**UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549**

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**FORM 10-K**

**    (MarkOne)**

**x**                               ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

**Forthe fiscal year ended December 31, 2006**

**or**

**o**                                  TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**Forthe transition periodfrom               to                **

**Commissionfile number 000-19119**

**Cephalon, Inc.**

(Exact Name of Registrantas Specified in Its Charter)

| **Delaware**                                                    |   | **23-2484489**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or Other Jurisdiction of  Incorporation or Organization) |   | (I.R.S. Employer  Identification No.) |
| **41 Moores Road**                                              |   | **19355**                             |
| **P.O. Box 4011**                                          |   | (Zip Code)                            |
| **Frazer, Pennsylvania**                                        |   |                                  |
| (Address of Principal Executive Offices)                        |   | ** **                            |

 

Registrant’s telephonenumber, including area code: **(610) 344-0200**

Securities registeredpursuant to Section 12(b) of the Act:

|                                         | **Title  of each class** | ** ** |   | ** ** | **Name  of each exchange on which registered** | ** ** |
|-----------------------------------------|--------------------------|------------|--------|------------|------------------------------------------------|------------|
| Common Stock, par  value $.01 per share |                     | Nasdaq     |

 

Securities registeredpursuant to Section 12(g) of the Act:

**None**

(Title of Class)

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Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes x No o.

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o No x.

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

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of the registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to thisForm 10-K. x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.

Large acceleratedfiler x Accelerated filer o Non-accelerated filer o.

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

The aggregate market valueof the voting stock held by non-affiliates of the registrant, as of June 30,2006, was approximately $1.6 billion. Such aggregate market value wascomputed by reference to the closing price of the Common Stock as reported onthe Nasdaq Stock Market on June 30, 2006. For purposes of making thiscalculation only, the registrant has defined affiliates as including onlydirectors and executive officers and shareholders holding greater than 10% ofthe voting stock of the registrant as of June 30, 2006.

The number of shares of the registrant’s Common Stockoutstanding as of February 15, 2007 was 65,691,380.

**DOCUMENTS INCORPORATED BYREFERENCE**

Portionsof the registrant’s definitive proxy statement for its 2007 annual meeting ofstockholders are incorporated by reference into Items 10, 11, 12, 13, and 14 ofPart III of this Form 10-K.

 

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**TABLEOF CONTENTS**
|                                                       | ** ** | ** **                                                                                                                      | ** ** | **Page**   |
|-------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| Cautionary Note Regarding Forward-Looking  Statements |       | ii                                                                                                                              |
| ** **                                            | ** ** | **PART I**                                                                                                                 | ** ** | ** ** |
| Item 1.                                               |       | Business                                                                                                                        |       | 1          |
| Item 1A.                                              |       | Risk Factors                                                                                                                    |       | 24         |
| Item 1B.                                              |       | Unresolved Staff Comments                                                                                                       |       | 37         |
| Item 2.                                               |       | Properties                                                                                                                      |       | 37         |
| Item 3.                                               |       | Legal Proceedings                                                                                                               |       | 38         |
| Item 4.                                               |       | Submission of Matters to a Vote of Security Holders                                                                             |       | 38         |
| ** **                                            | ** ** | **PART II**                                                                                                                | ** ** | ** ** |
| Item 5.                                               |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities              |       | 40         |
| Item  6.                                              |       | Selected  Financial Data                                                                                                        |       | 43         |
| Item 7.                                               |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations       |       | 44         |
| Item 7A.                                              |       | Quantitative and Qualitative Disclosures About Market  Risk                                                                     |       | 71         |
| Item 8.                                               |       | Financial Statements and Supplementary Data                                                                                     |       | 72         |
| Item 9.                                               |       | Changes in and Disagreements With Accountants on  Accounting and Financial Disclosure                  |       | 125        |
| Item 9A.                                              |       | Controls and Procedures                                                                                                         |       | 125        |
| Item  9B.                                             |       | Other  Information                                                                                                              |       | 125        |
| ** **                                            | ** ** | **PART III**                                                                                                               | ** ** | ** ** |
| Item 10.                                              |       | Directors, Executive Officers and Corporate Governance                                                                          |       | 126        |
| Item 11.                                              |       | Executive Compensation                                                                                                          |       | 126        |
| Item 12.                                              |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                  |       | 126        |
| Item 13.                                              |       | Certain Relationships and Related Transactions, and  Director Independence                                                      |       | 126        |
| Item 14.                                              |       | Principal Accounting Fees and Services                                                                                          |       | 126        |
| ** **                                            | ** ** | **PART IV**                                                                                                                | ** ** | ** ** |
| Item 15.                                              |       | Exhibits and Financial Statement Schedules                                                                                      |       | 127        |
| SIGNATURES                                            |       | 137                                                                                                                             |

 

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**CAUTIONARY NOTEREGARDING FORWARD-LOOKING STATEMENTS**

In addition tohistorical facts or statements of current condition, this report and thedocuments into which this report is and will be incorporated containforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. Forward-looking statements contained in thisreport or incorporated herein by reference constitute our expectations orforecasts of future events as of the date this report was filed with theSecurities and Exchange Commission (the “SEC”) and are not statements ofhistorical fact. You can identify these statements by the fact that they do notrelate strictly to historical or current facts. Such statements may includewords such as “anticipate,” “will,” “estimate,” “expect,” “project,” “intend,” “should,”“plan,” “believe,” “hope,” and other words and terms of similar meaning inconnection with any discussion of, among other things, future operating orfinancial performance, strategic initiatives and business strategies,regulatory or competitive environments, our intellectual property and productdevelopment. In particular, these forward-looking statements include, amongothers, statements about:

·       ourdependence on sales of PROVIGIL® (modafinil) [C-IV] in the United States andthe market prospects and future marketing efforts for PROVIGIL, FENTORATM(fentanyl buccal tablet) [C-II] and VIVITROL® (naltrexone for extended-releaseinjectable suspension);

·       anypotential approval of our product candidates, including NUVIGILÔ(armodafinil);

·       ouranticipated scientific progress in our research programs and our development ofpotential pharmaceutical products including our ongoing or planned clinicaltrials, the timing and costs of such trials and the likelihood or timing ofrevenues from these products, if any;

·       thetiming and unpredictability of regulatory approvals;

·       ourability to adequately protect our technology and enforce our intellectualproperty rights and the future expiration of patent and/or regulatoryexclusivity on certain of our products;

·       ourfuture cash flow, our ability to service or repay our existing debt and ourability to raise additional funds, if needed, in light of our current and projectedlevel of operations; and

·       otherstatements regarding matters that are not historical facts or statements ofcurrent condition.

