**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

**(Mark One)**

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

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

**or**

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

**Forthe transition periodfrom                  to              **

**Commissionfile number 0-19410**

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**Sepracor Inc.**

(Exact name of registrantas specified in its charter)

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

 

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

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

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

Large accelerated filer x    Accelerated filer o    Non-acceleratedfiler o

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

The number of sharesoutstanding of the registrant’s class of Common Stock as of July 31, 2006was: 109,258,202 shares.

 

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**SEPRACOR INC.**

**INDEX**

| **Part I—Financial Information** | ** ** | ** **                                                                                                                           |
|--------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------|
| Item 1.                                    |       | Condensed Consolidated Interim Financial Statements  (Unaudited)                                                                     |   |   |
|                                       |       | Consolidated Balance  Sheets as of June 30, 2006 and December 31, 2005 (Restated and  Unaudited)                           |   | 3 |
|                                       |       | Consolidated  Statements of Operations for the Three and Six Months Ended June 30,  2006 and 2005 (Restated and Unaudited) |   | 4 |
|                                       |       | Consolidated Statements of Cash Flows for the Six  Months Ended June 30, 2006 and 2005 (Restated and Unaudited)       |   | 5 |
|                                       |       | Notes to  Condensed Consolidated Interim Financial Statements                                                                        |   | 6 |
| Item 2.                                    |       | Management’s  Discussion and Analysis of Financial Condition and  Results of Operations                                         |   | 18 |
| Item 3.                                    |       | Quantitative  and Qualitative Disclosures About Market Risk                                                                          |   | 34 |
| Item 4.                                    |       | Controls and  Procedures                                                                                                             |   | 34 |
| **Part II—Other Information**    | ** ** | ** **                                                                                                                           |
| Item 1.                                    |       | Legal Proceedings                                                                                                                    |   | 35 |
| Item  1A.                                  |       | Risk  Factors                                                                                                                        |   | 36 |
| Item 4.                                    |       | Submission of  Matters to a Vote of Security Holders                                                                                 |   | 53 |
| Item  6.                                   |       | Exhibits                                                                                                                             |   | 54 |
|                                       |       | Signatures                                                                                                                           |   | 55 |
|                                       |       | Exhibit Index                                                                                                                   |   | 56 |

 

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

| ** **                                                                                                                                                                                                                                                            | ** ** | **June 30,  2006** | ** ** | **December 31,  2005  (as restated)** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------------------------|------------|
| **Assets**                                                                                                                                                                                                                                                            |       |                    |       |                                       |       |
| Current assets:                                                                                                                                                                                                                                                       |       |                    |       |                                       |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                            |       | $                       | 106,124    |                                       | $          | 178,144 |   |
| Short-term  investments                                                                                                                                                                                                                                               |       | 682,748                 |       | 666,615                                    |       |
| Accounts receivable, net                                                                                                                                                                                                                                              |       | 159,237                 |       | 140,465                                    |       |
| Inventories                                                                                                                                                                                                                                                           |       | 50,369                  |       | 38,951                                     |       |
| Other assets                                                                                                                                                                                                                                                          |       | 29,139                  |       | 22,370                                     |       |
| Total current assets                                                                                                                                                                                                                                                  |       | 1,027,617               |       | 1,046,545                                  |       |
| Long-term  investments                                                                                                                                                                                                                                                |       | 155,619                 |       | 131,442                                    |       |
| Property and equipment,  net                                                                                                                                                                                                                                          |       | 73,878                  |       | 72,467                                     |       |
| Investment in affiliate                                                                                                                                                                                                                                               |       | 5,153                   |       | 5,829                                      |       |
| Deferred financing costs  and patents, net                                                                                                                                                                                                                            |       | 15,101                  |       | 18,097                                     |       |
| Other assets                                                                                                                                                                                                                                                          |       | 117                     |       | 117                                        |       |
| Total assets                                                                                                                                                                                                                                                          |       | $                       | 1,277,485  |                                       | $          | 1,274,497 |   |
| **Liabilities and Stockholders’ Equity (Deficit)**                                                                                                                                                                                                               | ** ** | ** **              | ** ** | ** **                                 | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                  |       |                    |       |                                       |       |
| Accounts payable                                                                                                                                                                                                                                                      |       | $                       | 15,064     |                                       | $          | 11,544 |   |
| Accrued expenses                                                                                                                                                                                                                                                      |       | 124,070                 |       | 187,409                                    |       |
| Current portion of notes  payable and capital lease obligation                                                                                                                                                                                                        |       | 1,037                   |       | 2,030                                      |       |
| Current portion of  convertible subordinated debt                                                                                                                                                                                                                     |       | 440,000                 |       | —                                     |       |
| Other current  liabilities                                                                                                                                                                                                                                            |       | 84,880                  |       | 76,923                                     |       |
| Total current  liabilities                                                                                                                                                                                                                                            |       | 665,051                 |       | 277,906                                    |       |
| Notes payable and  capital lease obligation                                                                                                                                                                                                                           |       | 1,073                   |       | 1,260                                      |       |
| Convertible subordinated  debt                                                                                                                                                                                                                                        |       | 720,820                 |       | 1,160,820                                  |       |
| Total liabilities                                                                                                                                                                                                                                                     |       | 1,386,944               |       | 1,439,986                                  |       |
| Stockholders’ equity (deficit):                                                                                                                                                                                                                                  |       |                    |       |                                       |       |
| Preferred stock, $1.00  par value, 1,000 shares authorized; none outstanding at June 30, 2006  and December 31, 2005                                                                                                                                        |       | —                  |       | —                                     |       |
| Common stock, $.10 par  value, 240,000 shares authorized at June 30, 2006 and December 31,  2005, respectively; 109,197 and 108,354 shares issued, 104,936 and 104,093  shares outstanding, at June 30, 2006 and December 31, 2005,  respectively |       | 10,920                  |       | 10,835                                     |       |
| Treasury stock, at cost  (4,261 and 4,261 shares at June 30, 2006 and December 31,  2005, respectively)                                                                                                                                                |       | (232,028                | )          | (232,028                                   | )          |
| Additional paid-in  capital                                                                                                                                                                                                                                           |       | 1,749,701               |       | 1,711,653                                  |       |
| Accumulated deficit                                                                                                                                                                                                                                                   |       | (1,641,547              | )          | (1,662,627                                 | )          |
| Accumulated other  comprehensive income                                                                                                                                                                                                                               |       | 3,495                   |       | 6,678                                      |       |
| Total stockholders’  equity (deficit)                                                                                                                                                                                                                            |       | (109,459                | )          | (165,489                                   | )          |
| Total liabilities and stockholders’ equity (deficit)                                                                                                                                                                                                             |       | $                       | 1,277,485  |                                       | $          | 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)(In Thousands, Except Per Share Amounts)**

| ** **                                                                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**              | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                      | ** ** | **June 30,  2006**          | ** ** | **June 30,  2005  (as restated)** | ** ** | **June 30,  2006** | ** ** | **June 30,  2005  (as restated)** | ** ** |
| Revenues:                                                                       |       |                             |       |                                        |       |   |   |   |   |   |   |   |   |
| Product sales                                                                   |       | $                                | 256,427    |                                        |       | $ | 166,743 |   |   | $ | 533,932 |   |   | $ | 273,391 |   |   |
| Royalties                                                                       |       | 7,979                            |       |                                        | 18,321     |   |   | 16,152 |   |   | 30,718 |   |   |
| Total revenues                                                                  |       | 264,406                          |       |                                        | 185,064    |   |   | 550,084 |   |   | 304,109 |   |   |
| Costs and expenses:                                                             |       |                             |       |                                        |       |   |   |   |   |   |   |   |   |
| Cost of product sold                                                            |       | 20,693                           |       |                                        | 14,453     |   |   | 46,226 |   |   | 24,490 |   |   |
| Cost of royalties                                                               |       | 283                              |       |                                        | 202        |   |   | 442 |   |   | 405 |   |   |
| Research and development                                                        |       | 36,360                           |       |                                        | 37,132     |   |   | 85,629 |   |   | 65,701 |   |   |
| Selling, marketing and distribution                                             |       | 182,605                          |       |                                        | 130,183    |   |   | 372,596 |   |   | 223,390 |   |   |
| General and administrative                                                      |       | 18,087                           |       |                                        | 10,074     |   |   | 32,595 |   |   | 18,781 |   |   |
| Total costs and expenses                                                        |       | 258,028                          |       |                                        | 192,044    |   |   | 537,488 |   |   | 332,767 |   |   |
| Income (loss) from operations                                                   |       | 6,378                            |       |                                        | (6,980     | ) |   | 12,596 |   |   | (28,658 | ) |   |
| Other income (expense):                                                         |       |                             |       |                                        |       |   |   |   |   |   |   |   |   |
| Interest income                                                                 |       | 10,990                           |       |                                        | 5,422      |   |   | 20,784 |   |   | 10,670 |   |   |
| Interest expense                                                                |       | (5,543                           | )          |                                        | (5,839     | ) |   | (11,094 | ) |   | (11,681 | ) |   |
| Equity in investee losses                                                       |       | (95                              | )          |                                        | (300       | ) |   | (353 | ) |   | (468 | ) |   |
| Other income (expense)                                                          |       | (256                             | )          |                                        | 36         |   |   | (312 | ) |   | (357 | ) |   |
| Income (loss) before income taxes                                               |       | 11,474                           |       |                                        | (7,661     | ) |   | 21,621 |   |   | (30,494 | ) |   |
| Income taxes                                                                    |       | 430                              |       |                                        | —     |   |   | 541 |   |   | — |   |   |
| Net income (loss) after income taxes                                            |       | $                                | 11,044     |                                        |       | $ | (7,661 | ) |   | $ | 21,080 |   |   | $ | (30,494 | ) |   |
| Basic net income (loss) per common share                                        |       | $                                | 0.11       |                                        |       | $ | (0.07 | ) |   | $ | 0.20 |   |   | $ | (0.29 | ) |   |
| Diluted net income (loss) per common share                                      |       | $                                | 0.10       |                                        |       | $ | (0.07 | ) |   | $ | 0.18 |   |   | $ | (0.29 | ) |   |
| Shares used in computing  basic and diluted net income (loss) per common share: |       |                             |       |                                        |       |   |   |   |   |   |   |   |   |
| Basic                                                                           |       | 104,587                          |       |                                        | 104,686    |   |   | 104,441 |   |   | 104,118 |   |   |
| Diluted                                                                         |       | 115,371                          |       |                                        | 104,686    |   |   | 115,344 |   |   | 104,118 |   |   |

 

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

4

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

| ** **                                                                             | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                             | ** ** | **June 30,  2006**        | ** ** | **June 30,  2005  (as restated)** | ** ** |
| Cash flows from  operating activities:                                                 |       |                           |       |   |   |   |
| Net income (loss)                                                                      |       | $                              | 21,080     |   | $ | (30,494 | ) |   |
| Adjustments  to reconcile net income (loss) to net cash used in operating  activities: |       |                           |       |   |   |   |
| Depreciation and amortization                                                          |       | 10,723                         |       | 8,280 |   |   |
| Equity in investee losses                                                              |       | 353                            |       | 468 |   |   |
| Stock compensation                                                                     |       | 20,843                         |       | 522 |   |   |
| Loss (gain) on asset disposal                                                          |       | (150                           | )          | 377 |   |   |
| Changes in operating  assets and liabilities:                                          |       |                           |       |   |   |   |
| Accounts receivable                                                                    |       | (18,772                        | )          | (42,306 | ) |   |
| Inventories                                                                            |       | (11,016                        | )          | (6,066 | ) |   |
| Other current assets                                                                   |       | (6,756                         | )          | (4,610 | ) |   |
| Accounts payable                                                                       |       | 3,470                          |       | 533 |   |   |
| Accrued expenses                                                                       |       | (63,423                        | )          | (18,610 | ) |   |
| Other current liabilities                                                              |       | 8,007                          |       | 25,001 |   |   |
| Net cash used in  operating activities                                                 |       | (35,641                        | )          | (66,905 | ) |   |
| Cash flows from  investing activities:                                                 |       |                           |       |   |   |   |
| Purchases of short and long-term investments                                           |       | (617,961                       | )          | (624,443 | ) |   |
| Sales and maturities of short and long-term  investments                               |       | 582,858                        |       | 327,155 |   |   |
| Additions to property and equipment                                                    |       | (8,663                         | )          | (6,431 | ) |   |
| Proceeds from sales of equipment                                                       |       | 150                            |       | — |   |   |
| Investment in non-affiliate                                                            |       | (8,939                         | )          | (7,143 | ) |   |
| Change in other assets                                                                 |       | —                         |       | 697 |   |   |
| Net cash used in  investing activities                                                 |       | (52,555                        | )          | (310,165 | ) |   |
| Cash flows from  financing activities:                                                 |       |                           |       |   |   |   |
| Net proceeds from issuance of common stock                                             |       | 17,290                         |       | 27,718 |   |   |
| Settlement of call spread options                                                      |       | —                         |       | 123,798 |   |   |
| Repayments of long-term debt and capital  leases                                       |       | (1,180                         | )          | (930 | ) |   |
| Net cash provided  by financing activities                                             |       | 16,110                         |       | 150,586 |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                          |       | 66                             |       | 26 |   |   |
| Net decrease in  cash and cash equivalents                                             |       | (72,020                        | )          | (226,458 | ) |   |
| Cash and cash  equivalents at beginning of period                                      |       | $                              | 178,144    |   | $ | 435,905 |   |   |
| Cash and cash  equivalents at end of period                                            |       | $                              | 106,124    |   | $ | 209,447 |   |   |
|                                                                                        |            |                                |            |  |  |  |  |  |  |

 

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

5

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

**1.**   Basisof Presentation

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

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

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

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), “Share-Based Payment”,  (revised 2004). SFAS 123(R) isa revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”, supersedesAccounting Principles Board Opinion, or APB, No. 25, “Accounting for Stock Issued to Employees”,or APB 25, and amends FASB Statement No. 95, “Statement of Cash Flows”. SFAS 123(R) requires allshare-based payments to employees, including grants of employee stock optionsand stock purchases under employee stock purchase plans, to be recognized inthe financial statements based on their fair values. We adopted SFAS 123(R) usingthe modified prospective method during the quarter ended March 31, 2006.As noted in footnote 5 below, the adoption of SFAS 123(R) had a materialimpact on our condensed consolidated statements of operations and net incomeper share.

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

As previously announced, the Securities and ExchangeCommission, or SEC, is conducting an informal inquiry into our stock optionpractices.  In June 2006, we appointed aspecial committee of outside directors to conduct an internal review relatingto our stock option grants and stock option practices.  The special committee, with the assistance oflegal counsel and accounting specialists, has reviewed the stock option grantsto our officers, directors and employees from 1996 to the present under ourvarious stock option plans in effect during this period.  We have been cooperating with this review andour finance department has also reviewed the stock option grants and stockoption practices from 1996 to present. The special committee’s review is substantially complete but will remainopen for the duration of the SEC’s inquiry.

6

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Based on these reviews, we have determined that themeasurement dates for certain stock option grants to employees, officers anddirectors during prior periods differed from the recorded dates for such awardsprimarily due to the following circumstances: (i) stock option grants whichspecified effective dates that may have preceded the dates of receipt of allnecessary signatures or approvals, finalization of lists specifying stockoption grants or an employee’s first date of employment; and (ii) stock optionawards that were approved with exercise prices lower than fair market value onthe effective date of grant.  Inaddition, we have determined that (a) the modification of certain stock optiongrants in connection with an employee’s termination of employment and (b) theexercise of certain stock options that had not vested prior to an employee’stermination, resulted in a new measurement date for such stock options.  As a result, we are required to recordadjustments to non-cash charges for additional stock-based compensation expensein periods prior to July 1, 2006, For periods prior to January 1, 2006, suchcharges are recorded in accordance with APB No. 25, “Accounting for Stock Issuedto Employees” and for subsequent periods in accordance with SFAS 123(R). Thesenon-cash charges had no impact on reported revenue, cash or cash equivalents. Theaggregate amount of the additional stock-based compensation expense that wewill incur as a result of the stock option review is approximately $43.3million, of which $0.8 million will be charged equally over the fourquarters subsequent to June 30, 2006, ending June 30, 2007.

