additionally, we do not anticipate any near-termchanges in the nature of our market risk exposures or in our management’sobjectives and strategies with respect to managing such exposures.

**ITEM 4.**                CONTROLSAND PROCEDURES

**Disclosure Controlsand 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 March 31,2006. 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 reports thatit files or submits under the Exchange Act is accumulated and communicated tothe 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 March 31, 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.

**Changes in InternalControl 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 March 31, 2006 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

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**PART II**

**OTHER INFORMATION**

**ITEM 1.**                LEGALPROCEEDINGS

In September 2005, we received notification thatthe FDA had received an ANDA from Breath Limited seeking approval of a *g*eneric version of our 1.25 mg, 0.63 mg and 0.31 mglevalbuterol hydrochloride inhalation solution. Breath Limited’s submissionincludes a Paragraph IV certification alleging that our patents listed inthe FDA publication entitled “Approved Drug Products With TherapeuticEquivalence Evaluations,” commonly referred to as the “Orange Book,” forXOPENEX Inhalation Solution are invalid, unenforceable or not infringed byBreath Limited’s proposed product. We have filed a civil action against BreathLimited for patent infringement. We were notified in January 2006 of asecond 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 byDey, L.P. We have filed a civil action against Dey, L.P. for patentinfringement. In April 2006, we were notified of a third 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,which was submitted to the FDA by Watson Laboratories, Inc. We have yet todecide whether we will file a civil action against Watson Laboratories, Inc.for patent infringement.

Should we successfully enforce our patents,ANDA approval will not occur until the expiration of the applicablepatents. Otherwise, the FDA will stay its approval of the relevant ANDAuntil 30 months following the date we received notice of such ANDA oruntil a court decides that our patents are invalid, unenforceable or notinfringed, whichever is earlier. Patent litigation involves complex legal andfactual questions. We can provide no assurance concerning the outcome or theduration of the lawsuit. If we are not successful in enforcing our patents, wewill not be able to exclude the generic company, for the full term of ourpatents, from marketing their generic version of XOPENEX Inhalation Solution. Introductionof a generic copy of XOPENEX Inhalation Solution before the expiration of ourpatents would have a material adverse effect on our business.

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 Securities and Exchange Commission. Primarilythey allege that the defendants made certain materially false and misleadingstatements relating to the testing, safety and likelihood of FDA approval oftecastemizole. In both the debt purchasers’ action and equity purchasers’action, the court has granted the plaintiffs’ motion for class certification. Inlate February 2006, two corrected and amended consolidated complaints werefiled, one on behalf of the purchasers of our common stock and the other onbehalf of the purchasers of our debt securities. These corrected and amended consolidatedcomplaints reiterate the allegations contained in the previously filedcomplaints and define 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 the lawsuits due totheir uncertain resolution. However, any conclusion of these matters in amanner adverse to us would have a material adverse effect on our financialposition and results of operation.

**ITEM 1A.**        RISKFACTORS

You should carefullyconsider the risks described below in addition to the other informationcontained in this report, before making an investment decision. Our business,financial condition or results of operations could be harmed by any of theserisks. The risks and uncertainties described below are not 

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the onlyones we face. Additional risks not currently known to us or other factors notperceived by us to present significant risks to our business at this time alsomay impair our business operations.

**Risks Related toOur Financial Results**

**We have a history of net losses and we may not be ableto generate revenues sufficient to achieve and maintain profitability on aquarterly and annual basis.**

Except for our fiscal quarters ended December 31,2005 and March 31, 2006, we have incurred net losses each quarter sinceour inception. It is possible we will not be able to achieve profitabilityagain or maintain profitability on a quarterly or annual basis. We expect tocontinue to incur significant operating expenditures to further develop andcommercialize our products and product candidates. As a result, we will need togenerate significant revenues in future periods to achieve and maintainprofitability. We cannot assure you that we will achieve significant revenuesor that we will ever achieve profitability again. Even if we do achieveprofitability again, we may not be able maintain profitability for anysubstantial period of time. If revenues grow more slowly than we anticipate orif operating expenses exceed our expectations or cannot be adjustedaccordingly, our business, results of operations and financial condition willbe materially and adversely affected. In addition, if we are unable to achieveor maintain profitability on a quarterly or annual basis, the market price ofour common stock may decline.

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

Approximately 95% of our revenues for the three monthsended March 31, 2006 resulted from sales of LUNESTA and XOPENEX InhalationSolution and we expect sales from these two products to represent substantiallyall of our revenues for the foreseeable future. In April 2005, wecommercially launched LUNESTA as a new product in a highly and increasinglycompetitive market and we cannot be certain that it will achieve continuedcommercial success. In addition, we do not have long-term sales contracts withour customers, and we rely on purchase orders for sales of LUNESTA and XOPENEXInhalation Solution. Reductions, delays or cancellations of orders for LUNESTAor XOPENEX Inhalation Solution could adversely affect our operating results. Ifsales of LUNESTA and XOPENEX Inhalation Solution do not continue to increase,we may not have sufficient revenues to achieve our business plan or repay ouroutstanding debt, and our business will not be successful. In December 2005,we commercially launched XOPENEX HFA and we cannot be certain that it willachieve commercial success.