Any or all of ourforward-looking statements in this report and in the documents we have referredyou to may turn out to be wrong. They can be affected by inaccurate assumptionswe might make or by known or unknown risks and uncertainties. Therefore, youshould not place undue reliance on any such forward-looking statements. Thefactors that could cause actual results to differ from those expressed orimplied by our forward-looking statements include, among others:

·       theacceptance of our products by physicians and patients in the marketplace,particularly with respect to our recently launched products;

·       ourability to obtain regulatory approvals to sell our product candidates,particularly with respect to NUVIGIL, and to launch such products successfully;

·       scientificor regulatory setbacks with respect to research programs, clinical trials,manufacturing activities and/or our existing products;

·       unanticipatedcash requirements to support current operations, expand our business or incurcapital expenditures;

·       theinability to adequately protect our key intellectual property rights;

·       theloss of key management or scientific personnel;

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·       theactivities of our competitors in the industry, including the continued erosionof ACTIQ (oral transmucosal fentanyl citrate) [C-II] sales to genericcompetitors;

·       regulatoryor other setbacks with respect to our settlements of the PROVIGIL and ACTIQpatent litigations;

·       unanticipatedconversion of our convertible notes by our note holders;

·       marketconditions in the biopharmaceutical industry that make raising capital orconsummating acquisitions difficult, expensive or both; and

·       enactmentof new government laws, regulations, court decisions, regulatoryinterpretations or other initiatives that are adverse to us or our interests.

We do not intend to update publicly anyforward-looking statement, whether as a result of new information, futureevents or otherwise, except as required by law. We discuss in more detail therisks that we anticipate in Part I, Item 1A of this report. Thisdiscussion is permitted by the Private Securities Litigation Reform Act of1995.

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**PART I**

**ITEM 1.**                BUSINESS

**Overview**

Cephalon, Inc. is aninternational biopharmaceutical company dedicated to the discovery, developmentand marketing of innovative products to treat human diseases. We currentlyfocus our efforts in four core therapeutic areas: central nervous system (“CNS”)disorders, pain, cancer and addiction. In addition to conducting an activeresearch and development program, we market six products in the United Statesand numerous products in various countries throughout Europe. Consistent withour core therapeutic areas, we have aligned our 829-person U.S. fieldsales and sales management teams by area. In Europe, we have a sales andmarketing organization numbering approximately 412 persons that supports ourpresence in nearly 20 European countries, including France, the United Kingdom,Germany, Italy and Spain.

Our most significantproduct is PROVIGIL® (modafinil) Tablets [C-IV], which comprised approximately43% of our total consolidated net sales for the year ended December 31,2006, of which approximately 94% was in the U.S. market. For the year ended December 31,2006, consolidated net sales of PROVIGIL increased 43% over the year ended December 31,2005. Under our co-promotion agreement with Takeda Pharmaceuticals NorthAmerica, Inc., 500 Takeda sales representatives began promoting PROVIGILin the second position to primary care physicians and other appropriate healthcare professionals in the United States beginning July 1, 2006. Effective January 1,2007, an additional 250 Takeda sales representatives were added, all of whomare detailing PROVIGIL in the first position. Together with our CNS field salesand sales management teams, we now have nearly 1,200 persons focused ondetailing PROVIGIL in the United States.

Our second mostsignificant product in 2006 was ACTIQ® (oral transmucosal fentanyl citrate)[C-II], which comprised approximately 34% of our total consolidated net salesfor the year ended December 31, 2006, of which approximately 95% was inthe U.S. market. In late September 2006, Barr Laboratories, Inc.entered the U.S. market with a generic version of ACTIQ (“generic OTFC”)pursuant to our license and supply agreement. As a result, ACTIQ sales havebeen meaningfully eroded by generic OTFC products sold by Barr and by usthrough our sales agent, Watson Pharmaceuticals, Inc., and we expect thiserosion will continue during 2007.

During 2006, two of ourproducts were approved by the U.S. Foodand Drug Administration (the “FDA”). In late September 2006, wereceived FDA approval of our next-generation proprietary pain product, FENTORATM(fentanyl buccal tablet) [C-II], and launched the product in the United Statesin early October. FENTORA is indicated for the management of breakthrough painin patients with cancer who are already receiving and are tolerant to opioidtherapy for their underlying persistent cancer pain. We are focusing ourlonger-term clinical strategy on developing FENTORA for patients withbreakthrough pain associated with other conditions, including neuropathic painand back pain. In October 2006 and January 2007, we announced thatdata from Phase 3 clinical trials of FENTORA demonstrated efficacy in themanagement of breakthrough pain in opioid-tolerant patients with chronic lowback pain and chronic neuropathic pain, respectively. Pending positive datafrom an ongoing study in patients with non-cancer breakthrough pain, our goalis to submit a supplemental new drug application (“sNDA”) to the FDA in late2007. This sNDA would seek to expand the labeled indications for FENTORA beyondbreakthrough pain in patients with cancer.

In April 2006, theFDA approved VIVITROLTM (naltrexone for extended-release injectable suspension),and we launched the product in June. VIVITROL is indicated for the treatment ofalcohol dependent patients who are able to abstain from alcohol in anoutpatient setting and are not actively drinking when initiating treatment.Treatment with VIVITROL should be used in combination with psychosocialsupport, such as counseling or group therapy. Under the license andcollaboration agreement 

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wesigned with Alkermes, Inc. in June 2005, Alkermes is responsible formanufacturing commercial supplies of VIVITROL and we have primaryresponsibility for the marketing and sale of the product.

We also made progress in2006 toward the approval of NUVIGILTM (armodafinil) with an anticipatedindication for excessive sleepiness. NUVIGIL is a single-isomer version ofmodafinil, the active ingredient in PROVIGIL. In May 2006, we received anapprovable letter from the FDA; we currently expect a final approval decisionfrom the FDA on or before March 31, 2007. The FDA is continuing toevaluate the single case of serious rash reported in a SPARLONTM (modafinil)Tablets [C-IV] clinical study discussed below. We have provided additionalinformation to the FDA to help the agency place this isolated case in thecontext of the safety profile for modafinil that has been established over morethan a decade of commercial use. The reviewing division has not requested anyadditional information related to NUVIGIL and is working with us to finalizethe product’s label. Since NUVIGIL is derived from the active ingredient inPROVIGIL, we expect that the safety information in the PROVIGIL label will beappropriately modified to reflect the safety information in the final NUVIGILlabel. NUVIGIL is protected by a composition of matter patent that will expireon December 18, 2023 and covers a novel polymorphic form of armodafinil,the active pharmaceutical ingredient in NUVIGIL.