As a result of the review, we have concluded that wewill need to restate our financial statements for the quarters ended March 31,June 30, September 30 and December 31, 2005, the quarter ended March 31,2006 and the fiscal years ended December 31, 2005, 2004 and 2003, as wellas revise the financial information contained in our earnings release for theperiod ended June 30, 2006.

We have restated the 2005 financial statementsincluded in this Form 10-Q to reflect the non-cash charges for the additionalstock-based compensation expense for the periods presented.

Thetable below sets forth the impact of the non-cash charges for stock-basedcompensation expense within our consolidated statement of operations that werecorded for each of the quarterly periods in the fiscal year ended December31, 2005 and the quarter ended March 31, 2006.

| ** **                                                         | ** ** | **Quarterly Period Ended  (unaudited)**                  | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **March 31,**

**2006**                                       | ** ** | **December 31,  2005** | ** ** | **September 30,  2005** | ** ** | **June 30,  2005** | ** ** | **March 31,  2005** | ** ** |
| ** **                                                         | ** ** | **(in thousands, except per share data)** | ** ** |
| ** **                                                         | ** ** | **(as restated)**                                                  | ** ** |
| Net income (loss)  as previously reported                          |       |                                                               | $          | 10,259 |   |   |   | $ | 37,168 |   |   |   | $ | (2,224 | ) |   |   | $ | (7,400 | ) |   |   | $ | (22,573 | ) |   |
| Charge for  additional stock-based compensation                    |       |                                                               | (223       | ) |   |   | (261 | ) |   |   | (261 | ) |   |   | (261 | ) |   |   | (261 | ) |   |
| Net income (loss)  as restated                                     |       |                                                               | $          | 10,036 |   |   |   | $ | 36,907 |   |   |   | $ | (2,485 | ) |   |   | $ | (7,661 | ) |   |   | $ | (22,834 | ) |   |
| Diluted net income  (loss) per common share as previously reported |       |                                                               | $          | 0.09 |   |   |   | $ | 0.32 |   |   |   | $ | (0.02 | ) |   |   | $ | (0.07 | ) |   |   | $ | (0.22 | ) |   |
| Diluted net income (loss)  per common share as restated            |       |                                                               | $          | 0.09 |   |   |   | $ | 0.31 |   |   |   | $ | (0.02 | ) |   |   | $ | (0.07 | ) |   |   | $ | (0.22 | ) |   |

 

7

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Thetable below sets forth the impact of the additional non-cash charges forstock-based compensation expense within our consolidated balance sheets for thequarters ended March 31, June 30, September 30 and December 31,2005 and the quarter ended March 31, 2006.

| ** **                  | ** ** | **As of**                | ** ** |
|-----------------------------|------------|--------------------------|------------|
| ** **                  | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** | **September 30,  2005** | ** ** | **June 30,  2005** | ** ** | **March 31,  2005** | ** ** |
| ** **                  | ** ** | **(in thousands)**  | ** ** |
| ** **                  | ** ** | **(unaudited)**          | ** ** |
| Additional paid-in  capital |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As previously reported      |       | $                        | 1,686,315  |   |   | $ | 1,669,541 |   |   |   | $ | 1,525,823 |   |   | $ | 1,521,772 |   | $ | 1,374,495 |   |
| As restated                 |       | $                        | 1,728,650  |   |   | $ | 1,711,653 |   |   |   | $ | 1,567,674 |   |   | $ | 1,563,362 |   | $ | 1,415,824 |   |
| Accumulated deficit         |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |
| As previously reported      |       | $                        | (1,610,256 | ) |   | $ | (1,620,515 | ) |   |   | $ | (1,657,682 | ) |   | $ | (1,655,458 | ) | $ | (1,648,059 | ) |
| As restated                 |       | $                        | (1,652,591 | ) |   | $ | (1,662,627 | ) |   |   | $ | (1,699,533 | ) |   | $ | (1,697,048 | ) | $ | (1,689,388 | ) |

 

Thefollowing table sets forth the impact of the additional non-cash charges forstock-based compensation expense on our historical financial statements for thefiscal years ended December 31, 2005, 2004 and 2003 (unaudited).

| ** **                                                         | ** ** | **Year Ended December 31,**                         | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                         | ** ** | **(in thousands, except per share data)** | ** ** |
| Operating loss as  previously reported                             |       | $                                                                  | (16,573    | ) | $ | (202,689 | ) | (103,323 | ) |
| Charge for  additional stock-based compensation                    |       | (1,044                                                             | )          | (1,252 | ) | (1,986 | ) |
| Operating loss as  restated                                        |       | $                                                                  | (17,617    | ) | $ | (203,941 | ) | $ | (105,309 | ) |
| Net income (loss) as previously reported                           |       | $                                                                  | 4,971      |   | $ | (295,658 | ) | $ | (135,936 | ) |
| Charge for  additional stock-based compensation                    |       | (1,044                                                             | )          | (1,252 | ) | (1,986 | ) |
| Net income (loss)  as restated                                     |       | $                                                                  | 3,927      |   | $ | (296,910 | ) | $ | (137,922 | ) |
| Diluted net income (loss) per common share as  previously reported |       | $                                                                  | 0.04       |   | $ | (3.21 | ) | $ | (1.61 | ) |
| Diluted net  income (loss) per common share as restated            |       | $                                                                  | 0.03       |   | $ | (3.23 | ) | $ | (1.63 | ) |
| As a percentage  of:                                               |       |                                                               |       |   |   |   |   |
| Previously reported operating loss                                 |       | 6.3                                                                | %          | 0.6 | % | 1.9 | % |
| Previously reported net  income (loss)                             |       | 21.0                                                               | %          | 0.4 | % | 1.5 | % |
| Additional  paid-in capital                                        |       |                                                               |       |   |   |   |   |
| As previously reported                                             |       | $                                                                  | 1,669,541  |   | $ | 1,370,372 |   | $ | 689,907 |   |
| As restated                                                        |       | $                                                                  | 1,711,653  |   | $ | 1,411,440 |   | $ | 729,723 |   |
| Accumulated  deficit                                               |       |                                                               |       |   |   |   |   |
| As previously reported                                             |       | $                                                                  | (1,620,515 | ) | $ | (1,625,486 | ) | $ | (1,329,828 | ) |
| As restated                                                        |       | $                                                                  | (1,662,627 | ) | $ | (1,666,554 | ) | $ | (1,369,644 | ) |

 

 

8

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Inaddition, of the aggregate $43.3 million of non-cash charges for additionalstock-based compensation expense, approximately $37.8 million relates to fiscalyears prior to January 1, 2003, and the impact on net loss for fiscal yearsended December 31, 1996 through December 31, 2002 (unaudited) is as follows:

| **Fiscal Year**                 | ** ** | **Impact on   Net Loss** | ** ** | **As a Percentage  of Net Loss** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|------------------------------------------------------|------------|
| **(dollars in thousands)** |
| 1996                                 |       |                                    | $          | (1,075                                               | )          |   |   | 1.8 | % |   |
| 1997                                 |       |                                    | $          | (967                                                 | )          |   |   | 3.6 | % |   |
| 1998                                 |       |                                    | $          | (3,616                                               | )          |   |   | 3.9 | % |   |
| 1999                                 |       |                                    | $          | (5,617                                               | )          |   |   | 3.1 | % |   |
| 2000                                 |       |                                    | $          | (14,197                                              | )          |   |   | 7.0 | % |   |
| 2001                                 |       |                                    | $          | (8,058                                               | )          |   |   | 3.6 | % |   |
| 2002                                 |       |                                    | $          | (4,300                                               | )          |   |   | 1.6 | % |   |

 

Although substantially complete, the specialcommittee’s review is ongoing and will remain open for the duration of theSEC’s inquiry. Should additional information become available to us inconnection with the SEC inquiry, our current determination of stock-basedcompensation could change. The impact of additional non-cash compensationcharges in periods subsequent to June 30, 2006 totals approximately $0.8million, charged equally in each of the next four quarters through the quarterending June 30, 2007. 

**4.**   Basicand Diluted Net Loss Per Common Share (Restated)

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 upon theweighted average number of common shares outstanding during the period plus theadditional weighted average potential common shares during the period.Potential common shares are not included in the per share calculation when theeffect of their inclusion would be anti-dilutive. Potential common sharesresult from the assumed conversion of convertible subordinated debt, vesting ofrestricted stock awards and the assumed exercise of outstanding stock options,the proceeds of which are then assumed to have been used to repurchaseoutstanding stock options using the treasury stock method. Purchased calloptions are also not included in the per share calculations for the periodended June 30, 2005 because including them would be anti-dilutive. Therewere no outstanding purchased call options during 2006.

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

a.                 Optionsto purchase shares of common stock:

| ** **            | ** ** | **Three Months  Ended  June 30, 2006**                         | ** **      | **Three Months  Ended  June 30, 2005** | ** ** | **Six Months  Ended  June 30, 2006** | ** ** | **Six Months  Ended  June 30, 2005** | ** **      |
|-----------------------|------------|-------------------------------------------------------------------------------|-----------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|-----------------|
| ** **            | ** ** | **(in thousands, except price per share data)** | ** **      |
| Number of options     |       | 8,192                                                                         |            | 11,625                                                |       | 8,072                                               |       | 11,625                                              |            |
| Price range per share |       | $                                                                             | 38.26 to $87.50 |                                                  | $          | 5.75 to $87.50                                      |       | $                                                   | 38.26 to $87.50 |   | $ | 5.75 to $87.50 |   |
|                       |            |                                                                               |                 |                                                       |            |                                                     |            |                                                     |                 |  |  |  |  |

 

9

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

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

 

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

**5.**   Accountingfor Stock-Based Compensation

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

Our equity incentive plans were adopted in 1997, 1999,2000 and 2002. Stock options granted under the equity incentive plans aregenerally non-qualified stock options, but the equity incentive plans permit thegranting of “incentive stock options” under the U.S. Internal Revenue Code of1986, as amended, or the Code. The exercise price of a stock option generallyis equal to the fair market value of our common stock on the option grant date.The contractual term of stock options granted under our equity incentive plansis generally 10 years.

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

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

As required by SFAS 123(R), management has made anestimate of expected forfeitures, and we are recognizing compensation costsonly for those equity awards expected to vest.

10

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

| ** **                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | **June 30,  2006**          | ** ** | **June 30,  2005**        | ** ** | **June 30,  2006** | ** ** | **June 30,  2005** | ** ** |
| ** **                           | ** ** | **(in thousands)**          | ** ** |
| Cost of products  sold               |       | $                                | 148        |                           |       | $ | — |   |   | $ | 282 |   |   | $ | — |   |   |
| Research and  development            |       | 2,517                            |       |                           | —     |   |   | 4,942 |   |   | — |   |   |
| Selling,  marketing and distribution |       | 3,569                            |       |                           | 35         |   |   | 6,873 |   |   | 70 |   |   |
| General and  administrative          |       | 4,561                            |       |                           | 226        |   |   | 8,746 |   |   | 452 |   |   |
| Stock-based compensation  expense    |       | $                                | 10,795     |                           |       | $ | 261 |   |   | $ | 20,843 |   |   | $ | 522 |   |   |

 

As a result of adopting SFAS 123(R), our netincome for the three and six months ended June 30, 2006 is $10,572,000 and$20,397,000, respectively, less than if we had continued to account for stock-basedcompensation under APB 25. Basic and diluted income per share for thethree months ended June 30, 2006 were also less by $0.10 and $0.09,respectively, due to the adoption of SFAS 123(R). Basic and diluted income pershare for the six months ended June 30, 2006 were also less by $0.20 and$0.18, respectively, due to the adoption of SFAS 123(R).

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

| ** **                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                        | ** ** | **June 30,  2006**          | ** ** | **June 30,  2005**        | ** ** | **June 30,  2006** | ** ** | **June 30,  2005** | ** ** |
| ** **                        | ** ** | **(in thousands)**          | ** ** |
| Employee stock  options           |       | $                                | 9,952      |                           |       | $ | 261 |   |   | $ | 19,214 |   |   | $ | 522 |   |   |
| Restricted shares                 |       | 609                              |       |                           | —     |   |   | 911 |   |   | — |   |   |
| Employee stock  purchase plan     |       | 234                              |       |                           | —     |   |   | 718 |   |   | — |   |   |
| Stock-based compensation  expense |       | $                                | 10,795     |                           |       | $ | 261 |   |   | $ | 20,843 |   |   | $ | 522 |   |   |

 

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. Theassumptions we use 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 approach weutilized to develop the underlying assumptions are appropriate in calculatingthe fair values of the stock options granted in the three and six months ended June 30,2006. Estimates of fair value are not intended to predict actual future eventsor the value ultimately realized by persons who receive equity awards.

Theweighted average grant date fair market values of the options granted for thesix months ended June 30, 2006 and 2005, was $19.81 and $38.73,respectively. Assumptions used to determine the fair value of stock optionsgranted during the three and six months ended June 30, 2006, using theBlack-Scholes valuation model were:

| ** **                      | ** ** | **Three Months Ended  June 30, 2006** | ** ** | **Six Months Ended  June 30, 2006** | ** ** |
|---------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | **Employee Stock  Option Plans**                | ** ** | **1998 Employee Stock  Purchase Plan**   | ** ** | **Employee Stock  Option Plans** | ** ** | **1998 Employee Stock  Purchase Plan** | ** ** |
| Expected term                   |       |                                                      | 4.5 years  |                                                    |       |   | 0.5 years |   |   |   | 5.4 years |   |   |   | 0.5 years |   |   |
| Expected  volatility factor     |       |                                                      | 32.5%      |                                                    |       |   | 31.3% |   |   |   | 29.4% |   |   |   | 29.5% |   |   |
| Risk-free  interest rate        |       |                                                      | 4.9%       |                                                    |       |   | 4.7% |   |   |   | 4.7% |   |   |   | 4.4% |   |   |
| Expected annual dividend  yield |       |                                                      | —     |                                                    |       |   | — |   |   |   | — |   |   |   | — |   |   |

 

11

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

| ** **                                                                                    | ** ** | **Three Months Ended  June 30, 2005  (as restated)** | ** ** | **Six Months Ended  June 30, 2005  (as restated)** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **(in thousands, except  price per share data)**     | ** ** |
| Net loss as reported                                                                          |       |                                                                          | $          | (7,661                                                                      | )          |   |   | $ | (30,494 | ) |   |
| Add: Stock-based employee compensation expense  included in restated results                  |       |                                                                          | 261        |                                                                        |       |   | 522 |   |   |
| Less: Total stock-based employee compensation  expense determined under the fair value method |       |                                                                          | (12,540    | )                                                                           |       |   | (24,654 | ) |   |
| Pro forma net loss                                                                            |       |                                                                          | $          | (19,940                                                                     | )          |   |   | $ | (54,626 | ) |   |
| Net loss per  share:                                                                          |       |                                                                          |       |                                                                        |       |   |   |   |   |
| Basic and diluted—as reported                                                       |       |                                                                          | $          | (0.07                                                                       | )          |   |   | $ | (0.29 | ) |   |
| Basic and diluted—pro forma                                                              |       |                                                                          | $          | (0.19                                                                       | )          |   |   | $ | (0.52 | ) |   |

 

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

| ** **               | ** ** | **Three Months Ended June 30, 2005** | ** **     | **Six Months Ended June 30, 2005** | ** ** |
|--------------------------|------------|---------------------------------------------------------------|----------------|-------------------------------------------------------------|------------|
| ** **               | ** ** | **Employee Stock   Option Plans**              | ** **     | **1998 Employee Stock  Purchase Plan**       | ** ** | **Employee Stock  Option Plans** | ** ** | **1998 Employee Stock  Purchase Plan** | ** ** |
| Expected term            |       |                                                          | 5.0 years |                                                        |       |   | 0.5 years |   |   |   | 5.0 years |   |   |   | 0.5 years |   |   |
| Volatility               |       |                                                          | 40.0%          |                                                        |       |   | 36.0% |   |   |   | 71.1% |   |   |   | 36.0% |   |   |
| Risk-free  interest rate |       |                                                          | 3.8%           |                                                        |       |   | 2.4% |   |   |   | 3.9% |   |   |   | 2.4% |   |   |
| Dividend yield           |       |                                                          | —         |                                                        |       |   | — |   |   |   | — |   |   |   | — |   |   |

 

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

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

| ** **                           | ** ** | **Number of  Options  (in thousands)** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term   (in years)** | ** ** |
|--------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| Outstanding,  December 31, 2005 |       |                                             | 10,859     |                                       |       |                                                                       | $          | 32.78 |   |   |   |   |   |   |
| Granted                              |       |                                             | 1,789      |                                       |       |                                                                       | $          | 54.41 |   |   |   |   |   |   |
| Exercised                            |       |                                             | (757       | )                                          |       |                                                                       | $          | 17.86 |   |   |   |   |   |   |
| Cancelled                            |       |                                             | (159       | )                                          |       |                                                                       | $          | 43.38 |   |   |   |   |   |   |
| Outstanding,  June 30, 2006     |       |                                             | 11,732     |                                       |       |                                                                       | $          | 36.89 |   |   |   | 6.1 |   |   |
| Exercisable at  June 30, 2006   |       |                                             | 6,313      |                                       |       |                                                                       | $          | 27.94 |   |   |   | 4.4 |   |   |

 

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All stock options granted during the six months endedJune 30, 2006 and 2005 were granted with exercise prices equal to the fairmarket value of our common stock on the grant date.