With respect to XOPENEX Inhalation Solution, three genericcompanies have filed ANDAs with the FDA seeking to market a generic version oflevalbuterol hydrochloride inhalation solution. We have commenced patent litigationagainst two of these generic companies and we have yet to decide whether tocommence litigation against the third. A finding that the products thesecompanies wish to market do not infringe our patents or that our patents areinvalid or unenforceable will likely lead to introduction of genericlevalbuterol inhalation solution. If this occurs, sales of XOPENEX InhalationSolution will be 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 their markets.Specifically, the following factors, among others, could affect the level ofsuccess and market acceptance of LUNESTA, XOPENEX Inhalation Solution and/orXOPENEX HFA:

·       achange in the perception of the health care community of their safety and/orefficacy, both in an absolute sense and relative to that of competing products;

·       theintroduction of new products into the sleep or respiratory markets;

·       thelevel and effectiveness of our sales and marketing efforts;

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·       anyunfavorable publicity regarding these products or similar products;

·       litigationor threats of litigation with respect to these products;

·       theprice of the product relative to other competing drugs or treatments;

·       anychanges in government and other third-party payor reimbursement policiesand practices; and

·       regulatorydevelopments affecting the manufacture, marketing or use of these products.

Any adverse developments with respect to the sale ofLUNESTA or XOPENEX Inhalation Solution could significantly reduce revenues andhave a material adverse effect on our ability to maintain profitability andachieve our business plan.

**We have significant long-term debt and we may not beable to make principal payments when due.**

As of March 31, 2006, our total long-term debtwas approximately $1.2 billion and our stockholders’ equity (deficit) was($127.7) million. None of our 5% debentures due 2007, our 0% Series Anotes due 2008, our 0% Series B notes due 2010 nor our 0% notes due 2024restricts us or our subsidiaries’ ability to incur additional indebtedness,including debt that ranks senior to the notes. The 0% notes due 2024 are seniorto the Series A notes due 2008 and Series B notes due 2010, which aresenior to the 5% debentures due 2007. Additional indebtedness that we incur mayin certain circumstances rank senior to or on parity with this debt. Ourability to satisfy our obligations will depend upon our future performance,which is subject to many factors, including factors beyond our control. Theconversion prices for the 5% debentures due 2007, 0% Series A notes due2008 and 0% Series B notes due 2010 are $92.38, $31.89 and $29.84,respectively. On May 1, 2006, the closing sale price of our common stockwas $43.76. If the market price for our common stock does not exceed theconversion price, the holders of our outstanding convertible debt may notconvert their securities into common stock. Our 0% notes due 2024 areconvertible into cash and, if applicable, shares of our common stock at aconversion price of approximately $67.20, at the option of the holders undercertain circumstances. We may not be able to make the required cash paymentsupon conversion of the 0% notes due 2024.

Historically, we have had negative cash flow fromoperations. For the three months ended March 31, 2006, net cash used inoperating activities was approximately $27.6 million. Our annual debtservice through 2006, assuming no additional interest-bearing debt isincurred and no additional 5% debentures due 2007 are converted, redeemed,repurchased or exchanged, is approximately $22.0 million. Unless we havesufficient cash or are able to generate sufficient operating cash flow to payoff the principal of our outstanding debt, we will be required to raiseadditional funds or default on our obligations under the debentures and notes.If revenue generated from sales of LUNESTA and XOPENEX Inhalation Solution donot meet expected levels, it is unlikely that we would have sufficient cashflow to repay our outstanding convertible debt and/or make cash payments uponconversion of the 0% notes due 2024. There can be no assurance that, ifrequired, we would be able to raise the additional funds on favorable terms, ifat all.

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

As of March 31, 2006, we had approximately$1.2 billion of outstanding long-term debt. In order to reduce future cashinterest payments, as well as future payments due at maturity, we may, fromtime to time, depending on market conditions, repurchase additional outstandingconvertible debt for cash; exchange debt for shares of our common stock,warrants, preferred stock, debt or other consideration; or a combination of anyof the foregoing. If we exchange shares of our capital stock, or securitiesconvertible into or exercisable for our capital stock, for outstandingconvertible debt or use proceeds from the issuance of convertible debt to fundredemption of outstanding convertible debt with a higher conversion ratio, thenumber of shares that we might issue as a result of such exchanges wouldsignificantly exceed the number of shares originally issuable upon conversionof such debt and, accordingly, such exchanges would result in 