In March 2006, weannounced that the FDA’s Psychopharmacologic Drugs Advisory Committee voted notto recommend approval of SPARLON for the treatment of attentiondeficit/hyperactivity disorder (“ADHD”) in children and adolescents. Thisrecommendation was the result of concerns expressed by the advisory committeeregarding a possible case of Stevens-Johnson syndrome (“SJS”), a rare butserious skin rash condition, in a child who participated in one of the Phase 3clinical trials. In August 2006, we announced that the FDA had issued aletter indicating that the SPARLON sNDA was“not approvable.” In light of the FDA’s decision, we currently are not pursuingdevelopment of SPARLON.

We also have significantdiscovery research programs focused on developing therapeutics to treatneurological disorders and cancers. Our technology principally focuses on anunderstanding of kinases and the role they play in cellular survival andproliferation. We have coupled this knowledge with a library of novel, small,synthetic molecules that are orally active and inhibit the activities ofspecific kinases. We also work with our collaborative partners to provide amore diverse therapeutic breadth and depth to our research efforts.

As a biopharmaceuticalcompany, our future success is highly dependent on obtaining and maintainingpatent protection for our products and technology. We intend to vigorouslydefend the validity, and prevent infringement, of our patents. The loss ofpatent protection on any of our existing products, whether by third-partychallenge, invalidation, circumvention, license or patent expiration, couldmaterially impact our results of operations. In late 2005 and early 2006, weentered into settlement agreements with each of Teva Pharmaceuticals USA, Inc.,Mylan Pharmaceuticals Inc., Ranbaxy Laboratories Limited and Barr. As part ofthese separate settlements, we agreed to grant to each of these parties anon-exclusive royalty-bearing right to market and sell a generic version ofPROVIGIL in the United States. These licenses generally will become effectivein April 2012. For more information concerning these settlements, pleasesee “Central Nervous System Disorders—Modafinil Products and Product Candidates—IntellectualProperty Position” below.

Our activities andoperations are subject to significant government regulations and oversight. In September 2004,we announced that we had received subpoenas from the U.S. Attorney’s Office inPhiladelphia. That same month, we received a voluntary request for informationfrom the Office of the Connecticut Attorney General. Both the subpoenas and thevoluntary request for information appear to be focused on our sales andpromotional practices with respect to ACTIQ, GABITRIL® (tiagabine hydrochloride) and PROVIGIL,including the extent of off-label prescribing of our products by physicians. Weare cooperating with the U.S. Attorney’s Office and the Office of theConnecticut Attorney General, are providing documents and other information toboth offices in response to these and additional requests and are engaged inongoing discussions with both parties. These matters may involve the bringingof 

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criminalcharges and fines, and/or civil penalties. We cannot predict or determine theoutcome of these matters or reasonably estimate the amount or range of amountsof any fines or penalties that might result from a settlement or an adverseoutcome. However, a settlement or an adverse outcome could have a materialadverse effect on our financial position, liquidity and results of operations.

For the year ended December 31, 2006, our totalrevenues and net income were $1.8 billion and $144.8 million, respectively. Ourrevenues from U.S. and European operations are detailed in Note 16 to ourConsolidated Financial Statements included in Part II, Item 8 of thisAnnual Report on Form 10-K. While we seek to increase profitabilityand cash flow from operations, we will need to continue to achieve growth ofproduct sales and other revenues sufficient for us to attain these objectives.The rate of our future growth will depend, in part, upon our ability to obtainand maintain adequate intellectual property protection for our currentlymarketed products, and to successfully develop or acquire and commercialize newproduct candidates.

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We are a Delawarecorporation with our principal executive offices located at 41 Moores Road, P.O. Box4011, Frazer, Pennsylvania, 19355. Our telephone number is (610) 344-0200and our web site address is *http://www.cephalon.com*.Our research and development headquarters are in West Chester, Pennsylvania andwe also have offices in Salt Lake City, Utah, suburban Minneapolis-St. Paul,Minnesota, France, the United Kingdom, Denmark, Germany, Italy, theNetherlands, Poland, Spain and Switzerland. We operate manufacturing facilitiesin France for the production of modafinil, which is used in the production ofin PROVIGIL and NUVIGIL. We also have manufacturing facilities in Salt LakeCity, Utah, for the production of FENTORA, ACTIQ and generic OTFC for worldwidedistribution and sale, and Eden Prairie and Brooklyn Park, Minnesota, for theproduction of orally disintegrating versions of drugs for pharmaceuticalcompany partners.

Our Annual Reports on Form 10-K, QuarterlyReports on Form 10-Q, Current Reports on Form 8-K and allamendments to those reports are available free of charge through the InvestorInformation section of our web site as soon as reasonably practicable aftersuch material is electronically filed with or furnished to the Securities andExchange Commission. We include our web site address in this Annual Report on Form 10-Konly as an inactive textual reference and do not intend it to be an active linkto our web site.

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**CENTRAL NERVOUS SYSTEM DISORDERS**

Our CNS disordersportfolio includes two marketed products: PROVIGIL, for improving wakefulnessin patients with excessive daytime sleepiness associated with narcolepsy,obstructive sleep apnea/hypopnea syndrome (“OSA/HS”) and shift work sleepdisorder (“SWSD”), and GABITRIL, for use as adjunctive therapy in the treatmentof partial seizures in epileptic patients. We also are seeking final approvalfrom the FDA to market NUVIGIL for improving wakefulness in patients withexcessive daytime sleepiness associated with narcolepsy, OSA/HS and SWSD; weanticipate final FDA approval by March 31, 2007.