At June 30, 2006, the aggregate intrinsic valueof stock options outstanding and stock options exercisable was $259,473,000 and$191,864,000, respectively. The intrinsic value of a stock option is the amountby which the market value of the underlying stock exceeds the exercise price ofthe stock option.

The aggregate intrinsic value of stock optionsexercised during the three and six months ended June 30, 2006 was$13,649,000 and $27,622,000, respectively.

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

| ** **                                           | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**    | ** ** |
|------------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **Exercise Price Range**                   | ** ** | ** **                   | ** ** | **Number  (in thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted Average  Remaining  Contractual  Term (in years)** | ** ** | **Number  (in thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $  5.75 – $  8.31 |       |                         | 736        |                            |       |   | $ | 6.30 |   |   |   | 6.1 |   |   |   | 717 |   |   |   | $ | 6.27 |   |   |
| $11.25 – $16.78                       |       |                         | 1,901      |                            |       |   | $ | 13.10 |   |   |   | 4.5 |   |   |   | 1,428 |   |   |   | $ | 12.89 |   |   |
| $18.38 – $27.15                       |       |                         | 2,503      |                            |       |   | $ | 21.20 |   |   |   | 4.5 |   |   |   | 1,803 |   |   |   | $ | 20.52 |   |   |
| $27.70 – $39.07                       |       |                         | 1,088      |                            |       |   | $ | 34.47 |   |   |   | 4.2 |   |   |   | 957 |   |   |   | $ | 35.34 |   |   |
| $42.38 – $59.45                       |       |                         | 4,349      |                            |       |   | $ | 52.14 |   |   |   | 8.1 |   |   |   | 1,178 |   |   |   | $ | 53.80 |   |   |
| $64.50 – $87.50                       |       |                         | 1,155      |                            |       |   | $ | 74.31 |   |   |   | 6.5 |   |   |   | 230 |   |   |   | $ | 75.44 |   |   |
| $  5.75 – $87.50            |       |                         | 11,732     |                            |       |   | $ | 36.89 |   |   |   | 6.1 |   |   |   | 6,313 |   |   |   | $ | 27.94 |   |   |
|                                                      |            |                              |            |                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Ournon-vested share activity for the six months ended June 30, 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      |                                                    |       |   | $ | 43.77 |   |   |   | — |   |   |   | — |   |   |
| Granted                               |       |                                            | 1,789      |                                                    |       |   | $ | 54.41 |   |   |   | 174 |   |   |   | $ | 55.34 |   |   |
| Vested                                |       |                                            | (774       | )                                                       |       |   | $ | 34.50 |   |   |   | — |   |   |   | — |   |   |
| Forfeited                             |       |                                            | (159       | )                                                       |       |   | $ | 43.38 |   |   |   | — |   |   |   | — |   |   |
| Non-vested at  June 30, 2006     |       |                                            | 5,419      |                                                    |       |   | $ | 48.62 |   |   |   | 174 |   |   |   | $ | 55.34 |   |   |

 

At June 30, 2006, unrecognized compensationexpense related to non-vested stock options and restricted stock was $106,555,000and $8,365,000, respectively, which is expected to be recognized over weightedaverage periods of 3.5 years and 4.1 years, respectively.

At June 30, 2006, theestimated unrecognized compensation expense related to the June 1, 2006offering period of the 1998 ESPP, which concludes on November 30, 2006,was $987,000. The associated expense is amortized on a straight-line basis overthe offering period.

**6.**   Inventories

Inventoriesconsist of the following:

| ** **     | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **     | ** ** | **(in thousands)** | ** ** |
| Raw materials  |       | $                       | 23,532     |                        |       | $ | 21,780 |   |   |
| Finished goods |       | 26,837                  |       |                        | 17,171     |   |   |
| Total          |       | $                       | 50,369     |                        |       | $ | 38,951 |   |   |

 

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**7.**   DeferredFinancing and Patents Costs

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

| ** **                       | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                       | ** ** | **(in thousands)** | ** ** |
| Deferred  financing costs, gross |       | $                       | 34,440     |                        |       | $ | 34,440 |   |   |
| Accumulated  amortization        |       | (20,344                 | )          |                        | (17,474    | ) |   |
| Deferred  financing costs, net   |       | $                       | 14,096     |                        |       | $ | 16,966 |   |   |
| Patents, gross                   |       | $                       | 2,785      |                        |       | $ | 2,785 |   |   |
| Accumulated  amortization        |       | (1,780                  | )          |                        | (1,654     | ) |   |
| Patents, net                     |       | $                       | 1,005      |                        |       | $ | 1,131 |   |   |

 

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

| ** **                                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                | ** ** | **June 30,  2006**          | ** ** | **June 30,  2005**        | ** ** | **June 30,  2006** | ** ** | **June 30,  2005** | ** ** |
| ** **                                | ** ** | **(in thousands)**          | ** ** |
| Amortization of  deferred financing costs |       |                             | $          | 1,435                          |       |   |   | $ | 903 |   |   |   | $ | 2,870 |   |   |   | $ | 1,806 |   |   |
| Amortization of  patents                  |       |                             | 70         |                           |       |   | 137 |   |   |   | 126 |   |   |   | 290 |   |   |
| Total                                     |       |                             | $          | 1,505                          |       |   |   | $ | 1,040 |   |   |   | $ | 2,996 |   |   |   | $ | 2,096 |   |   |

 

We currently estimate thatour amortization expense will be $2,977,000,$4,344,000, $3,994,000, $2,862,000 and $730,000 for the remainder of 2006 andfor the years ending December 31, 2007, 2008, 2009 and 2010,respectively.

**8.**   ConvertibleSubordinated Debt

Convertiblesubordinated debt consists of the following:

| ** **                                                       | ** ** | **June 30,  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 |   |   |

 

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**9.**   ComprehensiveIncome (Loss)

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

| ** **                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**              | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **June 30,  2006**          | ** ** | **June 30,  2005  (as restated)** | ** ** | **June 30,  2006** | ** ** | **June 30,  2005  (as restated)** | ** ** |
| ** **                                               | ** ** | **(in thousands)**          | ** ** |
| Comprehensive  income (loss):                            |       |                             |       |                                        |       |   |   |   |   |   |   |   |   |
| Net income (loss)                                        |       | $                                | 11,044     |                                        |       | $ | (7,661 | ) |   | $ | 21,080 |   |   | $ | (30,494 | ) |   |
| Net foreign  currency translation adjustment             |       | 722                              |       |                                        | (186       | ) |   | 681 |   |   | (268 | ) |   |
| Unrealized gain  (loss) on available-for-sale securities |       | (14,670                          | )          |                                        | 10,037     |   |   | (3,864 | ) |   | 8,552 |   |   |
| Total comprehensive  income (loss)                       |       | $                                | (2,904     | )                                           |       | $ | 2,190 |   |   | $ | 17,897 |   |   | $ | (22,210 | ) |   |

 

**10.**   LegalProceedings

**Stock OptionInquiry and Derivative Stockholder Complaints**

In June 2006, we announced that we had received aletter of inquiry from the SEC requesting documents related to our stock optiongrants and stock option practices. We appointed a special committee of outsidedirectors to conduct an internal review relating to our stock option grants andstock option practices. The special committee, with the assistance of legalcounsel and accounting specialists, has reviewed stock option grants to ourofficers, directors and employees from 1996 to present under our various stockoption plans in effect during this period. We have been cooperating with thereview and our finance department has also reviewed our stock option grants andstock option practices. The special committee’s review is substantiallycomplete but will remain open for the duration of the SEC’s inquiry. See Note 3to our financial statements for additional information concerning thesereviews.

We have been notified thatthree stockholder derivative complaints were filed in the Superior Court,Middlesex County, Commonwealth of Massachusetts, naming Sepracor as nominaldefendant and also naming as defendants certain current members of our board ofdirectors and certain of our current and former employees. The complaintsallege purported breaches of fiduciary duties and unjust enrichment inconnection with certain stock option grants made by us between June 1998and May 2001. The complaints seek monetary damages in unspecified amounts,equitable and injunctive relief, including disgorgement of profits obtained bycertain defendants and other relief as determined by the Court. We and ourdirectors are reviewing the allegations and will respond when appropriate.

**Tecastemizole Class ActionComplaints**

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

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reasonablyestimate any possible range of loss related to the lawsuits due to theiruncertain resolution. However, any conclusion of these matters in a manneradverse to us would have a material adverse effect on our financial positionand results of operations.

**LevalbuterolHydrochloride Inhalation Solution ANDAs**

In September 2005, we received notification thatthe FDA had received an abbreviated new drug application, or ANDA, from BreathLimited seeking approval of a generic version of our 1.25 mg, 0.63 mg and 0.31mg levalbuterol hydrochloride inhalation solution. Breath Limited’s submissionincludes a Paragraph IV certification alleging that our patents listed in theFDA publication entitled “Approved Drug Products With Therapeutic EquivalenceEvaluations,” commonly referred to as the “Orange Book,” for XOPENEX InhalationSolution are invalid, unenforceable or not infringed by Breath Limited’sproposed product. We have filed a civil action against Breath Limited forpatent infringement. We were notified in January 2006 of a second ANDAseeking approval of a generic version of our 1.25 mg, 0.63 mg and 0.31 mglevalbuterol hydrochloride inhalation solution including a Paragraph IVcertification, which was submitted to the FDA by Dey, L.P. We have filed acivil action against Dey, L.P. for patent infringement. In April 2006, wewere notified of a third ANDA seeking approval of a generic version of our 1.25mg, 0.63 mg and 0.31 mg levalbuterol hydrochloride inhalation solutionincluding a Paragraph IV certification, which was submitted to the FDA byWatson Laboratories, Inc. Watson’s paragraph IV certification was limitedto our patent that expires in 2021 and covers certain levalbuterolhydrochloride inhalation solutions, including XOPENEX Inhalation Solution. Wehave decided not to file a civil action against Watson Laboratories, Inc.for patent infringement at this time.

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.

**Fexofenadine PatentClaim**

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

**11.**   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 that was formed in January 2005.Our purchase was made at a price of approximately $12.29 per share, whichrepresented a 25 percent premium over the 30-day trailing averageclosing price of ACADIA’s common stock on the NASDAQ Global Market and resultedin the issuance to us of 813,393 shares of ACADIA common stock. We recorded thepremium amount of $1,061,000 as research and development expense and theremaining amount of $8,939,000 as an investment in ACADIA.

On January 10, 2005, we completed the initial$10 million purchase of ACADIA Pharmaceuticals Inc. common stock inconnection with the collaboration. Our purchase was made at a price ofapproximately $9.28 per share, which represented a 40 percent premium overthe 30-day trailing average closing price of ACADIA’s common stock on theNASDAQ Global Market and resulted in the issuance to us of 1,077,029 

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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.

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

**12.    Commitmentsand Contingencies**

In conjunction with the review of our stock optiongranting practices, we have also evaluated the related tax issues to determineif we may be subject to additional tax liability as a result of the mattersunder review. As a result of the additional stock-based compensation charges,we may be entitled to additional tax deductions. Also as a result of suchcharges, previously deducted compensation related to exercised stock optionsmay be non-deductible under Section 162(m) of the Code. Accordingly, we havenet operating loss carryforwards, which may be affected, however, we have afull valuation allowance against our deferred tax assets and, as a result, donot expect any material impact on our financial position or results ofoperations.  In addition, due to therevision of measurement dates, certain stock options that we previously treatedas incentive stock options do not actually qualify for such treatment and mustbe treated as non-statutory stock options. Accordingly, we may be subject tofines and/or penalties relating to the tax treatment of such stock options.However, we do not believe it is probable that we will incur additional taxliability as a result of the matters under review and, to the extent we may,any such amount is not expected to have a material impact on our financial positionor results of operations.  

At the conclusion of the SEC’s informal inquiry, wecould be subject to regulatory fines or penalties or other contingentliabilities.

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

**Cautionary Statement Regarding Forward-LookingStatements**

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

**Executive Overview**

We are a research-basedpharmaceutical company focused on discovering, developing and commercializingdifferentiated products that address large and growing markets and unmetmedical needs, and can be marketed to primary care physicians through our salesforce.

We currently manufactureand sell three products, XOPENEX® (levalbuterol HCl) Inhalation Solution, ashort-acting bronchodilator, for the treatment or prevention ofbronchospasm in patients with reversible obstructive airway disease; XOPENEXHFAÔ (levalbuterol tartrate) Inhalation Aerosol, ahydrofluoroalkane, or HFA, metered-dose inhaler, or MDI, for the treatment orprevention of bronchospasm in adults, adolescents and children four years ofage and older with reversible obstructive airway disease; and LUNESTAÔ(eszopiclone) for the treatment of insomnia.

We market and sell XOPENEXInhalation Solution, LUNESTA and XOPENEX HFA directly through our sales force.We have entered into out-licensing arrangements with respect to several othercompounds. We expect to commercialize any additional products that wesuccessfully develop through our sales force, through co-promotion agreementsand through out-licensing partnerships.

**Restatement of Financial Statements Based on Review ofStock Option Practices**

In June 2006 we announcedthat the SEC had initiated an informal inquiry into our stock option practices.We appointed a special committee of outside directors in June 2006 toconduct an internal review relating to our stock option grants and stock optionpractices. The special committee, with the assistance of legal counsel andaccounting specialists, has reviewed the stock option grants to our officers,directors and employees from 1996 to the present under our various stock optionplans in effect during this period.  Wehave been cooperating with this review and our finance department has alsoreviewed the stock option grants and stock option practices from 1996 topresent. The special committee’s review is substantially complete but will remainopen for the duration of the SEC’s inquiry. The aggregate amount of theadditional stock-based compensation expense that we will incur as a result ofthe stock option review is approximately $43.3 million. The impact ofadditional stock-based compensation expense is approximately $1.0 million, $1.3million and $2.0 million for the years ended December 31, 2005, 2004 and2003, respectively. For the three months ended June 30, 2006 and March 31, 2006the additional stock-based compensation expense is approximately$0.2 million and $0.2 million, respectively. 