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material dilution toholders of our common stock. We cannot assure you that we will repurchase orexchange 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 these reflected in our projections and accruals.**

Our financial statements have been prepared inaccordance with accounting principles generally accepted in the United States.The preparation of these financial statements requires us to make estimates andjudgments that affect the reported amounts of our assets, liabilities, revenuesand expenses, the amounts of charges accrued by us and related disclosure ofcontingent assets and liabilities. We base our estimates on historicalexperience and on various other assumptions that we believe to be reasonableunder the circumstances. We cannot assure you, however, that our estimates, orthe assumptions underlying them will not be materially different from actualresults. For example, our royalty revenue is recognized based upon ourestimates of our collaboration partners’ sales during the period and, if thesesales estimates are greater than the actual sales that occur during the period,our net income would be reduced. This, in turn, could adversely affect ourstock 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 requireadditional funds for our research and product development programs, operatingexpenses, repayment of debt, the pursuit of regulatory approvals, license oracquisition opportunities and the expansion of our production, sales andmarketing capabilities. Historically, we have satisfied our funding needsthrough collaboration arrangements with corporate partners, sales of product,and equity and debt financings. These funding sources may not be available tous when needed in the future, and, if available, they may not be on termsacceptable to us. Insufficient funds could require us to delay, scale back oreliminate certain of our research and product development programs or to enterinto license agreements with third parties to commercialize products ortechnologies that we would otherwise develop or commercialize ourselves. Ourcash requirements may vary materially from those now planned because of factorsincluding:

·       patentdevelopments;

·       licensingor acquisition opportunities;

·       relationshipswith collaboration partners;

·       theFDA regulatory process;

·       litigation;

·       ourcapital 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. OnSeptember 8, 2005, in both the debt purchasers’ action and the equitypurchasers’ action, the district court granted the plaintiff’s motion for classcertification. In 

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late February 2006, two correctedand amended consolidated complaints were filed, one on behalf of the purchasersof our equity securities and the other on behalf 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 can provide no assurance as to the outcome of theselawsuits. Any conclusion of these matters in a manner adverse to us would havea material adverse effect on our financial condition and business. In addition,the costs to us of defending any litigation or other proceeding, even ifresolved in our favor, could be substantial. Such litigation could alsosubstantially divert the attention of our management and our resources ingeneral. Uncertainties resulting from the initiation and continuation of anylitigation or other proceedings could harm our ability to compete in themarketplace.

**Fluctuations in the demand for products, the successand timing of clinical trials, regulatory approvals, product launches, collaborationarrangements and any termination of development efforts will cause fluctuationsin our quarterly operating results, which could cause volatility in our stockprice.**

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

·       timingand extent of product sales and market penetration;

·       timingand extent of operating expenses, including selling and marketing expenses andthe costs of expanding and maintaining a direct sales force;

·       successand timing of regulatory filings and approvals for products developed by us orour licensing partners or for collaborative agreements;

·       timingand success of product launches;

·       introductionof competitive products into the market;

·       resultsof clinical trials with respect to products under development;

·       theinitiation of litigation against us, or adverse developments in any judicialproceedings in which we are involved;

·       achange in the perception of the health care and/or investor communities withrespect to our products;

·       successand timing of collaboration agreements for development of our pharmaceuticalcandidates and development costs for those pharmaceuticals;

·       timingof receipt of upfront, milestone or royalty payments under collaborationagreements;

·       terminationof development efforts of any product under development or any collaborationagreement; and

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

**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 

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substantiallyimpede the ability of public stockholders to benefit from a change of controlor change in our management and board of directors. These provisions include:

·       preferredstock that could be issued by our board of directors to make it more difficultfor a third party to acquire, or to discourage a third party from acquiring, amajority of our outstanding voting stock;

·       classificationof our directors into three classes with respect to the time for which theyhold office;

·       non-cumulativevoting for directors;

·       controlby our board of directors of the size of our board of directors;

·       limitationson the ability of stockholders to call special meetings of stockholders;

·       inabilityof our stockholders to take any action by written consent; and

·       advancenotice requirements for nominations of candidates for election to our board ofdirectors or for proposing matters that can be acted upon by our stockholdersat stockholder meetings.

In addition, in June 2002, our board of directorsadopted a shareholder rights plan, the provisions of which could make it moredifficult for a potential acquirer of Sepracor 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.

**Risks Related toCommercialization**

**We face intense competition and our competitors havegreater resources and capabilities than we have.**

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 developmentstaff and production facilities than we have. The fields in which we competeare subject to rapid and substantial technological change. Our competitors maybe able 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.