*Modafinil Products and ProductCandidates*

*PROVIGIL*

Modafinil, the activeingredient in PROVIGIL, is the first in a new class of wakefulness-promotingagents. While its exact mechanism of action remains to be fully elucidated,modafinil appears to act selectively in regions of the brain believed toregulate normal sleep and wakefulness. The FDA approved PROVIGIL to improvewakefulness in patients with excessive daytime sleepiness associated withnarcolepsy, and we launched the product in the United States in February 1999.In January 2004, we received FDA approval to expand the label for PROVIGILto include improving wakefulness in patients with excessive sleepinessassociated with OSA/HS and SWSD. In clinical studies, PROVIGIL was found to 

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begenerally well-tolerated, with a low incidence of adverse events relative toplacebo. The most commonly observed adverse events were headache, infection,nausea, nervousness, anxiety and insomnia.

Outside of the U.S.,modafinil currently is approved in more than 30 countries, including France,the United Kingdom, Ireland, Italy and Germany, for the treatment of excessivedaytime sleepiness associated with narcolepsy. In certain of these countries,we also have approval to market modafinil to treat excessive daytime sleepinessin patients with OSA/HS and/or SWSD.

*NUVIGIL*

An important focus of ourmodafinil strategy has been the development of next-generation compounds,including NUVIGIL, a single-isomer formulation of modafinil. In March 2005,we filed a new drug application (“NDA”) with the FDA seeking approval to marketNUVIGIL with the same labeled indications as PROVIGIL. In May 2006, wereceived an approvable letter from the FDA; we currently expect a finalapproval decision from the FDA on or before March 31, 2007. We areplanning to transition our wakefulness franchise to NUVIGIL around 2010, priorto the April 2012 license effectiveness dates under the generic settlementagreements related to PROVIGIL. The FDA is continuing to evaluate the singlecase of serious rash reported in a SPARLON (modafinil) clinical study. We haveprovided additional information to the FDA to help the agency place thisisolated case in the context of the safety profile for modafinil that has beenestablished over more than a decade of commercial use. The reviewing divisionhas not requested any additional information related to NUVIGIL and is workingwith us to finalize the product’s label. Since NUVIGIL is derived from theactive ingredient in PROVIGIL, we expect that the safety information in thePROVIGIL label will be appropriately modified to reflect the safety informationin the final NUVIGIL label.

In Phase 3 clinical trialsof 150- and 250-milligram daily doses of NUVIGIL in patientssuffering from excessive sleepiness associated with narcolepsy, SWSD or OSA/HS,results indicate that NUVIGIL significantly improves wakefulness and theoverall clinical condition of patients as compared to placebo. The 12-week,double-blind, randomized, placebo-controlled Phase 3 studies ofapproximately 1,000 patients included one study of excessive sleepiness innarcolepsy, one study in SWSD and two studies in OSA/HS. The primary endpointsin each Phase 3 study were measures of objective sleep latency (Maintenance ofWakefulness Test or Multiple Sleep Latency Test) and the physician rating ofClinical Global Impression-Change. These primary endpoints are identicalto those studied for the currently approved indications for PROVIGIL. In eachPhase 3 study, patients treated with NUVIGIL showed a highly statisticallysignificant improvement on both primary endpoints compared to placebo. In thesestudies, NUVIGIL was generally well-tolerated. The most commonly observedadverse effects included headache, nausea, dizziness, insomnia and anxiety.

In 2007, we expect toinitiate clinical studies of NUVIGIL in bi-polar depression, cognition inschizophrenia and excessive sleepiness and fatigue in conditions such asParkinson’s Disease and cancer. If the results of any of these studies arepositive, we plan to seek an expansion of the labeled indications for NUVIGIL.

*Co-Promotion Agreement with Takeda*

On June 12, 2006, weentered into a co-promotion agreement with Takeda with respect to PROVIGIL inthe United States. Under the co-promotion agreement, 500 Takeda salesrepresentatives began promoting PROVIGIL in the second position to primary carephysicians and other appropriate health care professionals in the United Statesbeginning July 1, 2006. Effective January 1, 2007, an additional 250Takeda sales representatives were added, all of whom are detailing PROVIGIL inthe first position. Together with our CNS field sales and sales managementteams, we now have nearly 1,200 persons focused on detailing PROVIGIL in theUnited States. We also have an option to utilize the Takeda sales force for thepromotion of NUVIGIL, assuming FDA approval of this product candidate. 

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Theparties have formed a joint commercialization committee to manage the promotionof PROVIGIL. We have retained all responsibility for the development,manufacture, distribution and sale of the product.

The co-promotion agreementhas a three-year term. If we undergo a change of control during the three-yearterm, we have the option to terminate the co-promotion agreement, subject toour obligation to make certain specified payments to Takeda. We pay Takeda aroyalty based on certain sales criteria for PROVIGIL and NUVIGIL during thethree-year term and, if specified sales levels are reached, during the threecalendar years following the expiration of the co-promotion agreement.

*Targeted Diseases/Disorders*

*Narcolepsy:*   Narcolepsy isa debilitating, lifelong sleep disorder whose symptoms often first arise inlate childhood. Its most common symptom is an uncontrollable propensity to fallasleep during the day. PROVIGIL has been recognized by the American Academy ofSleep Medicine as a standard of therapy for the treatment of excessive daytimesleepiness associated with narcolepsy.

*OSA/HS:*   Individuals withOSA/HS experience frequent awakenings, sometimes occurring hundreds of timesduring the night as a result of blockage of the airway passage, usually causedby the relaxation and collapse of the soft tissue in the back of the throatduring sleep. Continuous positive airway pressure (“CPAP”), a medical devicethat blows air through the nasal passage, is the primary treatment for OSA/HS.However, approximately 30 percent of patients that use CPAP continue toexperience excessive sleepiness, for which PROVIGIL may be an appropriateadjunctive treatment.

*SWSD:*   SWSD is defined asa persistent or recurrent pattern of sleep disruption that leads to excessivesleepiness or insomnia due to a mismatch between the natural circadiansleep-wake pattern and the sleep-wake schedule required by a person’senvironment. SWSD particularly affects those who frequently rotate shifts orwork at night, which is contrary to the body’s natural circadian rhythms.

*Intellectual Property Position*

We own various U.S. andforeign patent rights that expire between 2014 and 2015 and cover pharmaceuticalcompositions and uses of modafinil, specifically, certain particle sizes ofmodafinil contained in the pharmaceutical composition of PROVIGIL. We also holdrights to other patents and patent applications directed to polymorphs,manufacturing processes, formulations, and uses of modafinil and tonext-generation modafinil products. We also own rights to PROVIGIL and othervarious trademarks for our pharmaceutical products containing the active drugsubstance modafinil. Ultimately, these patents and patents related to our otherproducts and products candidates might be found invalid if challenged by athird party, or a potential competitor could develop a competing product orproduct formulation that avoids infringement of these patents.