As a result of the review,we have concluded that we will need to restate our financial statements for thequarters ended March 31, June 30, September 30 and December 31, 2005, thequarter ended March 31, 2006 and the fiscal years ended December 31, 2005and 2004 and 2003. See Note 3 to our financial statements for additionalinformation about the review and restatement.

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**Significant 2006Developments**

On July 27, 2006, UCBS.A., or UCB, announced it had submitted a New Drug Application, or NDA, to theUnited States Food and Drug Administration, or FDA, seeking approval for XYZAL® (levocetirizine). Levocetirizine is currentlymarketed by UCB under the brand names XYZAL and XUSALÔin the European Union, or E.U., for treatment of symptoms of seasonal andperennial allergic rhinitis, persistent allergic rhinitis and chronicidiopathic urticaria, or CIU, also known as hives of unknown cause, in adultsand children aged six years and older. On February 23, 2006, weannounced that we entered into a licensing agreement with UCB, relating tolevocetirizine. Under this agreement, we have exclusively licensed to UCB allof our patents and patent applications in the United States 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.

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

During the second quarterof 2006, we completed the hiring and training of an additional 495 salesrepresentatives and managers. This expansion will focus on supporting expectedfuture sales growth of our marketed products. As of June 30, 2006, we had atotal of 1,930 sales persons.

In March 2006, theMedicare Durable Medical Equipment Program Safeguard Contractors, or DME-PSCs,issued a draft local coverage determination under which Medicare reimbursementfor XOPENEX Inhalation Solution would be reduced to the level of reimbursementunder Medicare Part B. We estimate that approximately 25 percent of our XOPENEXInhalation sales are subject to reimbursement under Medicare Part B. If thislocal coverage determination is implemented, revenue from these sales of XOPENEXInhalation Solution would be materially adversely affected.

On January 17, 2006,we announced that we had completed the second $10 million purchase ofACADIA Pharmaceuticals Inc., or ACADIA, common stock in connection withour license, option and collaboration agreement, or collaboration, with ACADIAthat we entered into in January 2005. Our purchase was made at a price ofapproximately $12.29 per share, which represented a 25 percent premium tothe 30-day trailing average closing price on the NASDAQ Global Market asof the one-year anniversary of the collaboration, and resulted in the issuanceto us of 813,393 shares of ACADIA common stock.

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

On January 12, 2006, we announced that we hadbeen notified that the FDA had received an abbreviated new drug application, orANDA, from Dey, L.P. for a generic version of levalbuterol hydrochlorideinhalation solution. Dey’s submission includes a Paragraph IVcertification alleging our patents listed in the FDA publication entitled “ApprovedDrug Products With Therapeutic Equivalence Evaluations,” commonly referred toas the “Orange Book,” for XOPENEX Inhalation Solution are invalid,unenforceable or not infringed by Dey’s proposed product. On September 7,2005, we announced that the FDA had received an ANDA from Breath Limitedseeking marketing approval for generic copies of our 1.25 mg, 0.63 mg and 0.31mg XOPENEX Inhalation Solution (levalbuterol hydrochloride) unit-dose vialproduct. XOPENEX Inhalation Solution Concentrate is not subject to the ANDA.Breath Limited’s submission includes a Paragraph IV certification allegingthat our patents listed in the Orange Book for XOPENEX Inhalation Solution areinvalid, unenforceable or not infringed by Breath Limited’s proposed product.We have filed civil actions against Breath Limited and Dey, L.P. forpatent 

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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 was submittedto the FDA by Watson Laboratories, Inc. Watson’s Paragraph IVcertification was limited to our patent that expires in 2021 and covers certainlevalbuterol hydrochloride inhalation solutions, including XOPENEX InhalationSolution. We have decided not to file a civil action against WatsonLaboratories, Inc. for patent infringement at this time.

If we successfully enforceour patents, the FDA will not approve the relevant ANDA until expirationof the applicable patents. Otherwise, the FDA will stay its approval of therelevant ANDA for 30 months following the date we received notice ofsuch ANDA or until a court decides that our patents are invalid,unenforceable or not infringed, whichever is earlier.

**Three Month Periods ended June 30, 2006 and 2005 (Restated)**

*Revenues*

Product sales were$256,427,000 and $166,743,000 for the three months ended June 30, 2006 and2005, respectively, an increase of approximately 54%. The increase is primarilythe result of increases in LUNESTA and XOPENEX Inhalation Solution revenue.

Sales of LUNESTA were$139,132,000 and $83,459,000 for the three months ended June 30, 2006 and2005, respectively, an increase of approximately 67%. The increase is primarilythe result of a 32% increase in the number of units sold and a 26% increase inthe net selling price per unit, which was partially due to a 12% increase inthe gross selling price per unit. Adjustments recorded to gross sales aredisclosed below under the heading “Analysis of gross sales to net sales.”

Sales of XOPENEX InhalationSolution were $115,704,000 for the three months ended June 30, 2006 ascompared to $83,284,000 for the same period in 2005, an increase ofapproximately 39%. The sales increase for XOPENEX Inhalation Solution for thethree months ended June 30, 2006 as compared with the same period in 2005is due to (i) a 29% increase in the net selling price per unit, which includedan 8% increase in the gross selling price per unit and (ii) a 7% increase inthe number of units sold. Adjustments recorded to gross sales are disclosedbelow under the heading “Analysis of gross sales to net sales.”

Salesof XOPENEX HFA were $1,591,000 for the three months ended June 30,2006, as compared to $0 for the sameperiod in 2005. We introduced XOPENEXHFA commercially in December 2005.

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

| ** **                                   | ** ** | **For the Three Months Ended June 30,** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                                              | ** ** | **% of  sales** | ** ** | **2005** | ** ** | **% of  sales** | ** ** | **$  Change** | ** ** | **%  Change** | ** ** |
| ** **                                   | ** ** | **(dollars in thousands)**                                  | ** ** |
| Gross sales                                  |       | $                                                                     | 298,292    |   | 100.0% |   | $ | 221,580 |   | 100.0% |   | $ | 76,712 |   |   | 35% |   |   |
| Adjustments to gross  sales:                 |       |                                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Payment term discounts                       |       | 6,414                                                                 |       | 2.2% |   | 4,503 |   | 2.0% |   | 1,911 |   |   | 42% |   |   |
| Wholesaler fee for service                   |       | 7,291                                                                 |       | 2.4% |   | 5,516 |   | 2.5% |   | 1,775 |   |   | 32% |   |   |
| Government rebates and contractual discounts |       | 23,413                                                                |       | 7.8% |   | 21,837 |   | 9.8% |   | 1,576 |   |   | 7% |   |   |
| Returns                                      |       | 4,268                                                                 |       | 1.4% |   | 18,352 |   | 8.3% |   | (14,084 | ) |   | (77% | ) |   |
| Other (includes product launch discounts)    |       | 479                                                                   |       | 0.2% |   | 4,629 |   | 2.1% |   | (4,150 | ) |   | (90% | ) |   |
| Sub-total  adjustments                       |       | 41,865                                                                |       | 14.0% |   | 54,837 |   | 24.7% |   | (12,972 | ) |   | (24% | ) |   |
| Net sales                                    |       | $                                                                     | 256,427    |   | 86.0% |   | $ | 166,743 |   | 75.3% |   | $ | 89,684 |   |   | 54% |   |   |

 

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Decreases in theadjustments to gross sales as a percentage of gross sales for the three monthsended June 30, 2006 as compared with the three months ended June 30,2005 primarily reflects a lower return reserve as a percentage of gross salesdue to a reserve recorded in the three months ended June 30, 2005 relatingto a potential product return caused by a packaging issue for our LUNESTA 1milligram, or mg, strength form, which has been resolved, as well as anincrease in actual XOPENEX Inhalation Solution returns during the three monthsended June 30, 2005 causing a higher than average returns reserve rate forthat period. Decreases in the adjustments to gross sales as a percentage ofgross sales for the three months ended June 30, 2006 as compared to the sameperiod in 2005 is also attributable to an overall decrease in governmentrebates and contractual discounts. A portion of the decrease in the deductionsfor government rebates and contractual discounts is associated with lowerMedicaid discounts of XOPENEX Inhalation Solution sales as a result of a reviewof prior period rebate per unit calculations resulting in a reserve reversal ofa prior period estimate, in addition to a shift in patient coverage fromMedicaid to Medicare Part D, as a result of the introduction of theMedicare Part D program in 2006. The decrease in government rebates andcontractual discounts was partially offset by an increase in contractualdiscounts that we offered in connection with XOPENEX HFA, which wascommercially introduced in December 2005.

Included in the deductionsfor government rebates and contractual discounts is a reserve for Medicare Part Bdiscounts related to XOPENEX Inhalation Solution sales. Medicare reimbursementrates for XOPENEX Inhalation Solution have been favorable since January 2005,but we cannot be certain these favorable rates will continue. In March 2006, the DME-PSCs issued a draftlocal coverage determination under which Medicare reimbursement for XOPENEXInhalation Solution would be reduced to the level of reimbursement for genericalbuterol. We estimate that approximately 25 percent of our XOPENEX InhalationSolution sales are subject to reimbursement under Medicare Part B. If thislocal coverage determination is implemented, these sales of XOPENEX InhalationSolution would be materially adversely affected.

Royalties were $7,979,000and $18,321,000 for the three months ended June 30, 2006 and 2005,respectively, a decrease of approximately 56%. The decrease is primarily due tothe decrease in royalties earned on the sales of ALLEGRA under our agreementwith sanofi-aventis, which were $3,220,000 for the three months ended June 30,2006 compared to $14,579,000 for the same period in 2005, with the majority ofthe decrease resulting because we ceased to receive royalties on sales ofALLEGRA in the United States. Pursuant to the terms of our United Statesagreement with sanofi-aventis, our royalties on the sale of ALLEGRA in theUnited States, which have historically been between $15 and $20 million peryear, terminated based on the introduction of a generic equivalent of thisproduct in September 2005. We are still entitled to receive royalties onthe sale of ALLEGRA outside of the United States in countries where we holdpatents covering ALLEGRA and no generic equivalent product has been introduced.Royalties earned on sales of CLARINEX®, under our agreement with Schering-PloughCorporation, increased to $3,547,000 from $2,526,000 for the three months endedJune 30, 2006 versus the same period in 2005.

*Costs of Revenues*

Cost of product sold was$20,693,000 and $14,453,000 for the three months ended June 30, 2006 and2005, respectively.

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

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Cost of XOPENEX InhalationSolution sold as a percentage of XOPENEX Inhalation Solution gross sales wasapproximately 7% for the three months ended June 30, 2006 and 2005.

Cost of XOPENEX HFA soldas a percentage of XOPENEX HFA gross sales was approximately 17% for the threemonths ended June 30, 2006 as compared to 14% for the three months ended March 31,2006. The increase is primarily related to an increase in raw material costs. Includedin the costs of XOPENEX HFA sold is a royalty paid on net sales of XOPENEX HFAto 3M Company, or 3M, our third-party finished goods manufacturer of theproduct. We introduced XOPENEX HFA commercially in December 2005.

Cost of royalties earnedwas $283,000 and $202,000 for the three months ended June 30, 2006 and2005, respectively. The cost of royalties in both periods relates to anobligation to a third party as a result of royalties we earn from Schering-PloughCorporation based upon its sales of CLARINEX. This increase in third-partyobligations is due to the slight increase in royalties earned in the threemonths ended June 30, 2006 as compared with the same period in 2005.

*Research and Development*

Research and developmentexpenses were $36,360,000 and $37,132,000 for the three months ended June 30,2006 and 2005, respectively, a decrease of approximately 2%. The decrease isprimarily due to lower spending on our XOPENEX HFA, LUNESTA, Arformoterol andSEP-226330 programs. The decrease was partially offset by increasedspending on our SEP-225289 and SEP-227162 programs, both targetedfor the treatment of depression, as well as drug discovery efforts. Inaddition, share-based compensation expense resulting from our January 1,2006 implementation of SFAS 123(R) was$2,517,000 for the period ended June 30, 2006 as compared to $0 for theperiod ended June 30, 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, orclinical study, of the potential new drug. Clinical development typicallyinvolves three phases of study: Phase I, II and III. The most significantcosts in clinical development are in Phase III clinical trials, as they tend tobe the longest 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, which if conducted, could cause us to incur substantialcosts. Phase IIIB studies are initiated and either completed or substantiallycompleted while the NDA is under FDA review. These studies are conducted underan IND. Phase IV studies, also referred to as post-marketing studies, arestudies that are initiated and conducted after the FDA has approved a productfor marketing. Phase IV studies may be requested by the FDA either before orafter the FDA has approved an NDA. These studies may also be independently initiatedby the company for which an NDA has been approved. The FDA and the companiesconducting post-marketing studies use them to gather additional informationabout a product’s safety, 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 process of seeking FDA approvals, and subsequentcompliance with applicable statutes and regulations, require the expenditure ofsubstantial resources. Any failure by us to obtain, or delay in obtaining,regulatory approvals could materially adversely affect our business. We cannotassure you that we will obtain any approval required by the FDA on a timelybasis, if at all.

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

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Belowis a summary of development of our products and product candidates that represent10% or more of our direct project research and development spending for thethree months ended June 30, 2006. The “Estimate of Completion of Stage”column contains forward-looking statements regarding expected timing ofcompletion of product development phases. Completion of product development, ifsuccessful, culminates in the submission of an NDA to the FDA; however, therecan be no assurance that the FDA will accept for filing, or approve, any NDA.The actual timing of completion of phases could differ materially from theestimates provided in the table. The table is sorted by highest to lowestspending amounts, and the two commercial products and the three productcandidates listed accounted for approximately 91% of our direct projectresearch and development spending for the three months ended June 30,2006. No other product candidate accounted for more than 6% of our directresearch and development spending in this period.

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

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*                    Wecommercially launched XOPENEX HFA in December 2005.

**             Wecommercially launched LUNESTA in April 2005.

***      Wesubmitted an NDA to the FDA in December 2005 for Arformoterol. ThePrescription Drug User Fee Act, or PDUFA, date is October 12, 2006.The PDUFA date is the date by which the FDA is expected to review and act onthe NDA submission.

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 June 30, 2006 and 2005, as well asthe costs incurred to date on these projects. The costs in this analysisinclude only direct costs and do not include certain indirect labor, overhead,share-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  June 30, 2006** | ** ** | **Project costs to  date through  June 30,  2006** | ** ** | **Project costs for  the three  months ended  June 30, 2005** | ** ** | **Project costs to  date through  June 30,  2005** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                                                                     | ** ** |
| XOPENEX HFA  (levalbuterol tartrate) |       |                                                                                        | $          | 3,126                                                                  |       |                                                                                        |       | $                                                                      | 165,204    |   |   |   | $ | 8,049 |   |   |   | $ | 145,992 |   |   |
| LUNESTA  (eszopiclone)               |       |                                                                                        | $          | 2,841                                                                  |       |                                                                                        |       | $                                                                      | 210,544    |   |   |   | $ | 6,346 |   |   |   | $ | 189,715 |   |   |
| SEP-225289                           |       |                                                                                        | $          | 2,402                                                                  |       |                                                                                        |       | $                                                                      | 9,270      |   |   |   | $ | 665 |   |   |   | $ | 1,276 |   |   |
| Arformoterol                         |       |                                                                                        | $          | 2,007                                                                  |       |                                                                                        |       | $                                                                      | 167,228    |   |   |   | $ | 4,641 |   |   |   | $ | 151,956 |   |   |
| SEP-227162                           |       |                                                                                        | $          | 1,318                                                                  |       |                                                                                        |       | $                                                                      | 4,373      |   |   |   | $ | 334 |   |   |   | $ | 363 |   |   |

 

Due to the length of timenecessary to develop a product, uncertainties related to the ability to obtaingovernmental approval for commercialization, and difficulty in estimating costsof projects, it is difficult to make accurate and meaningful estimates of theultimate cost to bring our product candidates to FDA approved status. We do notbelieve it is possible to estimate, with any degree of accuracy, the costs ofproduct candidates that are in stages earlier than Phase III. Accordingly, wehave not provided any such estimates, as all of our product candidates, otherthan Arformoterol, for which we have submitted an NDA, are in Phase I development.