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In the respiratory market, we compete primarilyagainst albuterol. XOPENEX Inhalation Solution and generic albuterol inhalationsolution currently account for the majority of beta-agonist inhalation solutionprescriptions in the market. Albuterol has been marketed for many years, iswell established and sells at prices substantially lower than XOPENEXInhalation Solution. To continue successfully marketing XOPENEX InhalationSolution, we must continue to demonstrate that the efficacy and safety featuresof our drug outweigh its higher cost. In the sleep disorder market, we faceintense competition from established products, such as AMBIEN® and SONATA®. Wealso face competition from the newly approved sleep agents ROZEREMÔand AMBIEN CRÔ. There are also other potentially competitivetherapies that are in late-stage development for the treatment of insomnia. Forall of our products, we need to demonstrate to physicians, patients and third-partypayors that the cost of our product is reasonable and appropriate in light ofits safety and efficacy, its price and the health care benefits, each ascompared to other competing products.

**We may be unable to commercialize products for whichwe receive approval from the FDA.**

Commercialization of a product for which we havereceived an approval letter from the FDA could be delayed for a number ofreasons, some of which are outside of our control, including delays in deliveryof the product due to importation regulations and/or problems with ourdistribution channels or delays in the issuance of approvals from, or thecompletion of required procedures by, agencies other than the FDA, such as theUnited States Drug Enforcement Administration. In addition, commercializationof FDA-approved products may be delayed by our failure to timely finalizedistribution arrangements, manufacturing processes and arrangements, producesufficient inventory and/or properly prepare our sales force. If we are unableto commercialize a product promptly after receipt of an approval letter, ourbusiness and financial position may be materially adversely affected due toreduced revenue from product sales during the period or periods thatcommercialization is delayed and the shortening of any lead time to market wemay have had over our competitors. In addition, the exclusivity period, whichis the time during which the FDA will prevent generic pharmaceutical companiesfrom introducing a generic copy of the product, begins to run upon FDA approvaland, therefore, to the extent we are unable to commercialize a product promptlyafter receipt of an approval letter, our long-term product sales and revenuescould be adversely affected.

Even if the FDA or similar foreign agencies grant usregulatory approval of a product, if we fail to comply with the applicableregulatory requirements, we may be subject to fines, suspension or withdrawalof regulatory approvals, product recalls, seizures of products, operatingrestrictions and criminal prosecution. In any such event, our product sales andrevenues could be adversely affected.

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

We have limited marketing and sales experience. Wehave established a sales force to market XOPENEX Inhalation Solution, LUNESTAand XOPENEX HFA. We have incurred significant expense in expanding our salesforce and expect to incur additional expense as 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) license some of them to large pharmaceutical companies or (3) marketand sell them through other arrangements, including co-promotion arrangements. Wemay incur significant 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, if weenter into co-promotion arrangements or market and sell additional productsdirectly, we may need to significantly expand our sales force.

Our ability to realize significant revenues fromdirect marketing and sales activities depends on our ability to attract andretain qualified sales personnel. Competition for these persons is intense. Ifwe are 

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unable to attract andretain qualified sales personnel, we will not be able to successfully expandour marketing and direct sales force on a timely or cost effective basis. Wemay also need to enter into additional co-promotion arrangements with thirdparties, for example where our own direct sales force is not large enough orsufficiently well aligned to achieve maximum penetration in the market. We maynot be successful in entering into any co-promotion arrangements, and the termsof any co-promotion arrangements may 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 drugwholesalers, hospitals and pharmacies of a manufacturer-initiatedvoluntary Class III recall of one component of our XOPENEX Inhalation Solutionproduct line, XOPENEX Inhalation Solution Concentrate (1.25mg/0.5mL), which weintroduced in August 2004. The recall, which affects only XOPENEXInhalation Solution Concentrate and no other components of our XOPENEXInhalation Solution product line, was necessitated by packaging processvalidation issues relating to the automated process of placing finished vialsinto a foil pouch. We have suspended manufacture and sale of XOPENEX InhalationSolution Concentrate until the issues giving rise to the recall have been fullyaddressed. We expect to re-introduce XOPENEX Inhalation Solution Concentratebefore the end of 2006. If our manufacturer cannot remedy the GMP deficienciesgiving rise to the recall of XOPENEX Inhalation Solution Concentrate, or if theseor similar deficiencies are found to extend to other components or our XOPENEXInhalation Solution product line, our ability to supply product to the marketmay be limited or interrupted indefinitely, which could have a material adverseeffect on our business.

**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 andsubject us 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.

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**Risks Related tothe Regulatory Environment**

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

The FDA and similar foreign agencies must approve forcommercialization any pharmaceutical products developed by us or ourdevelopment partners. These agencies impose substantial requirements on drugmanufacturing and marketing. Any unanticipated preclinical and clinical studieswe are required to undertake could result in a significant increase in the costof advancing our products to commercialization. In addition, failure by us orour collaborative development partners to obtain regulatory approval on atimely basis, or at all, or the attempt by us or our collaborative developmentpartners to receive regulatory approval to achieve labeling objectives, couldprevent or adversely affect the timing of commercial introduction of, or ourability to market and sell, our products.