In late 2005 and early2006, we entered into settlement agreements with each of Teva, Mylan, Ranbaxyand Barr. As part of these separate settlements, we agreed to grant to each ofthese parties a non-exclusive royalty-bearing right to market and sell ageneric version of PROVIGIL in the United States. These licenses will becomeeffective in April 2012. An earlier entry may occur based upon the entryof another generic version of PROVIGIL. Each of these settlements has beenfiled with both the United States Federal TradeCommission (the “FTC”) and the Antitrust Division of the Department of Justice(the “DOJ”) as required by the MedicarePrescription Drug, Improvement and Modernization Act of 2003 (the “MedicareModernization Act”). The FTC has requested from us, and we haveprovided, certain information in connection with its review of the PROVIGILsettlements. In July 2006, the FTC requested that we voluntarily submitadditional information and documents in connection with its investigation ofthis matter. We are cooperating fully with this request. The FTC couldchallenge in an administrative or judicial proceeding any or all of thesettlements if they believe that the agreements violate the antitrust laws,although we believe that such a challenge would take years to resolve.

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We also are aware of anumber of civil antitrust complaints, purportedly filed as class actions, filedby private parties in U.S. District Court for the Eastern District ofPennsylvania, each naming Cephalon, Barr, Mylan, Teva and Ranbaxy as co-defendantsand claiming, among other things, that the patent litigation settlementsconcerning PROVIGIL violate the antitrust laws of the United States and certainstate laws. The proposed consolidated class action complaints have beendesignated by plaintiffs, each of which seeks to certify separate, purportedclasses of plaintiffs: direct purchasers of PROVIGIL, and consumers and otherindirect purchasers of PROVIGIL. The plaintiffs in both cases are seekingmonetary damages and/or equitable relief. Separately, in June 2006, Apotex, Inc.,a subsequent abbreviated new drugapplication (“ANDA”) filer seeking FDA approval of a generic form ofmodafinil, filed suit against us also in the U.S. District Court for theEastern District of Pennsylvania alleging similar violations of antitrust lawsand state law. Apotex asserts that the PROVIGIL settlement agreementsimproperly prevent it from obtaining FDA approval of its ANDA, and seeksmonetary and equitable remedies, including a declaratory judgment that our U.S.Patent No. RE37,516 (the “‘516 Patent”) is invalid and unenforceable. Wefiled a motion to dismiss the Apotex case in late September 2006. Webelieve that both the purported class action cases and the Apotex case arewithout merit. While we intend to vigorously defend ourselves and the proprietyof the settlement agreements, these efforts will be both expensive and timeconsuming and, ultimately, due to the nature of litigation, there can be noassurance that these efforts will be successful.

In early August 2006,we entered into a settlement agreement with Carlsbad Technology, Inc. andits development partner, Watson, which we understand has the right tocommercialize the Carlsbad modafinil product if approved by FDA. As part ofthis settlement, we agreed to grant to Watson a non-exclusive royalty-bearingright to market and sell a generic version of PROVIGIL in the United States.This license will become effective on or after April 6, 2012, subject toapplicable regulatory considerations. An earlier entry may occur based upon theentry of another generic version of PROVIGIL. This agreement has been filedwith both the FTC and the DOJ, as required by the Medicare Modernization Act.

In late November 2005 and March 2006, wereceived notice that Caraco Pharmaceutical Laboratories, Ltd. and Apotex,respectively, also filed Paragraph IV ANDAs with the FDA in which eachfirm is seeking to market a generic form of PROVIGIL. We have not filed apatent infringement lawsuit against either Caraco or Apotex as of the filingdate of this report, although Apotex has filed suit against us, as describedabove.

With respect to NUVIGIL,we successfully obtained issuance of a U.S. patent in November 2006claiming the Form I polymorph of armodafinil, the active drug substance inNUVIGIL. This patent is currently set to expire in 2023. Foreign patentapplications directed to the use of the Form I polymorph of armodafinil intreating sleep disorders are pending in Europe and elsewhere. We also owncomposition of matter patents covering armodafinil that are set to expire in May 2007in the United States and that expired in January 2007 outside the UnitedStates. In addition, the particle size patent described above for PROVIGIL alsocovers NUVIGIL. Assuming success in attaining FDA approval for this compound inMarch 2007, we would expect to receive a three year period of marketingexclusivity (until early 2010). In addition, assuming this same timetable forapproval, we would anticipate that the term of this patent would be extendedunder the Hatch-Waxman Act until approximately early 2010. If we performan additional clinical study of this product in pediatric patients, the FDAcould grant us six months of exclusivity beyond the expiration of the patentand the three-year period of marketing exclusivity (until early 2010). Weintend to perform such a study once a mutually agreed upon clinical protocol isreached with the FDA. We also hold rights to other patent applications directedto other polymorphic forms of armodafinil and to the manufacturing processrelated to armodafinil. We also hold rights to the NUVIGIL trademark.

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*Manufacturing and Product Supply*

At our manufacturingfacility in Mitry-Mory, France, we produce modafinil for use in the productionof PROVIGIL and NUVIGIL. We also have third party agreements with fourcompanies to supply us with modafinil (which requirements include certainminimum purchase requirements) and two companies to supply us with finishedcommercial supplies of PROVIGIL. With respect to NUVIGIL, we have two thirdparties who will manufacture the active drug substance armodafinil and onequalified manufacturer of finished supplies of NUVIGIL tablets. We also arepreparing to qualify an additional manufacturer to provide active drugsubstance and finished product following FDA approval of NUVIGIL. We seek tomaintain inventories of active drug substance and finished products to protectagainst supply disruptions. Any future change in manufacturers or manufacturingprocesses requires regulatory approval.

*Competition*

With respect to PROVIGIL,and, if approved, NUVIGIL, there are several other products used for thetreatment of excessive sleepiness or narcolepsy in the United States. Many ofthese products, including methylphenidate products such as RITALIN® by NovartisPharma AG, have been available for a number of years and are available ininexpensive generic forms. We also are aware of numerous companies seeking todevelop products to treat excessive sleepiness.