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*Selling, Marketingand Distribution*

Selling, marketing and distribution expenses were$182,605,000 and $130,183,000 for the three months ended June 30, 2006 and2005, respectively, an increase of approximately 40%. Of the $52,422,000increase, approximately 36% is due to increased payroll related expensesprimarily as a result of hiring an additional 495 sales representatives andmanagers to support our marketed products. Approximately 14% of the increase isdue to additional costs related to the increased sales force for additionalsamples and relocation and training costs. Approximately 19% of the increase isrelated to an increase in marketing, advertising and promotion costs to supportLUNESTA.In addition, stock-basedcompensation expense was $3,569,000for the three months ended June 30, 2006, which included $3,539,000 resultingfrom our January 1, 2006 implementation of SFAS 123(R), as comparedto $35,000 of stock-based compensation expense for the three months ended June30, 2005.

*General andAdministrative*

General and administrativecosts were $18,087,000 and $10,074,000 for the three months ended June 30,2006 and 2005, respectively, an increase of approximately 80%. Stock-basedcompensation expense was $4,561,000for the three months ended June 30, 2006, which included $4,368,000 resultingfrom our January 1, 2006 implementation of SFAS 123(R), as comparedto $226,000 of stock-based compensation expense for the three months ended June30, 2005. The remainder of theincrease is primarily attributable to increased legal fees largely related topatent and shareholder litigation.

*Other Income (Expense)*

Interest income was $10,990,000 and $5,422,000 for thethree months ended June 30, 2006 and 2005, respectively, an increase ofapproximately 103%. 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 $926,079,000 and $810,863,000 for thethree months ended June 30, 2006 and 2005, respectively. For the threemonths ended June 30, 2006 and 2005, the average annualized interest ratethat we earned on our investments was 4.75% and 2.67%, respectively.

Interest expense was$5,543,000 and $5,839,000 for the three months ended June 30, 2006 and2005, respectively. The expense in both periods is primarily related to theinterest we paid on our 5% convertible subordinated debentures.

Equity in investee losseswere $95,000 and $300,000 for the three months ended June 30, 2006 and2005, respectively, a decrease of approximately 68%. The loss represents ourportion of BioSphere losses.

**Six Month Periods ended June 30, 2006 and 2005 (Restated)**

*Revenues*

Product sales were$533,932,000 and $273,391,000 for the six months ended June 30, 2006 and2005, respectively, an increase of approximately 95%. This increase isprimarily a result of the commercial introduction of LUNESTA inApril 2005, an increase in XOPENEX Inhalation Solution revenue and thecommercial introduction of XOPENEX HFAin December 2005.

Sales of LUNESTA were$277,217,000 and $83,459,000 for the six months ended June 30, 2006 and2005, respectively, an increase of approximately 232%. The increase isprimarily the result of a 164% increase in the number of units sold, which isprincipally attributable to a full six months of sales in 2006 as compared tothree months of sales in 2005, and a 26% increase in the net selling price perunit, which was partially due to a 12% increase in the gross selling price perunit. Adjustments recorded to gross sales are disclosed below under the heading“Analysis of gross sales to net sales.”

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Sales of XOPENEXInhalation Solution were $249,769,000 for the six months ended June 30,2006 as compared to $189,932,000 for the same period in 2005, an increase ofapproximately 32%. The increase is primarily due to a 12% increase in thenumber of units sold and a 17% increase in the net selling price per unit,which was impacted by a gross unit price increase of approximately 9%.Adjustments recorded to gross sales are disclosed below under the heading“Analysis of gross sales to net sales.”

Sales of XOPENEX HFA were$6,946,000 for the six months ended June 30, 2006, as compared to $0 for thesame period in 2005. We introduced XOPENEX HFA commercially in December 2005.

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

| ** **                                   | ** ** | **For the Six Months Ended June 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                   | ** ** | **2006**                              | ** ** | **% of  sales** | ** ** | **2005** | ** ** | **% of  sales** | ** ** | **Change** | ** ** | **%  Change** | ** ** |
| ** **                                   | ** ** | **(dollars in thousands)**  | ** ** |
| Gross sales                                  |       | $                                     | 638,707    |   | 100.0% |   | $ | 350,610 |   | 100.0% |   | $ | 288,097 |   |   | 82% |   |   |
| Adjustments to gross  sales:                 |       |                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Payment term discounts                       |       | 13,299                                |       | 2.1% |   | 7,253 |   | 2.1% |   | 6,046 |   |   | 83% |   |   |
| Wholesaler fee for service                   |       | 15,852                                |       | 2.5% |   | 5,516 |   | 1.6% |   | 10,336 |   |   | 187% |   |   |
| Government rebates and contractual discounts |       | 63,605                                |       | 10.0% |   | 38,121 |   | 10.9% |   | 25,484 |   |   | 67% |   |   |
| Returns                                      |       | 10,550                                |       | 1.6% |   | 21,628 |   | 6.1% |   | (11,078 | ) |   | (51% | ) |   |
| Other (includes product launch discounts)    |       | 1,469                                 |       | 0.2% |   | 4,701 |   | 1.3% |   | (3,232 | ) |   | (69% | ) |   |
| Sub-total  adjustments                       |       | 104,775                               |       | 16.4% |   | 77,219 |   | 22.0% |   | 27,556 |   |   | 36% |   |   |
| Net sales                                    |       | $                                     | 533,932    |   | 83.6% |   | $ | 273,391 |   | 78.0% |   | $ | 260,541 |   |   | 95% |   |   |

 

Decreases in the adjustments to gross sales as apercentage of gross sales from the six months ended June 30, 2005 to thesix months ended June 30, 2006 primarily reflect a lower return reserve asa percentage of gross sales due to a reserve recorded in the quarter ended June 30,2005 relating to a potential product return resulting from a packaging issuefor the LUNESTA 1 mg strength, which has been resolved. Also impacting theadjustments was a decrease in other adjustments, which primarily related toLUNESTA launch discounts that we offered to our wholesalers in the secondquarter of 2005. The decrease in the adjustments to gross sales was partiallyoffset by the establishment of wholesaler fee-for-service discount arrangementsbeginning in the second quarter of 2005 to provide for fees consistent with theterms of the wholesaler service agreements we executed in that period.

Included in the government rebates and contractualdiscounts is a reserve for Medicare Part B discounts related to XOPENEXInhalation Solution sales. Medicare reimbursement rates for XOPENEX InhalationSolution have been favorable since January 2005, but we cannot be certainthese favorable rates will continue. In March 2006,the DME-PSCs issued a draft local coverage determination under which Medicarereimbursement for XOPENEX Inhalation Solution would be reduced to the level ofreimbursement for generic albuterol. We estimate that approximately 25 percentof our XOPENEX Inhalation Solution sales are subject to reimbursement underMedicare Part B. If this local coverage determination is implemented, revenuefrom these sales of XOPENEX Inhalation Solution would be materially adverselyaffected.

Royalties were $16,152,000and $30,718,000 for the six months ended June 30, 2006 and 2005, respectively,a decrease of approximately 47%. The decrease is primarily due to the decreasein royalties earned on the sales of ALLEGRA under our agreement withsanofi-aventis, which were $8,659,000 for the six months ended June 30, 2006compared to $23,656,000 for the same period in 2005, with the majority of thedecrease resulting because we ceased to received royalties on sales of ALLEGRAin the United States. 

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Pursuantto the terms of our U.S. agreement with sanofi-aventis, our royalties on thesale of ALLEGRA in the United States, which have historically been between $15and $20 million per year, terminated based on the introduction of a genericequivalent of this product in September 2005. We are still entitled to receiveroyalties on the sale of ALLEGRA outside of the United States in countrieswhere we hold patents covering ALLEGRA and no generic equivalent product hasbeen introduced. Royalties earned on sales of CLARINEX®, under our agreementwith Schering-Plough Corporation, increased to $5,528,000 from $5,066,000 forthe six months ended June 30, 2006 versus the same period in 2005.

*Costs of Revenues*

Cost of product sold was $46,226,000 and $24,490,000for the six months ended June 30, 2006 and 2005, respectively.

Cost of LUNESTA sold as a percentage of LUNESTA grosssales was approximately 6% for the six months ended June 30, 2006 and 2005,with the largest portion being the royalty paid on net sales of LUNESTA to athird party. In accordance with our accounting policies, we did not begin tocapitalize product manufacturing costs associated with LUNESTA inventory untilthe FDA approved the NDA for LUNESTA. Therefore, we expect costs of LUNESTAsold as a percentage of LUNESTA sales to increase after we have sold all of ourproduct for which we have not capitalized manufacturing costs. We expect thisto occur by the end of 2006.

Cost of XOPENEX Inhalation Solution sold as apercentage of XOPENEX Inhalation Solution gross sales was approximately 8% forthe six months ended June 30, 2006 and for the same period in 2005.

Cost of XOPENEX HFA sold as a percentage of XOPENEXHFA net sales was approximately 15% for the six months ended June 30, 2006.Included in the costs of XOPENEX HFA sold is a royalty paid on net sales ofXOPENEX HFA to or 3M, our third party finished goods manufacturer of theproduct. We introduced XOPENEX HFA commercially in December 2005.

Cost of royalties earnedwas $442,000 and $405,000 for the six months ended June 30, 2006 and 2005,respectively. The cost of royalties in both periods relates to an obligation toa third party as a result of royalties we earn from Schering-PloughCorporation based upon its sales of CLARINEX. This increase in third-partyobligations is due to the slight increase in royalties earned in the six monthsended June 30, 2006 as compared with the same period in 2005.

*Research andDevelopment*

Research and developmentexpenses were $85,629,000 and $65,701,000 for the six months ended June 30,2006 and 2005, respectively, an increase of approximately 30%. The increase isprimarily due to our increased spending on our LUNESTA Phase IIIB/IV program,as well as drug discovery efforts. We also incurred increased spending on twoof our early-stage programs, SEP-225289 and SEP-227162, bothtargeted for the treatment of depression. In addition, share-based compensationexpense resulting from our January 1, 2006 implementation of SFAS 123(R) was $4,942,000 for the six months ended June 30,2006 as compared to $0 for the period ended June 30, 2005.

Belowis a summary of development of our products and product candidates thatrepresent 10% or more of our direct project research and development spendingfor the six months ended June 30, 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;however, there can be no assurance that the FDA will accept for filing, orapprove, any NDA. The actual timing of completion of phases could differmaterially from the estimates provided in the table. The table is sorted byhighest to lowest spending amounts, and the two commercial products and the twoproduct candidates listed accounted for approximately 86% of our direct projectresearch and development spending for the six months ended 

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June 30, 2006. No other product candidateaccounted for more than 5% 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.

**             We commerciallylaunched XOPENEX HFA in December 2005.

***      We submitted an NDA to theFDA for Arformoterol in December 2005. The 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 six months ended June 30, 2006, and 2005, as well asthe costs incurred to date on these projects. The costs in this analysisinclude only direct costs and do not include certain indirect labor, overhead,share-based compensation or other costs which benefit multiple projects. As a result,fully loaded research and development cost summaries by project are notpresented.

| ** **                           | ** ** | **Project costs for  the six  months ended  June 30, 2006** | ** ** | **Project costs to  date through  June 30,  2006** | ** ** | **Project costs for  the six  months ended  June 30, 2005** | ** ** | **Project costs to  date through  June 30,  2005** | ** ** |
|--------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**                                                                   | ** ** |
| LUNESTA  (eszopiclone)               |       |                                                                                      | $          | 10,822                                                                 |       |                                                                                      |       | $                                                                      | 210,544    |   |   |   | $ | 6,152 |   |   |   | $ | 189,715 |   |   |
| XOPENEX HFA  (levalbuterol tartrate) |       |                                                                                      | $          | 8,413                                                                  |       |                                                                                      |       | $                                                                      | 165,204    |   |   |   | $ | 13,295 |   |   |   | $ | 145,992 |   |   |
| Arformoterol                         |       |                                                                                      | $          | 5,650                                                                  |       |                                                                                      |       | $                                                                      | 167,228    |   |   |   | $ | 8,437 |   |   |   | $ | 151,956 |   |   |
| SEP-225289                           |       |                                                                                      | $          | 5,201                                                                  |       |                                                                                      |       | $                                                                      | 9,270      |   |   |   | $ | 1,158 |   |   |   | $ | 1,276 |   |   |

 

Due to the length of timenecessary to develop a product, uncertainties related to the ability to obtaingovernmental approval for commercialization, and difficulty in estimating costsof projects, it is difficult to make accurate and meaningful estimates of theultimate cost to bring our product candidates to FDA approved status. We do notbelieve it is possible to estimate, with any degree of accuracy, the costs ofproduct candidates that are in stages earlier than Phase III. Accordingly,we have not provided any such estimates, as all of our product candidates, otherthan Arformoterol, for which we have submitted an NDA, are in Phase I development.

*Selling, Marketing and Distribution*

Selling, marketing and distribution expenses were$372,596,000 and $223,390,000 for the six months ended June 30, 2006 and2005, respectively, an increase of approximately 67%. Of the $149,206,000increase, approximately 49% is due to an increase in marketing, advertising andpromotion costs in support of LUNESTA, which was launched in April 2005.Additionally, we incurred increased payroll and commission expense as well asincreased training and relocation costs as a result of hiring additional salesrepresentatives and management to support marketed products. These costsaccounted for approximately 26% of the increase during the six months endedJune 30, 2006 over the same period ended June 30, 2005. In addition,stock-based compensation expense was $6,873,000for the six months ended June 30, 2006, which included $6,813,000 resultingfrom our January 1, 2006 implementation of SFAS 123(R), as compared to$70,000 of stock-based compensation expense for the six months ended June 30,2005.

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*General and Administrative*

General and administrativecosts were $32,595,000 and $18,781,000 for the six months ended June 30,2006 and 2005, respectively, an increase of approximately 74%. Stock-basedcompensation expense was $8,746,000for the six months ended June 30, 2006, which included $8,360,000 resultingfrom our January 1, 2006 implementation of SFAS 123(R), as compared to$452,000 of stock-based compensation expense for the six months ended June 30,2005. The remainder of the increaseis primarily attributable to increased legal fees related to patent support andlitigation and shareholder lawsuit-related cost.

*Other Income(Expense)*

Interest income was$20,784,000 and $10,670,000 for the six months ended June 30, 2006 and2005, respectively, an increase of approximately 95%. The increase is due tohigher average balances of cash and short- and long-term investmentscombined with an increase in the interest rates earned on investments in 2006.Our monthly average cash and investment balance was approximately $937,801,000and $801,721,000 for the six months ended June 30, 2006 and 2005,respectively. For the six months ended June 30, 2006 and 2005, the averageannualized interest rate that we earned on our investments was 4.43% and 2.66%,respectively.

Interest expense was$11,094,000 and $11,681,000 for the six months ended June 30, 2006 and2005, respectively. The expense in both periods is primarily related to theinterest we paid on our 5% convertible subordinated debentures.

Equity in investee losseswere $353,000 and $468,000 for the six months ended June 30, 2006 and2005, respectively, a decrease of approximately 25%. The loss represents ourportion of BioSphere losses.