**If we fail to successfully develop and receiveregulatory approval for arformoterol or other product candidates, we will beunable to commercialize the product candidates and future sales and earningsgrowth will be substantially hampered.**

Our ability to maintain profitability will depend inlarge part on successful development and commercialization of additionalproducts, including arformoterol. In February 2006, the FDA accepted ourarformoterol NDA for filing. The PDUFA date for the arformoterol NDA isOctober 12, 2006. We cannot assure you that the FDA will approve our NDAfor arformoterol on a timely basis, or at all. If the FDA does not approve ourNDA for arformoterol, we will not be able to commercialize the productcandidate and, therefore, will not receive any revenues from sales of theproduct.

Other than arformoterol, our product candidates are inthe early stages of development. We cannot assure you that we will be able todevelop or acquire and commercially introduce new products in a timely manneror that new products, if developed, will be approved for the indications,and/or with the labeling, we expect or that they will achieve marketacceptance. Before we commercialize any other product candidate, we will needto successfully develop the product candidate by completing successful clinicaltrials, submitting an NDA for the product candidate that is accepted by the FDAand receiving FDA approval to market the candidate. If we fail to successfullydevelop a product candidate and/or the FDA delays or denies approval of anysubmitted NDA or any NDA that we submit in the future, then commercializationof our products under development may be delayed or terminated, which couldhave a material adverse effect on our business.

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

·       resultsof clinical trials may not be consistent with preclinical study results;

·       resultsfrom later phases of clinical trials may not be consistent with results fromearlier phases;

·       resultsfrom clinical trials may not demonstrate that the product candidate is safe andefficacious;

·       wemay not receive regulatory approval for our product candidates;

·       theproduct candidate may not offer therapeutic or other improvements overcomparable drugs;

·       wemay elect not to continue funding the development of our product candidates; or

·       fundsmay not be available to develop all of our product candidates.

In addition, our growth is dependent on our continuedability to penetrate new markets where we have limited experience andcompetition is intense. We cannot assure you that the markets we serve willgrow in the future, that our existing and new products will meet therequirements of these markets, that our products will achieve customeracceptance in these markets, that competitors will not force prices to anunacceptably low level or take market share from us, or that we can achieve ormaintain profits in these markets.

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**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 onour 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:

·       resultsof clinical trials may not be consistent with preclinical study results;

·       resultsfrom later phases of clinical trials may not be consistent with results fromearlier phases; and

·       productsmay not be shown to be safe and efficacious.

Even if the FDA or similar foreign agencies grant usregulatory approval of a product, the approval may take longer than weanticipate and may be subject to limitations on the indicated uses for whichthe product may be marketed or contain requirements for costly post-marketingfollow-up studies. Moreover, if we fail to comply with applicable regulatoryrequirements, we may be subject to fines, suspension or withdrawal ofregulatory approvals, product recalls, seizure of products, operatingrestrictions and criminal prosecution.

**Our sales depend on payment and reimbursement fromthird-party payors, and a reduction in payment rate or reimbursementcould 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 medical productsand 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 reimbursementreductions in response to legislation. Reduction in reimbursement for our productscould have a material adverse effect on our results of operations. Also, theincreasing emphasis on managed care in the U.S. may put increasing pressure onthe price and usage of our products, which may adversely affect product sales.Further, when a new drug product is approved, governmental and/or privatereimbursement for that product is uncertain, as is the amount for which thatproduct will be reimbursed. We cannot predict availability or amount ofreimbursement for our approved products or product candidates, including thoseat a late stage of development, and current reimbursement policies for marketedproducts may change at any time.

The MMA also establishes a prescription drug benefitbeginning in 2006 for all Medicare beneficiaries. We cannot be assured that ourproducts will be included in the Medicare prescription drug benefit. Even ifour products are included, we may be required to provide significant discountsor rebates to drug plans participating in the Medicare drug benefit. Moreover,the Federal government may acquire the ability to negotiate price and demanddiscounts on pharmaceutical products that may implicitly create price controlson prescription drugs. On the other hand, the drug benefit may increase thevolume of pharmaceutical drug purchases, offsetting at least in part thesepotential price discounts. In addition, Managed Care Organizations, or MCOs,Health Maintenance Organizations, or HMOs, Preferred 

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Provider Organizations, orPPOs, health care institutions and other government agencies continue to seekprice discounts. 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. In addition,certain states have proposed and certain other states have adopted variousprograms to control prices for their seniors’ and low-income drug programs,including price or patient reimbursement constraints, restrictions on access tocertain products, importation from other countries, such as Canada, and bulkpurchasing of drugs.

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.