*GABITRIL*

GABITRIL is a selectiveGABA (gamma-aminobutyric acid) reuptake inhibitor approved for use asadjunctive therapy in the treatment of partial seizures in epileptic patients.Epilepsy is a chronic disorder characterized by seizures that cause sudden,involuntary, time-limited alteration in behavior, including changes in motoractivities, autonomic functions, consciousness or sensations, and accompaniedby an abnormal electrical discharge in the brain. We currently have worldwideproduct rights to GABITRIL, excluding Canada and Latin America, and we marketGABITRIL in the United States, France, the United Kingdom and Germany, amongother countries. We have one third-party manufacturer of the active drugsubstance in GABITRIL and finished commercial supplies of the product in theUnited States and one third-party manufacturer of the active drugsubstance and finished commercial supplies outside the United States.

While applicable laws andregulations prevent us from promoting our products for uses beyond thosecontained in the approved label, our analysis of prescription data in theUnited States for GABITRIL indicates that many physicians have elected toprescribe the product to treat conditions outside of its currently labeledindication. In February 2005, working with the FDA, we updated ourprescribing information for GABITRIL to include a bolded warning describing therisk of new onset seizures in non-induced patients without epilepsy. Followingthis update, we actively communicated this risk to physicians and otherwiselimited our sales and marketing efforts for GABITRIL. These actions have led toa decrease in prescriptions and sales of GABITRIL.

In June 2006, weannounced that data from our Phase 3 clinical program evaluating GABITRIL forthe treatment of generalized anxiety disorder (“GAD”) did not reach statisticalsignificance on the primary study endpoints. We have no plans to continuefurther study of GABITRIL for the treatment of GAD or any other disease ordisorder.

*Intellectual Property Position*

GABITRIL is our trademarkthat is used in connection with pharmaceuticals containing tiagabine as theactive drug substance. This product is covered by U.S. and foreign patents thatare held by Novo-Nordisk A/S. The U.S. patents have been licensed in the UnitedStates exclusively to Abbott Laboratories. 

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We havean exclusive sublicense from Abbott to these patents in the United States and exclusivelicenses from Novo-Nordisk to corresponding foreign patents.

There are four U.S.composition-of-matter patents covering the currently approved product: a patentclaiming tiagabine, the active drug substance in GABITRIL; a patent claimingcrystalline tiagabine hydrochloride monohydrate and its use as ananti-epileptic agent; a patent claiming the pharmaceutical formulation and apatent claiming anhydrous crystalline tiagabine hydrochloride and processes forits preparation. These patents currently are set to expire in 2011, 2012, 2016and 2017, respectively. Supplemental Protection Certificates based uponcorresponding foreign patents covering this product are set to expire in 2011.We also hold rights to the GABITRIL trademark.

**PAIN**

Our pain therapeuticsportfolio currently includes three marketed products, FENTORA, ACTIQ andgeneric OTFC, focused on treating breakthrough cancer pain. One of the mostchallenging components of cancer pain is breakthrough pain. Breakthrough painis a transitory flare of moderate to severe pain that “breaks through” themedication patients use to control their persistent pain. Breakthrough cancerpain typically develops rapidly, can reach maximum intensity in three to fiveminutes and typically lasts for 30 to 60 minutes. Breakthrough pain may berelated to a specific activity, or may occur spontaneously and unpredictably.Cancer patients who suffer from breakthrough pain may suffer a number ofepisodes every day. Breakthrough pain can have a profound impact on an individual’sphysical and psychological well-being and is often associated with a moresevere and difficult to treat pain condition.

While applicable laws andregulations prevent us from promoting our product for uses beyond thosecontained in the approved label, our analysis of prescription data for FENTORAand ACTIQ in the United States indicated that many physicians have elected toprescribe these products to treat conditions outside their respective labeledindications.

*FENTORA*

We received FDA approvalof FENTORA in late September 2006 and launched the product in the UnitedStates in early October. FENTORA is indicated for the management ofbreakthrough pain in patients with cancer who are already receiving and aretolerant to opioid therapy for their underlying persistent cancer pain. FENTORAis the first and only buccal tablet approved for this indication.

FENTORA delivers fentanyl,a powerful, Schedule II opioid analgesic, through the oral mucosa (the liningof the mouth) utilizing our proprietary, enhanced absorption technology,ORAVESCENT®. The sugar-free FENTORA tablet is placed between the upper cheekand gum above a rear molar tooth. When it comes into contact with saliva,FENTORA’s delivery system generates a reaction leading to the release of carbondioxide. It is believed that transient pH changes accompanying this reactionmay optimize how well the tablet dissolves and how quickly the medicine passesacross the buccal mucosa.

In clinical trials,FENTORA was generally well tolerated. Most adverse events occurring withFENTORA are typical opioid side effects. The most serious adverse eventsassociated with all opioids are respiratory depression (potentially leading toapnea or respiratory arrest), circulatory depression, hypotension, and shock.The most common (greater than or equal to 10 percent) adverse events observedin clinical trials of FENTORA were nausea, vomiting, application siteabnormalities, fatigue, anemia, dizziness, constipation, edema, asthenia,dehydration and headache. Most side effects were mild to moderate in severity.

We are focusing ourlonger-term clinical strategy on developing FENTORA for patients withbreakthrough pain associated with other conditions, including neuropathic painand back pain. In October 2006 and January 2007, we announced thatdata from Phase 3 clinical trials of FENTORA demonstrated efficacy in themanagement of breakthrough pain in opioid-tolerant patients with chronic 

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low backpain and chronic neuropathic pain, respectively. Pending positive data from anongoing study in patients with non-cancer breakthrough pain, our goal is tosubmit a sNDA to the FDA in late 2007. This sNDA would seek to expand thelabeled indications for FENTORA beyond breakthrough pain in patients withcancer.

*ACTIQ/GenericOTFC*

ACTIQ is approved in theUnited States for the management of breakthrough cancer pain in opioid tolerantpatients. It was approved by the FDA in November 1998 and was launched inthe United States in March 1999. Following our acquisition of Anesta Corp.in October 2000, we relaunched ACTIQ in February 2001. In October 2002,we reacquired rights to ACTIQ in 12 countries, principally in Europe, from ElanPharma International Limited.