**Liquidity and Capital Resources**

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

Cash, cash equivalents andshort- and long-term investments totaled $944,491,000, or 74% of totalassets at June 30, 2006, compared to $976,201,000, or 77% of total assets,at December 31, 2005.

Net cash used in operatingactivities for the six months ended June 30, 2006 was $35,641,000, whichincludes net income of $21,080,000. Our net income includes non-cash charges of$31,769,000, consisting primarily of share-based compensation and depreciationand amortization expense. Accounts receivable and inventory increased by$18,772,000 and $11,016,000, respectively, primarily due to LUNESTA and XOPENEXInhalation Solution sales. Other current assets increased by $6,756,000, whichis primarily attributable to an increase in prepaid expenses. Accounts payableincreased by $3,470,000 primarily due to timing of vendor payments. Accruedexpenses decreased by $63,423,000 primarily due to the timing of paymentsrelating to commissions and sales and marketing accruals. Other currentliabilities increased by $8,007,000 primarily due to an increase in accrualsfor product revenue rebates related to LUNESTA and XOPENEX HFA product sales,offset by a decrease in accruals for product revenue rebates related to XOPENEXInhalation Solution.

Net cash used in investingactivities for the six months ended June 30, 2006 was $52,555,000. Cashused in net purchases of short- and long-term investments was$35,103,000. We made purchases of 

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propertyand equipment of $8,663,000 and received proceeds from sales of equipment of$150,000. We also made an investment in ACADIA of $8,939,000.

Net cash provided byfinancing activities for the six months ended June 30, 2006 was$16,110,000. We received proceeds of $17,290,000 from issuing common stock uponthe exercise of stock options issued under our stock option plans. We also used$1,180,000 to repay capital lease obligations and long-term debt.

Webelieve our existing cash and the anticipated cash flow from operations andcurrent strategic alliances will be sufficient to support existing operationsthrough at least 2007. In the longer term, we expect to continue to fund ouroperations with revenue generated from product sales. Our actual future cashrequirements and our ability to generate revenue, however, will depend on manyfactors, 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;

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

·       royaltiesfrom agreements with parties to which we have licensed our technology; and

·       theoutcome of pending litigation and/or the informal SEC inquiry.

If ourassumptions underlying our beliefs regarding future revenues and expenseschange, or if unexpected opportunities or needs arise, we may seek to raiseadditional cash by selling debt or equity securities or borrowing money from abank. However, we may not be able to raise such funds on favorable terms, or atall.

Based on our currentoperating plan, we believe that we will not be required to raise additionalcapital to fund the repayment of our outstanding convertible debt when due. Ifwe are not able to successfully continue to grow our revenue and properlymanage our expenses, it is likely that our business would be materially andadversely affected and that we would be required to raise additional funds inorder to repay our outstanding convertible debt. We cannot assure that, ifrequired, we would be able to raise the additional funds on favorable terms, ifat all.

**Critical Accounting Policies**

We identified criticalaccounting policies in our annual report on Form 10-K for the yearended December 31, 2005. These critical accounting policies relate toproduct revenue recognition, royalty revenue recognition, rebate and returnreserves, patents, intangibles and other assets, accounts receivable and baddebt, income taxes, induced conversion of debt, inventory write-downs andstock-based compensation. These policies require us to make estimates in thepreparation of our financial statements as of a given date. Because of theuncertainty inherent in these matters, our actual results could differ from theestimates we use in applying the critical accounting policies. Other than theadoption of SFAS 123(R), no changes to these critical accounting policies havetaken place since December 31, 2005; however, we have expanded the disclosureof our accounting policies relating to product sale allowances and reserves.

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***Product Sales Allowances 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 our directpurchase 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 takenadvantage of this discount. Based on common industry practices and ourcustomers’ overall payment performance, we accrue for cash discounts on productsales recorded during the period. We adjust the accrual to reflect actualexperience as necessary, and historical adjustments have not been material.Based on our history of estimating payment term discounts and the low dollarexposure, we do not anticipate that changes to estimates will have a materialimpact on net sales.

2)   *Wholesaler Fee for Service Discounts—*Inthe second quarter of both 2006 and 2005, we entered into letter agreementswith certain wholesaler customers that provide these wholesalers with theopportunity to earn discounts in exchange for the performance of certainservices. These agreements are subject to termination upon thirty days priorwritten notice. Our effective rate of wholesaler fee-for-service discountsapplied across all product sales in the first half of 2006 was approximately2.5% as compared to 1.6% in the first half of 2005. Our accruals for wholesalerfee-for-service discounts are based on actual data of product sales made towholesale customers with letter agreements and not on estimates. If thepercentage of gross sales sold to wholesalers with letter agreements increases,our liability related to these discounts could increase materially.

3)   *Government Rebates and Contractual Discounts*—

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

We recorded a provision for Medicaid rebates of 4.5%and 7.7% of gross sales for the six months ended June 30, 2006 and 2005,respectively. The decrease is attributable to a change in the product mix withthe commercial introduction of LUNESTA in the second quarter of 2005, which hassignificantly lower Medicaid-eligible units than XOPENEX Inhalation Solution.The decrease is also the result of a Medicaid reserve reversal in the secondquarter of 2006 relating to a prior period estimate, in addition to a shift inpatient coverage from Medicaid to Medicare Part D, as a result of theintroduction of the Medicare 

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Part D program in2006. Actual Medicaid discounts could exceed historical experience and ourestimates of expected Medicaid activity and rebate per unit amounts. The mostsignificant estimate we make in connection with this accrual is the estimate ofthe number of Medicaid-eligible units in the distribution channel. In recentquarters, our estimates have been approximately 98% accurate. Although theactual Medicaid rebate may vary by more than 2% of the estimated eligibleMedicaid units in future periods, we believe, based on prior experience, a 2%variation in our estimate is reasonably likely. A 2% understatement ofMedicaid-eligible units at June 30, 2006 would have resulted in anadditional provision of approximately $0.3 million.

*MedicareDiscounts—Part B—**We* record accruals for rebates to beprovided through Medicare Part B programs, as a reduction of sales whenthe product is sold. We established a Medicare Part B rebate program inorder to increase the access by Medicare Part B beneficiaries to ourXOPENEX Inhalation Solution 1.25 mg strength product through MedicarePart B pharmacy providers, or MPPs. XOPENEX Inhalation Solution is coveredunder a Medicare Part B code for drugs used with durable medicalequipment, in our case, nebulizers. We estimate the expected rebate using historicaldata and by examining trends and expected changes in Medicare Part Bcodes. Medicare Part B payments are paid to MPPs primarily on a monthlybasis. Accordingly, the provision typically relates to the activity over aone-month period and, as a result, the total provision consists of (i) anestimate of the amount expected to be incurred for the current month’sprescriptions, (ii) an accrual for prior months’ unpaid rebates and(iii) an accrual for estimated inventory in the distribution channel.

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

The provision for Medicare rebates was less than 1% ofgross sales for both the six months ended June 30, 2006 and 2005. ActualMedicare discounts could change significantly in the future based on futureMedicare reimbursement classifications.

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

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

The provision for MCO rebates was approximately 1.2%and 0.8% of gross sales in the six months ended June 30, 2006 and 2005,respectively. Actual MCO discounts could exceed historical experience and ourestimates of expected future participation in these programs. However, in partdue to the fact that only a few organizations currently account forapproximately 90% of our MCO discounts, our MCO discount 

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estimates havehistorically been very similar to the actual MCO discounts. We expect that asmall number of organizations will continue to account for substantially all ofour MCO discounts for the foreseeable future and, therefore, do not expectsignificant changes to our MCO discount estimates in future periods.

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

*Theprovision for chargebacks and GPO contract credits was approximately 2.9% and1.4% of gross sales* in the six months ended June 30,2006 and 2005, respectively.*Actual chargeback and GPO contract credits couldexceed historical experience and our estimates of future participation in theseprograms. However, over the past few years, chargeback activity has been fairlystable with the exception of XOPENEX HFA, which currently has low sales volumesand a limited number of chargeback contracts. In addition, the dollar value ofour chargebacks and GPO contract credits are relatively low. Therefore, we donot expect significant variation between actual chargeback and GPO credits andour estimates.*

4)   *Return*s—Customers can return short-datedor expired product that meets the guidelines set forth in our returned goodspolicy. 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 product returnsif we are aware of other factors that we believe could significantly impact ourexpected return percentages. These factors include our estimate of inventorylevels of our products in the distribution channel, the product shelf-life of theproduct we have shipped, competitive issues such as new product entrants andother known changes in sales trends.

The provision for returns was approximately 1.7% and6.2% for the six months ended June 30, 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, inaddition to a reserve recorded in the second quarter of 2005 relating to apotential product return caused by a packaging issue with respect to ourLUNESTA 1 mg strength, which has been resolved. Actual returns couldexceed historical experience and our estimates of expected future returns dueto factors such as wholesaler and retailer stocking patterns and inventorylevels and/or competitive changes. Based on these factors, and as a result offluctuations observed in prior periods, we believe it is reasonably likely thatthe actual returns provision percentage could vary from the estimatedpercentage within a range of 0.25% to 0.5%. If the returns provision percentagefor each of these products had increased by 0.25% to 0.5% of gross sales forthe six months ended June 30, 2006, an additional provision of between $1.6million and $3.2 million would have been necessary.

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Many of our accruals include an estimate of inventoryin the distribution pipeline. At June 30, 2006, we believe a reasonableestimate of the value of our pipeline inventory is approximately $57 millionfor XOPENEX Inhalation Solution, $13 million for XOPENEX HFA and $67 millionfor 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 MDI 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.Under the coupon program, physicians give patients coupons to purchase theprescribed drug at a discount from any retail pharmacy. We reimburse retailpharmacies for these discounts through a third-party administrator. Under thevoucher program, physicians give patients vouchers to obtain free samples ofthe prescribed drug from any retail pharmacy. We reimburse retail pharmaciesfor the cost of these products through a third-party administrator. We use thevoucher program primarily in states where samples cannot be shipped directly tophysicians.

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

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

| ** **                             | ** ** | **Payment  Terms  Discount** | ** ** | **Wholesaler  Fee  for Service** | ** ** | **Government  Rebates and  Contractual  Discounts** | ** ** | **Returns** | ** ** | **Other  Discounts** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|------------------------------|------------|---------------------------------------|------------|----------------------------------------------------------|------------|-------------|------------|----------------------|------------|-----------|------------|
| ** **                             | ** ** | **(in thousands)**      | ** ** |
| **Balance  at December 31, 2005** |       | $                            | (2,632     | )                                     |       | $                                                        | (9,503     | )           |       |                 | $          | (47,462   | )          |   | $ | (16,269 | ) |   | $ | (553 | ) |   | $ | (76,419 | ) |
| Current  provision:                    |       |                         |       |                                  |       |                                                     |       |        |       |                 |       |      |       |   |   |   |   |   |   |
| Current year                           |       | (13,299                      | )          |                                  | (15,852    | )                                                        |       |        | (67,476    | )                    |       | (10,549   | )          |   | (1,454 | ) |   | (108,630 | ) |
| Prior year                             |       | —                       |       |                                  | —     |                                                     |       |        | 3,871      |                 |       | —    |       |   | 20 |   |   | 3,891 |   |
| Total                                  |       | (13,299                      | )          |                                  | (15,852    | )                                                        |       |        | (63,605    | )                    |       | (10,549   | )          |   | (1,434 | ) |   | (104,739 | ) |
| Actual:                                |       |                         |       |                                  |       |                                                     |       |        |       |                 |       |      |       |   |   |   |   |   |   |
| Current year                           |       | 9,669                        |       |                                  | 2,649      |                                                     |       |        | 32,420     |                 |       | —    |       |   | 592 |   |   | 45,330 |   |
| Prior year                             |       | 2,958                        |       |                                  | 9,315      |                                                     |       |        | 31,949     |                 |       | 5,994     |       |   | 597 |   |   | 50,813 |   |
| Total                                  |       | 12,627                       |       |                                  | 11,964     |                                                     |       |        | 64,369     |                 |       | 5,994     |       |   | 1,189 |   |   | 96,143 |   |
| **Balance at June 30, 2006**      |       | $                            | (3,304     | )                                     |       | $                                                        | (13,391    | )           |       |                 | $          | (46,698   | )          |   | $ | (20,824 | ) |   | $ | (798 | ) |   | $ | (85,015 | ) |

 

***Share-Based Compensation***—EffectiveJanuary 1, 2006, we adopted the provisions of SFAS 123(R), whichresulted in changes to our financial statements as detailed in Note 5 tothe financial statements. Determining the amount and distribution of expensefor stock-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 expense.

We estimate the fair valueof stock options using the Black-Scholes valuation model. This valuation modeltakes into account the exercise price of the award, as well as a variety ofassumptions. These assumptions used to estimate the fair value of stock optionsinclude the expected term, the expected volatility of our stock over theexpected term, the risk-free interest rate over the expected term, and ourexpected annual dividend yield. As required by SFAS 123(R), management has alsomade an estimate of expected forfeitures in determining the amount of expenseto be recorded, and is recognizing 

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compensationexpense only for those equity awards expected to vest. We believe that thevaluation technique and the approach utilized to develop the underlyingassumptions are appropriate in calculating the fair value of stock-basedcompensation expenses. These estimates are not intended to predict actualfuture events or the value ultimately realized by persons who receive equityawards.

**ContractualObligations**

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

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

**Market Risk**

We are exposed to marketrisk from changes in interest rates and equity prices, which could affect ourfuture results of operations and financial condition. These risks are describedin our annual report on Form 10-K for the year ended December 31,2005. As of August 14, 2006, there have been no material changes to themarket risks described in our annual report on Form 10-K for theyear ended December 31, 2005. Additionally, we do not anticipate anynear-term changes in the nature of our market risk exposures or in ourmanagement’s objectives and strategies with respect to managing such exposures.

**ITEM 4.**                                                 CONTROLSAND PROCEDURES

**Evaluation ofDisclosure Controls and Procedures**

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

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

There has been no change in our internal control overfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) during our quarter ended June 30, 2006 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

In light of the conclusions of our special committee’sreview of our stock option granting practices, we have re-evaluated the Reportof Management on Internal Control Over Financial Reporting as of December 31,2005 as set forth in our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2005.  Based on thisanalysis, we have determined that there is no material weakness in our internalcontrols over financial reporting relating to the matters under review.

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**PART II**

**OTHER INFORMATION**

**ITEM 1.**                LEGALPROCEEDINGS

**Stock OptionInquiry and Derivative Stockholder Complaints**

In June 2006, we announced that we had received aletter of inquiry from the Securities and Exchange Commission, or SEC,requesting documents related to our stock option grants and stock optionpractices. We appointed a special committee of outside directors to conduct aninternal review relating to our stock option grants and stock option practices.The special committee, with the assistance of legal counsel and accounting specialists,has reviewed stock option grants to our officers, directors and employees from1996 to present under our various stock option plans in effect during thisperiod. We have been cooperating with the review and our finance department hasalso reviewed our stock option grants and stock option practices. The specialcommittee’s review is substantially complete but will remain open for theduration of the SEC’s inquiry.  See Note 3to our financial statements for additional information concerning thesereviews.

We have been notified thatthree stockholder derivative complaints were filed in the Superior Court,Middlesex County, Commonwealth of Massachusetts, naming Sepracor as nominaldefendant and also naming as defendants certain current members of our board ofdirectors and certain of our current and former employees. The complaintsallege purported breaches of fiduciary duties and unjust enrichment inconnection with certain stock option grants made by us between June 1998and May 2001. The complaints seek monetary damages in unspecified amounts,equitable and injunctive relief, including disgorgement of profits obtained bycertain defendants and other relief as determined by the Court. We and ourdirectors are reviewing the allegations and will respond when appropriate.