On March 24, 2006, the Medicare Durable MedicalEquipment Program Safeguard Contractors, or DME-PSCs issued a draft localcoverage determination under which Medicare reimbursement for XOPENEXInhalation Solutions would be reduced to the level of reimbursement for genericalbuterol. We oppose the DME-PSCs’ proposal and are seeking its withdrawal. However,if this local coverage determination is implemented, our sales of XOPENEXInhalation Solution would be material adversely affected.

If reimbursement for our marketed products changesadversely or if we fail to obtain adequate reimbursement for our other currentor future products, health care providers may limit how much or under whatcircumstances they will prescribe or administer them, which could reduce use ofour products or cause us to reduce the 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:

·       FederalMedicare and Medicaid Anti-Kickback laws, which prohibit persons from knowinglyand willfully soliciting, offering, receiving or providing remuneration,directly or indirectly, in cash or in kind, to induce either referral of anindividual, or furnishing or arranging for a good or service, for which paymentmay be made under Federal health care programs such as the Medicare andMedicaid programs;

·       otherMedicare laws and regulations that establish requirements for coverage andpayment for our products, including the amount of such payments;

·       theFederal False Claims Act, which imposes civil and criminal liability onindividuals and entities who submit, or cause to be submitted, false orfraudulent claims for payment to the government;

·       theFederal Health Insurance Portability and Accountability Act of 1996, or HIPAA,which prohibits executing a scheme to defraud any health care benefit program,including private payors and, further, requires us to comply with standardsregarding privacy and security of individually identifiable health informationand conduct certain electronic transactions using standardized code sets;

·       theFederal False Statements Statute, which prohibits knowingly and willfullyfalsifying, concealing or covering up a material fact or making any materiallyfalse statement in connection with the delivery of or payment for health carebenefits, items or services;

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·       theFederal Food, Drug and Cosmetic Act, which regulates manufacturing, labeling,marketing, distribution and sale of prescription drugs and medical devices;

·       theControlled Substances Act, which regulates handling of controlled substancessuch as LUNESTA;

·       stateand foreign law equivalents of the foregoing;

·       statefood and drug laws, pharmacy acts and state pharmacy board regulations, whichgovern sale, distribution, use, administration and prescribing of prescriptiondrugs; and

·       statelaws that prohibit practice of medicine by non-physicians and fee-splittingarrangements between physicians and non-physicians, as well as state lawequivalents to the Federal Medicare and Medicaid Anti-Kickback Laws, which maynot be limited to government reimbursed items or services.

If our past or present operations are found to be inviolation of any of the laws described above or other governmental regulationsto which we or our customers are subject, we may be subject to the applicablepenalty associated with the violation, including civil and criminal penalties,damages, fines, exclusion from Medicare and Medicaid programs and curtailmentor restructuring of our operations. Similarly, if our customers are foundnon-compliant with applicable laws, they may be subject to sanctions, whichcould also have a negative impact on us. In addition, if we are required toobtain permits or licenses under these laws that we do not already possess, wemay become subject to substantial additional regulation or incur significantexpense. Any penalties, damages, fines, curtailment or restructuring of ouroperations would adversely affect our ability to operate our business and ourfinancial results. The risk of our being found in violation of these laws isincreased by the fact that many of them have not been fully interpreted by theregulatory authorities or the courts and their provisions are open to a varietyof interpretations. Any action against us for violation of these laws, even ifwe successfully defend against it, could cause us to incur significant legalexpenses, divert our management’s attention from operating our business anddamage our reputation.

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

We are a participant in the Medicaid rebate programestablished by the Omnibus Budget Reconciliation Act of 1990. Under theMedicaid rebate program, we pay a rebate for each unit of our productreimbursed by Medicaid. The amount of the rebate for each product is set bylaw. We are also required to pay certain statutorily defined rebates onMedicaid purchases for reimbursement on prescription drugs under state Medicaidplans. Both the Federal government and state governments have initiatedinvestigations into the rebate practices of many pharmaceutical companies toensure compliance with these rebate programs. Any investigation of our rebatepractices could be costly, could divert the attention of our management fromour core business and could damage our reputation.

**The approval of sale of certain medications without aprescription may adversely affect our business.**

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.

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**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 toinitiate litigation against others to protect or enforce our intellectualproperty rights.

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, invalidatedor circumvented. Moreover, the United States Patent and Trademark Office maycommence interference proceedings involving our patents or patent applications.Any challenge to, or invalidation or circumvention of, our patents or patentapplications would be costly, would require significant time and attention ofour management and could have a material adverse effect on our business.