ACTIQ uses an oraltransmucosal delivery system (“OTS®”) to deliver fentanyl citrate, a powerful,Schedule II opioid analgesic. The OTS delivery system consists of a drugmatrix that is mounted on a handle. It is designed to achieve rapid absorptionof fentanyl through the oral mucosa and into the bloodstream, with pain reliefthat may begin within 15 minutes. ACTIQ is available in six dosage strengths toallow individualization of dosing. Side effects of ACTIQ are typical of opioidproducts and include somnolence, nausea, vomiting and dizziness. The greatestrisk from improper use of ACTIQ, as with all opioid-based products, isthe potential for respiratory depression, which can be life-threatening. Wemarket ACTIQ under a comprehensive risk management program of educational andsafe use messages that inform health care professionals, patients and theirfamilies of proper use, storage, handling and disposal of the product.

To secure FTC clearance ofour acquisition of CIMA LABS INC.,we agreed to license to Barr our U.S. rights to intellectual property necessaryto manufacture and market a generic OTFC. The rights we granted to Barr becameeffective on September 5, 2006 and Barr entered the United States marketwith generic OTFC on September 27, 2006. On this same date, we alsoentered the market with a generic OTFC. We are utilizing Watson as our salesagent in this effort. As a result, ACTIQ sales have been meaningfully eroded bygeneric OTFC products sold by Barr and by us through Watson and we expect thiserosion will continue during 2007.

Under our agreement withBarr, we also agreed to sell to Barr generic OTFC for resale in the UnitedStates until the earlier of such time that Barr is able to gain FDA approval ofits ANDA or September 2009. Barr has invoked this supply option and wehave been manufacturing generic OTFC for Barr since the launch of the productin September 2006. Under the agreement, we are responsible for deliveringbulk units to Barr and Barr is responsible for all packaging and labeling ofthe product. In addition, we have agreed to forbear from asserting anyremaining patent rights in ACTIQ against other parties beginning on March 5,2007.

*Intellectual Property Position*

*FENTORA:*   We own patentsand/or patent applications covering formulation, method of treatment andmanufacturing for FENTORA expiring between 2019 and 2024. Upon FDA approval forthis product, we also received a three-year period of marketing exclusivitythat extends until September 2009. We also hold rights to the FENTORAtrademark.

*ACTIQ:*   The U.S. patentscovering the currently approved compressed powder pharmaceutical compositionand the method for administering fentanyl via this composition expired in September 2006.As described above, we have licensed to Barr our U.S. rights to intellectualproperty necessary to manufacture and market a generic OTFC. Correspondingpatents covering the current formulation of ACTIQ in foreign countriesgenerally expire between 2009 and 2010. Our patent protection with respect tothe ACTIQ formulation we sold in the United States prior to June 2003expired in May 2005.

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Other issued patents andpending patent applications in the United States and foreign countries that areowned or licensed by us are directed to various formulations (including asugar-free formulation), processes for manufacturing the product, methods ofusing the product and disposable containers required by the FDA to be providedas part of the product. We also hold the rights to the ACTIQ trademark.

*Manufacturing and Product Supply*

At our facility in SaltLake City, Utah, we manufacture FENTORA, ACTIQ and generic OTFC for our sale inthe United States and international markets. We also currently aremanufacturing generic OTFC bulk units for Barr. In August 2006, wecompleted a nearly $70 million, two-year capital expansion project at ourSalt Lake City facility to increase our manufacturing and packaging capacitywith respect to FENTORA, ACTIQ and generic OTFC.

Fentanyl, the activeingredient in FENTORA, ACTIQ and generic OTFC, is a Schedule II controlledsubstance under the Controlled Substances Act. Our purchases of fentanyl foruse in the production of FENTORA, ACTIQ and generic OTFC are subject to quotathat is approved by the U.S. Drug Enforcement Administration (“DEA”). Supplydisruption could result from delays in obtaining DEA approvals or the receipt ofapprovals for quantities of fentanyl that are insufficient to meet current orprojected product demand. The quota system also limits our ability to buildinventories as a method of insuring against possible supply disruptions. Whilewe currently have available fentanyl quota to produce ACTIQ and generic OTFC,in the future we could face shortages of quota that could negatively impact ourability to supply product to Barr or to produce ACTIQ or our generic OTFCproduct. If we are unable to provide product to Barr, it is possible thateither Barr or the FTC could claim that such a failure would constitute abreach of our agreements with these parties.

*Competition*

Both long-acting and short-actingformulations are prescribed to treat cancer pain. Persistent pain is typicallytreated by around-the-clock administration of long- or short-actingopioids. Breakthrough cancer pain is usually treated with a short-actingproduct, such as FENTORA, ACTIQ or generic OTFC, that is used in conjunctionwith an around-the-clock formulation.

Long-acting products,which have a slower onset and longer duration of action relative to FENTORA,ACTIQ and generic OTFC, are commonly prescribed to treat persistent pain. Threelong-acting opioid analgesics and their generic equivalents currently marketedfor chronic pain dominate this market: Johnson & Johnson’s DURAGESIC®and Purdue Pharmaceuticals’ OXYCONTIN® and MS-CONTIN®. Persistent cancer painalso is treated with short-acting opioid tablets, capsules and elixirs,as well as quick-acting invasive opioid delivery systems (i.e.,intravenous, intramuscular and subcutaneous), many of which have been availablefor many years and are available in inexpensive generic form.

The overwhelming majorityof prescriptions written to treat breakthrough cancer pain are for short-actingopioids other than FENTORA, ACTIQ or generic OTFC, such as morphine andcombination products (with acetaminophen and oxycodone or hydrocodone), as wellas quick-acting opioids delivered via invasive delivery systems. In somecases, physicians also may attempt to manage breakthrough pain by increasingthe dose of a long-acting opioid.

We are aware of numerouscompanies developing other technologies for rapid delivery of opioids to treatbreakthrough pain, including transmucosal, transdermal, nasal spray, andinhaled delivery systems, among others. If these technologies are successfullydeveloped and approved over the next few years, they could representsignificant competition for FENTORA, ACTIQ and generic OTFC.

The existence of genericOTFC has and will likely continue to impact sales of ACTIQ and could negativelyimpact the growth of FENTORA. Since the launch of generic OTFC in September 2006,ACTIQ sales have been meaningfully eroded and we expect this erosion will continueduring 2007. In 

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addition,sales of our own generic OTFC could be significantly impacted by the entranceinto the market of additional generic OTFC products, which could occur at anytime.