**TecastemizoleClass Action Complaints**

We and several of ourcurrent and former officers and a current director are named as defendants inseveral class action complaints which have been filed on behalf of certainpersons who purchased our common stock and/or debt securities during differenttime periods, beginning on various dates, the earliest being May 17, 1999,and all ending on March 6, 2002. These complaints allege violations of theSecurities Exchange Act of 1934, as amended, and the rules and regulationspromulgated thereunder by the SEC. Primarily, they allege that the defendantsmade certain materially false and misleading statements relating to thetesting, safety and likelihood of approval of tecastemizole by the FDA. In boththe debt purchasers’ action and equity purchasers’ action, the court hasgranted the plaintiffs’ motion for class certification. In lateFebruary 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 amendedconsolidated complaints reiterate the allegations contained in the previouslyfiled complaints and define the alleged class periods as May 17, 1999through March 6, 2002. The parties are currently engaged in discovery. Weare unable to reasonably estimate any possible range of loss related to thelawsuits due to their uncertain resolution. However, any conclusion of thesematters in a manner adverse to us would have a material adverse effect on ourfinancial position and results of operations.

**LevalbuterolHydrochloride Inhalation Solution ANDAs**

In September 2005, we received notification thatthe FDA had received an 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 

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XOPENEX InhalationSolution are invalid, unenforceable or not infringed by Breath Limited’sproposed product. We have filed a civil action against Breath Limited forpatent infringement. We were notified in January 2006 of a second ANDAseeking approval of a generic version of our 1.25 mg, 0.63 mg and 0.31 mglevalbuterol hydrochloride inhalation solution including a Paragraph IVcertification, which was submitted to the FDA by Dey, L.P. We have filed acivil action against Dey, L.P. for patent infringement. In April 2006, wewere notified of a third ANDA seeking approval of a generic version of our 1.25mg, 0.63 mg and 0.31 mg levalbuterol hydrochloride inhalation solutionincluding a Paragraph IV certification, which was submitted to the FDA byWatson Laboratories, Inc. Watson’s Paragraph IV certification was limitedto our patent that expires in 2021 and covers certain levalbuterolhydrochloride inhalation solutions, including XOPENEX Inhalation Solution. Wehave decided not to file a civil action against Watson Laboratories, Inc.for patent infringement.

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. 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.Introduction of a generic copy of XOPENEX Inhalation Solution before theexpiration of our patents would have a material adverse effect on our business.

**Fexofenadine PatentClaim**

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

**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 the only ones weface. Additional risks not currently known to us or other factors not perceivedby us to present significant risks to our business at this time also may impairour 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 ona quarterly and annual basis.**

Except for our three mostrecent fiscal quarters, we have incurred net losses each quarter since ourinception. It is possible we will not be able to achieve profitability again ormaintain profitability on a quarterly or annual basis. We expect to continue toincur significant operating expenditures to further develop and commercializeour products and product candidates. As a result, we will need to generatesignificant revenues in future periods to achieve and maintain profitability.We cannot assure you that we will achieve significant revenues or that we willever achieve profitability again. Even if we do achieve profitability again, wemay not be able to maintain profitability for any substantial period of time.If 

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revenuesgrow more slowly than we anticipate or if operating expenses exceed ourexpectations or cannot be adjusted accordingly, our business, results ofoperations and financial condition will be materially and adversely affected.In addition, if we are unable to achieve or maintain profitability on aquarterly or annual basis, the market price of our common stock may decline.

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

Approximately 97% of our revenues for the six monthsended June 30, 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. InDecember 2005, we commercially launched XOPENEX HFA and we cannot becertain that it will achieve commercial success.

With respect to XOPENEX Inhalation Solution, three companieshave filed ANDAs with the FDA seeking to market a generic version oflevalbuterol hydrochloride inhalation solution. We have commenced patentlitigation against two of these companies and we have decided not to commencelitigation against the third at this time. A finding that the products thesecompanies wish to market do not infringe our patents or that our patents areinvalid or unenforceable will likely lead to the 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 theirmarkets. Specifically, the following factors, among others, could affect thelevel of success and market acceptance of LUNESTA, XOPENEX Inhalation Solutionand/or XOPENEX 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;

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

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

As of June 30, 2006, our total debt wasapproximately $1.2 billion and our stockholders’ equity (deficit) was($109.5) 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 July 31, 2006, the closing sale price of our common stockwas $49.40. 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 hadnegative cash flow from operations. For the six months ended June 30,2006, net cash used in operating activities was approximately$35.6 million. Our annual debt service through 2006, assuming noadditional interest-bearing debt is incurred and no additional 5%debentures due 2007 are converted, redeemed, repurchased or exchanged, isapproximately $22.0 million. Unless we have sufficient cash or are able togenerate sufficient operating cash flow to pay off the principal of ouroutstanding debt, we will be required to raise additional funds or default onour obligations under the debentures and notes. If revenue generated from salesof LUNESTA and XOPENEX Inhalation Solution do not meet expected levels, it isunlikely that we would have sufficient cash flow to repay our outstandingconvertible debt and/or make cash payments upon conversion of the 0% notes due2024. There can be no assurance that, if required, we would be able to raisethe additional funds on favorable terms, if at all.

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

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

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

Our financial statementshave been prepared in accordance with accounting principles generally acceptedin the United States. The preparation of these financial statements requires usto make estimates and judgments that affect the reported amounts of our assets,liabilities, net revenues and expenses, the amounts of charges accrued by usand related disclosure of contingent assets and liabilities. We base ourestimates on historical experience and on various other assumptions that webelieve to be reasonable 

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underthe circumstances. We cannot assure you, however, that our estimates, or theassumptions 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 andmanufacturing expenses in connection with commercialization of products.

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

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

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

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resourcesin general. Uncertainties resulting from the initiation and continuation of anylitigation or other proceedings could harm our ability to compete in themarketplace.

**Our stock optiongranting practices are the subject of an informal inquiry by the Securities andExchange Commission. A special committee of our outside directors is conductinga review of these practices.**

**As we announced on June 2, 2006,the Securities and Exchange Commission, or SEC, is conducting an informalinquiry into our stock option grants and stock option practices and we have setup a special committee of our outside directors to oversee a review of ourstock option granting practices and the documentation relating to suchgrants.  We cannot assure you that wewill not be subject to regulatory fines or penalties or other contingentliabilities at the conclusion of the SEC’s informal inquiry.**

**Based on the results of the specialcommittee’s review, which is substantially complete, we have concluded that wewill need to restate our financial statements for the quarters ended March 31,June 30 and September 30, 2005, the quarter ended March 31, 2006 and the fiscalyears ended December 31, 2005, 2004 and 2003, as well as revise the financialinformation contained in our earnings release for the period ended June 30, 2006.**

**We have civillitigation pending that relates to our stock option granting practices, and wecannot predict the ultimate outcome of this litigation.**

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

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

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

·       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;

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·       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

·       timing of expenses we mayincur with respect to any license or acquisitions of products or 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 substantially impede the ability of public stockholders tobenefit from a change of control or change in our management and board ofdirectors. 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 directors adopted a shareholder rights plan, the provisions ofwhich could make it more difficult for a potential acquirer of Sepracor toconsummate an acquisition transaction.

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

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

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**Risks Related toCommercialization**

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

We face intense competition in the sale of our currentproducts, and expect to face intense competition in the sale of any futureproducts we sell. If we are unable to compete effectively, our financialcondition and results of operations could be materially adversely affected becausewe may not achieve our product revenue objectives and because we may use ourfinancial resources to seek to differentiate ourselves from our competition.Large and small companies, academic institutions, governmental agencies andother public and private organizations conduct research, seek patentprotection, develop products, establish collaborative arrangements for productdevelopment and sell products in competition with us. Many of our competitorsand potential competitors have substantially greater resources, manufacturingand sales and marketing capabilities, research and development staff andproduction facilities than we have. The fields in which we compete are subjectto rapid and substantial technological change. Our competitors may be able torespond more quickly to new or emerging technologies or to devote greaterresources to the development, manufacture and marketing of new products and/ortechnologies than we can. As a result, any products and/or technologies that wedevelop may become obsolete or noncompetitive before we can recover expensesincurred in connection with their development.

In the respiratory market,we compete primarily against albuterol. XOPENEX Inhalation Solution and genericalbuterol inhalation solution currently account for the majority ofbeta-agonist inhalation solution prescriptions in the market. Albuterol hasbeen marketed for many years, is well established and sells at pricessubstantially lower than XOPENEX Inhalation Solution. With XOPENEX HFA, wecompete with generic chlorofluorocarbon-based albuterol metered-dose inhalersand brand-name HFA albuterol metered-dose inhalers. Generic chlorofluorocarbonMDIs sell at substantially lower prices than XOPENEX HFA. To continuesuccessfully marketing our XOPENEX products, we must continue to demonstratethat the efficacy and safety features of our drug outweigh their higher cost.In the sleep disorder market, we face intense competition from establishedproducts, such as AMBIEN® and SONATA®. We also face competition from the newly approved sleepagents ROZEREMÔ and AMBIEN CRÔ.There are also other potentially competitive therapies that are in late-stagedevelopment for the treatment of insomnia. For all of our products, we need todemonstrate to physicians, patients and third-party payors that the costof our product is reasonable and appropriate in light of its safety andefficacy, its price and the health care benefits, each as compared to othercompeting products.

**We may be unable tocommercialize products for which we 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 that commercializationis delayed and the shortening of any lead time to market we may have had overour competitors. In addition, the exclusivity period, which is the time duringwhich the FDA will prevent generic pharmaceutical companies from introducing ageneric copy of the product, begins to run upon FDA approval and, therefore, tothe extent we are unable to commercialize a product promptly after receipt ofan approval letter, our long-term product sales and revenues could be adverselyaffected.

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Even if the FDA or similarforeign agencies grant us regulatory approval of a product, if we fail tocomply with the applicable regulatory requirements, we may be subject to fines,suspension or withdrawal of regulatory approvals, product recalls, seizures ofproducts, operating restrictions and criminal prosecution. In any such event,our product sales and revenues could be adversely affected.

**We sell our products primarily through a direct salesforce and if we are not successful in attracting and retaining 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 we may incur additional expense if we further expand. If wesuccessfully develop and obtain regulatory approval for the products we aredeveloping, we may (1) market and sell them through our sales force, (2) licensesome of them to large pharmaceutical companies or (3) market and sell themthrough other arrangements, including co-promotion arrangements. We may incursignificant costs in expanding our sales force before the products underdevelopment have been approved for marketing. For example, we expanded oursales force in 2004 in anticipation of marketing and selling LUNESTA and in2005 in anticipation of marketing and selling XOPENEX HFA. In addition, if weenter into co-promotion arrangements or market and sell additional productsdirectly, we may need to significantly expand our sales force.

Our ability to realizesignificant revenues from direct marketing and sales activities depends on ourability to attract and retain qualified sales personnel. Competition for thesepersons is intense. If we are unable to attract and retain qualified salespersonnel, we will not be able to successfully expand our marketing and directsales force on a timely or cost effective basis. We may also need to enter intoadditional co-promotion arrangements with third parties, for example where ourown direct sales force is not large enough or sufficiently well aligned toachieve maximum penetration in the market. We may not be successful in enteringinto any co-promotion arrangements, and the terms of any co-promotionarrangements 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 drug wholesalers, hospitals and pharmacies of amanufacturer-initiated voluntary Class III recall of one componentof our XOPENEX Inhalation Solution product line, XOPENEX Inhalation SolutionConcentrate (1.25mg/0.5mL), which we introduced in August 2004. Therecall, which affected only XOPENEX Inhalation Solution Concentrate and noother components of our XOPENEX Inhalation Solution product line, wasnecessitated by packaging process validation issues relating to the automatedprocess of placing finished vials into a foil pouch. We suspended manufactureand sale of XOPENEX Inhalation Solution Concentrate until the issues givingrise to the recall were fully addressed. We re-introduced XOPENEX InhalationSolution Concentrate in June 2006. If these or similar deficiencies arefound to extend to other components or our XOPENEX Inhalation Solution productline, our ability to supply product to the market may be limited or interruptedindefinitely, which could have a material adverse effect on our busines**s.**

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

We may be subject to productliability claims that arise through testing, manufacturing, marketing, sale anduse of pharmaceutical products. Product liability claims could distract ourmanagement and key personnel from our core business, require us to spendsignificant time and money in litigation or to pay significant damages, whichcould prevent or interfere with our product commercialization efforts and couldadversely 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.

**Risks Related tothe Regulatory Environment**

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

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

**If we fail to successfully develop and receiveregulatory approval for 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 is October 12,2006. We cannot assure you that the FDA will approve our NDA for arformoterolon a timely basis, or at all. If the FDA does not approve our NDA forarformoterol, we will not be able to commercialize the product candidate and,therefore, will not receive any revenues from sales of the product.

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/orwith the labeling we expect, or that they will achieve market acceptance.Before we commercialize any other product candidate, we will need tosuccessfully 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;

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

**Ifthe FDA delays or denies approval of any NDA that we file in the future, thencommercialization of theproduct subject to the NDA will be delayed or terminated, which could have amaterial adverse effect on our business.**

Theregulatory process to obtain marketing approval requires clinical trials of aproduct to establish its safety and efficacy. Problems that may arise duringclinical trials 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 similarforeign agencies grant us regulatory approval of a product, the approval maytake longer than we anticipate and may be subject to limitations on theindicated uses for which the product may be marketed or contain requirementsfor costly post-marketing follow-up studies. Moreover, if we fail to complywith applicable regulatory requirements, we may be subject to fines, suspensionor withdrawal of regulatory approvals, product recalls, seizure of products,operating restrictions and criminal prosecution.

**Oursales depend on payment and reimbursement from third-party payors, and areduction in paymentrate or reimbursement could result in decreased use or sales of our products.**

Sales of our products aredependent, in part, on the availability of reimbursement from third-partypayors such as state and Federal governments under programs such as Medicareand Medicaid, and private insurance plans. Third-party payors continuallyattempt to contain or reduce the cost of health care by challenging the pricescharged for medical products and services. We may not be able to sell ourproducts profitably if reimbursement is unavailable or limited in scope oramount.

There have been, thereare, and we expect there will continue to be, state and Federal legislativeand/or administrative proposals that could limit the amount that state orFederal governments will pay to reimburse the cost of pharmaceutical products.The Medicare Prescription Drug Improvement and Modernization Act of 2003, orthe MMA, which was signed into law in December 2003, contains provisionsthat permit reductions in government reimbursement for drugs. We are not ableto predict the full impact of the MMA and its regulatory requirements on ourbusiness. However, we believe that legislative or administrative acts thatreduce reimbursement for our products could adversely affect our business. Inaddition, private insurers, such as managed care organizations, may adopt theirown reimbursement reductions in response to legislation. Reduction inreimbursement for our products could have a material adverse effect on ourresults of operations. Also, the increasing emphasis on managed care in theU.S. may put increasing pressure on the price and usage of our products, whichmay adversely affect product sales. 

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Further,when a new drug product is approved, governmental and/or private reimbursementfor that product is uncertain, as is the amount for which that product will bereimbursed. We cannot predict availability or amount of reimbursement for ourapproved products or product candidates, including those at a late stage ofdevelopment, and current reimbursement policies for marketed products maychange at any time.

The MMA also established aprescription drug benefit beginning in 2006 for all Medicare beneficiaries. Wedo not know the extent to which our products will continue to be included inthe Medicare prescription drug benefit, and we may be required to providesignificant discounts or rebates to drug plans participating in the Medicaredrug benefit. Moreover, the Federal government may acquire the ability tonegotiate price and demand discounts on pharmaceutical products that may implicitlycreate price controls on prescription drugs. In addition, Managed CareOrganizations, or MCOs, Health Maintenance Organizations, or HMOs, PreferredProvider Organizations, or PPOs, health care institutions and other governmentagencies continue to seek price discounts. MCOs, HMOs, PPOs and private healthplans will administer the Medicare drug benefit, leading to managed care andprivate health plans influencing prescription decisions for a larger segment ofthe population. In addition, certain states have proposed and certain otherstates have adopted various programs to control prices for their seniors’ andlow-income drug programs, including price or patient reimbursement constraints,restrictions on access to certain products, importation from other countries,such as Canada, and bulk purchasing of drugs. 