On September 7, 2005, we announced that the FDAreceived an abbreviated new drug application, or ANDA from Breath Limitedseeking marketing approval for generic copies of our 1.25 mg, 0.63 mg and 0.31mg XOPENEX brand levalbuterol HCl Inhalation Solution unit-dose vial products.XOPENEX Inhalation Solution Concentrate is not subject to the ANDA. On January 12,2006, we announced that we received notice that the FDA had received an ANDAfrom Dey, L.P. for a generic version of our 1.25 mg, 0.63 mg and 0.31 mg levalbuterolhydrochloride inhalation solution. Both submissions include a Paragraph IVcertification 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. In April 2006, we were notified of a third ANDA seeking approval of ageneric version of our 1.25 mg, 0.63 mg and 0.31 mg levalbuterol hydrochlorideinhalation solution including a Paragraph IV certification, which wassubmitted to the FDA by Watson Laboratories, Inc. We have yet to decide whetherwe will file a civil action against Watson Laboratories, Inc. for patentinfringement.

Should  wesuccessfully enforce our patents, the FDA will not approve the ANDA untilexpiration of the applicable patents. Otherwise, the FDA will stay its approvalof the relevant ANDA until 30 months following the date we received noticeof such ANDA or until a court decides that our patents are invalid,unenforceable or not infringed, whichever is earlier. Patent litigationinvolves complex legal and factual questions. We can provide no assuranceconcerning the outcome or the duration of the lawsuits. Any conclusion of thesematters in a manner adverse to us would have a material adverse effect on ourfinancial condition and business. If we are not successful in enforcing ourpatents, we will not be able to prevent the generic company, for the full termof our patents, from marketing their generic version of XOPENEX InhalationSolution. Introduction of a generic copy of XOPENEX Inhalation Solution beforethe 

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expiration of our patentswould have a material adverse effect on our business. In addition, the costs tous of conducting these proceedings, even if resolved in our favor, could besubstantial. Such litigation could also substantially divert the attention ofour management and other key personnel from our core business and our resourcesin general. Uncertainties resulting from the initiation and continuation of anylitigation or other proceedings could harm our ability to compete in the marketplace.

**If we face a claim of intellectual propertyinfringement by a third party, then we could be liable for significant damagesor 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 drug candidatesfor which we have patents or patent applications. Third parties also holdpatents 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 requireus to pay 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.

**Risks Related toOur Dependence on Third Parties**

***If any third-partycollaborator is not successful in development of our product candidates, we maynot realize the potential commercial benefits of the arrangement and ourresults of operations could be adversely affected.***

We have entered into a collaboration agreement with 3Mfor the scale-up and manufacturing of XOPENEX HFA and we may enter intoadditional collaboration agreements in the future. Under our agreement with 3M,3M is responsible for manufacturing an MDI formulation of XOPENEX. Wecommercially launched XOPENEX HFA in December 2005. If 3M, or any futuredevelopment or commercialization collaborator, does not devote sufficient timeand resources to its collaboration arrangement with us, breaches or terminatesits agreement with us, fails to perform its obligation to us in a timely manneror is unsuccessful in its development and/or commercialization efforts, we maynot realize the potential commercial benefits of the arrangement and our resultsof operations may be adversely affected. In addition, if regulatory approval orcommercialization of any product candidate under development by or incollaboration with a partner is delayed or limited, we may not realize, or maybe delayed in realizing, the potential commercial benefits of the arrangement.

**The royalties we receive under licensing arrangementscould be delayed, reduced or terminated if our licensing partners terminate, orfail to perform their obligations under, their agreements with us, or if ourlicensing partners are unsuccessful in their sales 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 

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time andresources to its licensing arrangement with us or focuses its efforts incountries where we do not hold patents, we may not realize the potentialcommercial benefits of the arrangement, our revenues under these arrangementsmay be less than anticipated and our results of operations may be adverselyaffected. If any of our licensing partners was to breach or terminate itsagreement with us or fail to perform its obligations to us in a timely manner,the royalties we receive under the licensing agreement could decrease or cease.If we are unable or fail to perform, or breach in our performance of, ourobligations under a licensing agreement, the royalties and benefits to which weare otherwise entitled under the agreement could be reduced or eliminated. Anydelay or termination of this type could have a material adverse effect on ourfinancial condition and results of operations because we may lose technologyrights and milestone or royalty payments from licensing partners and/orrevenues from product sales, if any, could be delayed, reduced or terminated.

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

We currently operate amanufacturing plant that we believe can meet our commercial requirements of theactive pharmaceutical ingredient for XOPENEX Inhalation Solution and XOPENEXHFA, partially fulfill our commercial requirements of the active pharmaceuticalingredient for LUNESTA, and support production of our product candidates inamounts needed for our clinical trials. We do not, however, have the capabilityto manufacture at our manufacturing facility all of our requirements for theactive ingredients of our currently approved products, and we have nofacilities for manufacturing pharmaceutical dosage forms or finished drugproducts. Developing and obtaining this capability would be time consuming andexpensive. Unless and until we develop this capability, we will relysubstantially, and in some cases, entirely, on third-party manufacturers.Cardinal Health, Inc. is currently the sole finished goods manufacturer ofour XOPENEX Inhalation Solution, Patheon Inc. is the sole manufacturer ofLUNESTA brand eszopiclone and 3M is the sole manufacturer and supplier ofXOPENEX HFA. Certain components of XOPENEX HFA are available from only a singlesource. If Cardinal Health, Patheon, 3M, or any of our sole-source componentsuppliers experiences delays or difficulties in producing, packaging ordelivering XOPENEX Inhalation Solution, LUNESTA, or XOPENEX HFA, as the casemay be, we could be unable to meet our customers’ demands for such products,which could lead to customer dissatisfaction and damage to our reputation.Furthermore, if we are required to change manufacturers, we will be required toverify that the new manufacturer maintains facilities and procedures thatcomply with quality standards and with all applicable regulations andguidelines, including FDA guidelines. The delays associated with theverification of a new manufacturer for XOPENEX Inhalation Solution, LUNESTA orXOPENEX HFA could negatively affect our ability to produce such products in atimely 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 will be impaired.**

We are currentlycommercializing three products. However, other than arformoterol, for which wehave filed an NDA, our product candidates are in the early stages ofdevelopment. In order to increase the likelihood that we will be able tosuccessfully develop and/or commercialize additional drugs, we intend to 

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acquireand develop additional product candidates and /or approved products. Thesuccess of this growth strategy depends upon our ability to correctly establishcriteria for such acquisitions and successfully identify, select and acquireproduct candidates and/or products that meet such criteria. We will be requiredto integrate any acquired product candidates into our research and developmentoperations and any acquired products into our sales and marketing operations.Managing the development and/or commercialization of a new product involvesnumerous financial and operational risks, including difficulties allocatingresources between existing and acquired assets and attracting and retainingqualified employees to develop and/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 willbe 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 such acquisitions could adversely affect our stock price, operatingresults and results 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 moredifficult or expensive than we predict. The diversion of our management’sattention and any delay or difficulties encountered in connection with anyfuture acquisitions we may consummate could result in the disruption of ouron-going business or inconsistencies in standards, controls, procedures andpolicies that could negatively affect our ability to maintain relationshipswith customers, suppliers, collaborators, employees and others with whom wehave business 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 orevaluating all such risks and, as a result, might not realize the intendedadvantages of the transaction. If we fail to realize the expected benefits fromacquisitions we may consummate in the future, whether as a result ofunidentified risks, integration difficulties, regulatory setbacks and otherevents, our business, results of operations and financial condition could beadversely affected. If we acquire product candidates, we will also need to makecertain assumptions about, among other things, development costs, thelikelihood of receiving regulatory approval and the market for such productcandidates. Our 

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assumptionsmay prove to be incorrect, which could cause us to fail to realize theanticipated benefits of these transactions.

In addition, we willlikely experience significant charges to earnings in connection with ourefforts, if any, to consummate acquisitions. For transactions that areultimately not consummated, these charges may include fees and expenses forinvestment bankers, attorneys, accountants and other advisers in connectionwith our efforts. Even if our efforts are successful, we may incur as part of atransaction substantial charges for closure costs associated with elimination ofduplicate 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 ourability to enter into additional collaboration agreements with pharmaceuticalcompanies to fund all or part of the costs of development and commercializationof these product candidates. We may not be able to enter into collaborationagreements and the terms of the collaboration agreements, if any, may not befavorable to us. Inability to enter into collaboration agreements could delayor preclude development, manufacture and/or marketing of some of our drugs andcould have a material adverse effect on our financial condition and results ofoperations because:

·       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 andwaiting period under the HSR Act. If expiration or termination of the noticeand waiting 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

**ITEM6.**                EXHIBITS

| 10.1       | Summary of Executive Officer Compensation for 2006.                                                                                                                                                                                                                                                     |
|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2† | U.S. License Agreement for Levoceterizine, dated as  of February 17, 2006, by and between UCB S.A. and the Registrant (filed  as Exhibit 10.43 to the Registrant’s Form 10-K (File No. 000-19410)  for the annual period ended December 31, 2005 and incorporated herein by  reference). |
| 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: May 9, 2006 | By:               | /s/  TIMOTHY J. BARBERICH |
|                   | * *          | Timothy J.  Barberich |
|                   | * *          | *Chairman  and Chief Executive Officer  (Principal Executive Officer)* |
| Date: May 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**                                                                                                                                                                                                                                                                                              |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1             |       | Summary of Executive Officer Compensation for 2006.                                                                                                                                                                                                                                                          |
| 10.2†       |       | U.S. License Agreement for Levoceterizine, dated as  of February 17, 2006, by and between UCB S.A. and the Registrant (filed  as Exhibit 10.43 to the Registrant’s Form 10-K (File No. 000-19410)  for the annual period ended December 31, 2005 and incorporated herein by  reference). |
| 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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