Some states have adoptedpreferred drug lists, or PDLs, for their Medicaid programs and more states mayadopt this practice. Medicaid PDLs indicate which drugs a provider is permittedunder the Medicaid program to prescribe without first seeking priorauthorization from the state Medicaid agency. If our drugs are not included onMedicaid PDLs, use of our drugs in the Medicaid program may be adverselyaffected. In some states that have adopted PDLs, we have been, and may continueto be, required to provide substantial supplemental rebates to state Medicaidauthorities in order for our drugs to be included on the PDL.

On March 24, 2006,the Medicare Durable Medical Equipment Program Safeguard Contractors, orDME-PSCs, issued a draft local coverage determination under which Medicarereimbursement for XOPENEX Inhalation Solution would be reduced to the level ofreimbursement for generic albuterol. We estimate that approximately 25 percentof our XOPENEX Inhalation Solution sales are subject to reimbursement underMedicare Part B. We oppose the DME-PSCs’ proposal and are seeking itswithdrawal. However, if this local coverage determination is implemented, oursales of XOPENEX Inhalation Solution would be materially adversely affected.

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

**Wewill spend considerable time and money complying with Federal and state lawsand regulations and, ifwe are unable to fully comply with such laws and regulations, we could facesubstantial penalties.**

We aresubject to extensive regulation by Federal and state governments. The laws thatdirectly or indirectly affect our business include, but are not limited to, thefollowing:

·  Federal Medicare and Medicaid Anti-Kickbacklaws, which prohibit persons from knowingly and willfully soliciting, offering,receiving or providing remuneration, directly or indirectly, in cash or inkind, to induce either referral of an individual, or furnishing or arrangingfor a good or service, for which payment may be made under Federal health careprograms such as the Medicare and Medicaid programs;

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·       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;

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

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

We are a participant inthe Medicaid rebate program established by the Omnibus Budget ReconciliationAct of 1990. Under the Medicaid rebate program, we pay a rebate for each unitof our product reimbursed by Medicaid. The amount of the rebate for eachproduct is set by law. We are also required to pay certain statutorily definedrebates on Medicaid purchases for reimbursement on prescription drugs understate Medicaid plans. Both the Federal government and state governments have 

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

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

**Risks Related toOur Intellectual Property**

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

Our success depends in part on our ability to obtain,maintain and enforce patents, and protect trade secrets. Our ability tocommercialize any drug successfully will largely depend upon our ability toobtain and maintain patents of sufficient scope to prevent third parties fromdeveloping substantially equivalent products. In the absence of patent andtrade secret protection, competitors may adversely affect our business byindependently developing and marketing substantially equivalent products. It isalso possible that we could incur substantial costs if we are required 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 factual questions,and has been and remains the subject of much litigation. Legal standardsrelating to scope and validity of patent claims are evolving. Any patents wehave obtained, or obtain in the future, may be challenged, invalidated orcircumvented. 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.

As we have previously announced, the FDA has receivedAbbreviated New Drug Applications, or ANDAs, from Breath Limited, Dey, L.P. andWatson Laboratories, Inc. seeking marketing approval for generic copies ofour 1.25 mg, 0.63 mg and 0.31 mg XOPENEX brand levalbuterol HCl InhalationSolution. XOPENEX Inhalation Solution Concentrate is not subject to the ANDA.These submissions include Paragraph IV certifications alleging that ourpatents listed in the Orange Book for XOPENEX Inhalation Solution are invalid,unenforceable or not infringed by the submitter’s proposed product. We havefiled civil actions against Breath Limited and Dey, L.P. for patent infringement.

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 

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following the date wereceived notice of such ANDA or until a court decides that our patents areinvalid, unenforceable or not infringed, whichever is earlier. Patentlitigation involves complex legal and factual questions. We can provide noassurance concerning the outcome or the duration of the lawsuits. Anyconclusion of these matters in a manner adverse to us would have a materialadverse effect on our financial condition and business. If we are notsuccessful in enforcing our patents, we will not be able to prevent the genericcompany, for the full term of our patents, from marketing their generic versionof XOPENEX Inhalation Solution. Introduction of a generic copy of XOPENEXInhalation Solution before the expiration of our patents would have a materialadverse effect on our business.

In June 2006, we were notified that TevaPharmaceutical Industries Limited and Teva UK Limited have filed a claim namingus as defendant in the United Kingdom’s High Court of Justice, ChanceryDivision, Patents Court. The claim alleges that our two patents relating to fexofenandine,which we have licensed to sanofi-aventis in connection with its sale ofALLEGRA, are invalid, and seeks to have them invalidated.  Sanofi-aventis is defending this action. Ifpatent-based exclusivity for ALLEGRA is lost in the United Kingdom or in anyother jurisdiction where a similar action is brought our rights to receiveroyalty revenue in any such jurisdiction will terminate.

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

**If we face a claim of intellectual propertyinfringement by a third party, then we could be liable for significant damages or beprevented from commercializing our products.**

Our success depends inpart on our ability to operate without infringing upon proprietary rights ofothers, including patent and trademark rights. Third parties, typically drugcompanies, hold patents or patent applications covering compositions, methodsof making and uses, covering the composition of matter for some of the drugcandidates for which we have patents or patent applications. Third parties alsohold patents relating to drug delivery technology that may be necessary fordevelopment or commercialization of some of our drug candidates. In each of thesecases, 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-party collaborator is notsuccessful in development of our product candidates, we may not realize the potentialcommercial benefits of the arrangement and our results of operations could beadversely affected.**

We have entered into acollaboration agreement with 3M for the scale-up and manufacturing of XOPENEXHFA and we may enter into additional collaboration agreements in the future.Under our agreement with 3M, 3M is responsible for manufacturing an MDIformulation of XOPENEX. We commercially launched XOPENEX HFA in December 2005.If 3M, or any future development or 

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commercializationcollaborator, does not devote sufficient time and resources to itscollaboration arrangement with us, breaches or terminates its agreement withus, fails to perform its obligation to us in a timely manner or is unsuccessfulin its development and/or commercialization efforts, we may not realize thepotential commercial benefits of the arrangement and our results of operationsmay 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 partnersterminate, or fail to perform their obligations under, their agreements withus, or if our licensing partners are unsuccessful in their sales efforts.**

We have entered into licensing arrangements pursuantto which we license patents to pharmaceutical companies and our revenues underthese licensing arrangements consist primarily of royalties on sales ofproducts. Payments and royalties under these arrangements depend in large parton the commercialization efforts of our licensing partners in countries wherewe hold patents, including sales efforts and enforcement of patents, which wecannot control. If any of our licensing partners does not devote sufficienttime and resources to its licensing arrangement with us or focuses its effortsin countries where we do not hold patents, we may not realize the potential commercialbenefits of the arrangement, our revenues under these arrangements may be lessthan anticipated and our results of operations may be adversely affected. Ifany of our licensing partners was to breach or terminate its agreement with usor fail to perform its obligations to us in a timely manner, the royalties wereceive under the licensing agreement could decrease or cease. If we are unableor fail to perform, or breach in our performance of, our obligations under alicensing agreement, the royalties and benefits to which we are otherwiseentitled under the agreement could be reduced or eliminated. Any delay ortermination of this type could have a material adverse effect on our financialcondition and results of operations because we may lose technology rights andmilestone or royalty payments from licensing partners and/or revenues fromproduct sales, if any, could be delayed, reduced or terminated.

In June 2006, we werenotified that Teva Pharmaceutical Industries Limited and Teva UK Limited have fileda claim naming us as defendant in the United Kingdom’s High Court of Justice,Chancery Division, Patents Court. The claim alleges that our two patentsrelating to fexofenandine, which we have licensed to sanofi-aventis inconnection with its sale of ALLEGRA (fexofenadine HCl), are invalid, and seeksto have them invalidated.  Sanofi-aventisis defending this action. If patent-based exclusivity for ALLEGRA is lost inthe United Kingdom or in any other jurisdiction where a similar action isbrought our rights to receive royalty revenue in any such jurisdiction willterminate.

**We rely on third-party manufacturers, and thisreliance could adversely affect our ability to meet our customers’ demands.**

We currently operate a manufacturing plant that webelieve can meet our commercial requirements of the active pharmaceuticalingredient for XOPENEX Inhalation Solution and XOPENEX HFA, partially fulfillour commercial requirements of the active pharmaceutical ingredient forLUNESTA, and support production of our product candidates in amounts needed forour clinical trials. We do not, however, have the capability to manufacture atour manufacturing facility all of our requirements for the active ingredientsof our currently approved products, and we have no facilities for manufacturingpharmaceutical dosage forms or finished drug products. Developing and obtainingthis capability would be time consuming and expensive. Unless and until wedevelop this capability, we will rely substantially, and in some cases, entirely,on third-party manufacturers. Cardinal Health, Inc. is currently thesole finished goods manufacturer of our XOPENEX Inhalation Solution,Patheon Inc. is the sole manufacturer of LUNESTA and 3M is the solemanufacturer and supplier of XOPENEX HFA. Certain components of 

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XOPENEX HFA are availablefrom only a single source. If Cardinal Health, Patheon, 3M, or any of oursole-source component suppliers experiences delays or difficulties inproducing, packaging or delivering XOPENEX Inhalation Solution, LUNESTA, orXOPENEX HFA, as the case may be, we could be unable to meet our customers’demands for such products, which could lead to customer dissatisfaction anddamage to our reputation. Furthermore, if we are required to changemanufacturers, we will be required to verify that the new manufacturermaintains facilities and procedures that comply with quality standards and withall applicable regulations and guidelines, including FDA guidelines. The delaysassociated with the verification of a new manufacturer for XOPENEX InhalationSolution, LUNESTA or XOPENEX HFA could negatively affect our ability to producesuch products in a timely manner or within budget.

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

**Risks Related to Growthof Our Business**

**If we fail to acquire and develop additional productcandidates or approved products, our ability to grow will be impaired.**

We are currently commercializing three products.However, other than arformoterol, for which we have filed an NDA, our productcandidates are in the early stages of development. In order to increase thelikelihood that we will be able to successfully develop and/or commercializeadditional drugs, we intend to acquire and develop additional productcandidates and /or approved products. The success of this growth strategydepends upon our ability to correctly establish criteria for such acquisitionsand successfully identify, select and acquire product candidates and/orproducts that meet such criteria. We will be required to integrate any acquiredproduct candidates into our research and development operations and anyacquired products into our sales and marketing operations. Managing thedevelopment and/or commercialization of a new product involves numerous financialand operational risks, including difficulties allocating resources betweenexisting and acquired assets and attracting and retaining qualified employeesto develop and/or sell the product.

Any product candidate we acquire may requireadditional research and development efforts prior to commercial sale, includingextensive pre-clinical and/or clinical testing and approval by the FDA andcorresponding foreign regulatory authorities. All product candidates are proneto the risks of failure inherent in pharmaceutical product development,including the possibility that the product candidate will be safe and effectiveor approved by regulatory authorities.

In addition, wecannot assure you that any products that we develop or acquire will 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 

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not beable to acquire the rights to additional product candidates and approvedproducts on terms that we find acceptable, or at all.

**We may undertake strategic acquisitions in the futureand any difficulties from integrating such acquisitions couldadversely affect our stock price, operating results and results of operations.**

We may acquire additional businesses and products thatcomplement or augment our existing business. We may not be able to integrateany acquired business or product successfully or operate any acquired businessprofitably. Integrating any newly acquired business or product could beexpensive and time-consuming. Integration efforts often take a significantamount of time, place a significant strain on managerial, operational andfinancial resources and could prove to be more difficult or expensive than wepredict. The diversion of our management’s attention and any delay ordifficulties encountered in connection with any future acquisitions we mayconsummate could result in the disruption of our on-going business orinconsistencies in standards, controls, procedures and policies that couldnegatively affect our ability to maintain relationships with customers,suppliers, collaborators, employees and others with whom we have businessdealings. Moreover, we may need to raise additional funds through public orprivate debt or equity financing to acquire any businesses or products, whichmay result in dilution for stockholders or the incurrence of indebtedness.

As part of our efforts to acquire businesses orproduct candidates or to enter into other significant transactions, we conductbusiness, legal and financial due diligence with the goal of identifying andevaluating material risks involved in the transaction. Despite our efforts, weultimately may be unsuccessful in ascertaining or evaluating all such risksand, as a result, might not realize the intended advantages of the transaction.If we fail to realize the expected benefits from acquisitions we may consummatein the future, whether as a result of unidentified risks, integrationdifficulties, regulatory setbacks and other events, our business, results ofoperations and financial condition could be adversely affected. If we acquireproduct candidates, we will also need to make certain assumptions about, amongother things, development costs, the likelihood of receiving regulatoryapproval and the market for such product candidates. Our assumptions may proveto be incorrect, which could cause us to fail to realize the anticipatedbenefits of these transactions.

In addition, we will likely experience significantcharges to earnings in connection with our efforts, if any, to consummateacquisitions. For transactions that are ultimately not consummated, thesecharges may include fees and expenses for investment bankers, attorneys,accountants and other advisers in connection with our efforts. Even if ourefforts are successful, we may incur as part of a transaction substantialcharges for closure costs associated with elimination of duplicate operationsand facilities and acquired in-process research and development charges. Ineither case, the incurrence of these charges could adversely affect our resultsof operations for particular quarterly or annual periods.

**Development and commercialization of our productcandidates could be delayed or terminated if we are unable to enter intocollaboration agreements in the future or if any future collaboration agreementis subject to lengthy government review.**

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

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

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·       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 2-3.**                              NONE

**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

Our annual meetingof stockholders was held on May 18, 2006. The following represents theresults of the voting on proposals submitted to a vote of stockholders at theannual meeting:

1.                To elect each ofJames G. Andress, Robert J. Cresci and James F. Mrazek to serve as a Class Idirector until the 2009 annual meeting and until his successor is duly electedand qualified.

| **For**    | ** ** | **Withheld Authority** | ** ** |
|------------|------------|-----------------------------|------------|
| 81,258,859 |       | 3,401,335                   |       |

 

The terms of office of the following directorscontinued after the annual meeting:

TimothyJ. BarberichDigby W. BarriosTimothy J. RinkAlan A. Steigrod

2.                To approve anamendment to our 2000 Stock Incentive Plan increasing from 9,500,000 to 11,000,000the number of shares reserved for issuance under the 2000 plan.

| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 42,235,033 |       | 29,321,312  |       | 45,648      |       |

 

3.                Toapprove an amendment to our 1998 Employee Stock Purchase Plan increasing from900,000 to 1,400,000 the number of shares of our common stock reserved forissuance under the 1998 purchase plan.

| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 69,726,570 |       | 1,830,120   |       | 45,303      |       |

 

4.                To ratify theselection of PricewaterhouseCoopers LLP as our independent registered publicaccounting firm for the current fiscal year.

| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 83,941,217 |       | 692,655     |       | 26,321      |       |

 

**ITEM 5.**                NONE

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**ITEM 6.**                EXHIBITS

| 10.1 |   | 2000 Stock Incentive Plan, as amended.                                                                                                                         |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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: August 14, 2006  |       | By:               |   | /s/  TIMOTHY J. BARBERICH |
|                        |       |              |   | Timothy J.  Barberich |
|                        | * *   | * *          | * * | *Chairman  and Chief Executive Officer (Principal Executive Officer)* |
| Date: August 14,  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             |       | 2000 Stock Incentive Plan, as amended.                                                                                                                         |
| 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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