**ONCOLOGY**

Our U.S. oncologyportfolio includes one marketed product and two product candidates to treatpatients with hematologic cancers: TRISENOX®, an intravenous arsenic-basedtargeted therapy currently marketed in the U.S., as well as in Europe; CEP-701(lestaurtinib), an oral small molecule tyrosine kinase inhibitor; and TREANDA®(bendamustine hydrochloride), a multi-functional hybrid cytotoxic. InEurope, we have two commercialized oncology products in our portfolio: MYOCET®(liposomal doxorubicin), a cardio-protective chemotherapy agent used totreat late-stage breast cancer and TARGRETIN® (bexarotene), a treatment forcutaneous T-cell lymphoma. In addition, we market and sell ABELCET®(amphotericin B lipid complex), an anti-fungal product used bycancer patients.

*TRISENOX*

In July 2005, weacquired substantially all of the assets related to the TRISENOX injectionbusiness from Cell Therapeutics, Inc. TRISENOX was approved for marketingin the United States and Europe in 2000 and 2002, respectively, for thetreatment of patients with relapsed or refractory acute promyelocytic leukemia(“APL”), a life threatening hematologic cancer. APL is one of eight subtypes ofacute myeloid or myelogenous leukemia (“AML”). According to the American CancerSociety, approximately 12,000 patients are diagnosed with AML in the UnitedStates every year, 10 to 15 percent of whom will have the APL subtype.Research indicates that approximately 10 to 30 percent of patients withAPL will not respond to, or will relapse from, first-line therapy.

TRISENOX is a highlypurified salt of arsenic, a natural element. TRISENOX appears to have multipletargets and mechanisms of antileukemic activity; it degrades a protein thatcauses abnormal levels of immature white blood cells while simultaneouslyforcing immature cancer cells to self-destruct through a process calledprogrammed cell death or apoptosis. Apoptosis is a normal part of a cell’s lifecycle. Because cancer is often associated with a malfunction of the normalprocess of apoptosis, drugs that can induce apoptosis offer the hope of affectingcancer cells more selectively without the typical toxic side effects ofconventional treatments. Direct induction of apoptosis represents a relativelynew method of killing tumor cells that is different than the majority ofconventional cancer drugs. As a result, in addition to its use as a single-agenttherapy, TRISENOX may work well when administered in combination with othercancer therapies to produce more durable response rates.

In January 2007, theNational Cancer Institute and one of its Cooperative Clinical Trial Groupsannounced positive results from a clinical trial using TRISENOX in newlydiagnosed patients with APL. According to the NCI, the results of the trialshowed that adult patients with previously untreated APL who had standardchemotherapy to induce remission of their disease, and who then receivedTRISENOX to maintain remission, had significantly better event-free survivaland better overall survival than those who received only standard chemotherapy.We are continuing to investigate uses of TRISENOX, as a single agent or incombination with other treatments, to treat APL and other forms of hematologiccancers.

*Intellectual Property Position*

We have a license topatents and patent applications covering methods of treating APL with the activeingredient arsenic trioxide that protect this product until 2018. TRISENOX isalso protected by orphan drug exclusivity until 2007. We also hold rights tothe TRISENOX trademark.

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*Manufacturing and Product Supply*

We have one third-partymanufacturer that produces the active drug substance arsenic trioxide for usand two third-party manufacturers that provide finished commercialsupplies of TRISENOX to us in the United States and Europe. We seek to maintaininventories of active drug substance and finished commercial supplies toprotect against supply disruptions.

*Competition*

The pharmaceutical marketfor the treatment of patients with relapsed or refractory APL is served by anumber of available therapeutics, such as VESANOID® by Roche in combination withchemotherapy.

*CEP-701*

CEP-701 is underdevelopment as a treatment for flt-3-mutated AML, a hematologiccancer characterized by uncontrolled growth of myeloid cells of the blood andbone marrow. According to the American Cancer Society, in 2007, an estimated12,700 people in the United States will be diagnosed with AML and approximately9,000 people will die from AML. Approximately 25 to 30 percent of AMLpatients have a flt-3 genetic mutation that is associated with a poorerprognosis for relapse and survival.

We are currentlyconducting a Phase 2/3 study of approximately 200 patients with AML who bear aflt-3 activating mutation at first relapse from standard inductionchemotherapy. In December 2005, we announced that the preliminary data of44 patients in this study suggest that chemotherapy followed by the oralcompound CEP-701 may offer a clinical benefit compared to chemotherapyalone. A clinical response has been achieved in all patients who showed an85 percent or greater inhibition of flt-3 activity and baselinecellular sensitivity to CEP-701. Patients with low flt-3-inhibitoryactivity or cells insensitive to CEP-701 had a very low rate of clinicalresponse. These data suggest that there may be the potential to predict whichpatients will respond positively to CEP-701. Preliminary safety analysesindicate that CEP-701 is generally well tolerated, with only a modestincrease in gastrointestinal events such as nausea and dyspepsia reported.

As of December 31,2006, 112 patients have been randomly assigned to one of two treatment arms inthe Phase 2/3 clinical trial: standard chemotherapy alone, or chemotherapyfollowed two days later by a daily 80-mg orally administered dose of CEP-701,continued for up to 113 days. We are targeting late 2007 for the completionof this study, with an NDA submission planned for early 2008. We also areplanning to initiate studies of CEP-701 in patients withmyeloproliferative disorder in 2007. CEP-701 is not presently indicatedor approved by the FDA for the treatment of any disease.

*Intellectual Property Position*

We have a license to acomposition of matter patent directed to CEP-701 that is set to expire in2008 in the United States. If we are successful in attaining FDA approval forthis compound in 2008, we would anticipate that the term of this patent wouldbe extended under the Hatch-Waxman Act until 2013. In addition, assumingthis same timetable for approval, we would expect to receive a five year NewChemical Entity period of marketing exclusivity (until 2013). In April 2006,the FDA granted orphan drug designation for CEP-701 for the treatment ofAML. The orphan drug designation will provide a seven-year period of marketingexclusivity for the treatment of AML with CEP-701 from the date of finalFDA marketing approval of CEP-701. We also hold rights to other patentapplications directed to methods of treatment, formulations and polymorphs forCEP-701.

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*Competition*

If approved, CEP-701would compete with a number of available therapeutics, particularly those thatare indicated for the treatment of hematologic cancers. We understand thatNovartis and Millennium Pharmaceuticals are each developing drugs with asimilar mechanism of action.

*TREANDA*

We obtained the rights to market TREANDA inJune 2005. TREANDA is an investigational therapeutic under development forthe treatment of indolent (slowly progressing) non-Hodgkin’s lymphoma (“NHL”).According to the National Cancer Institute, NHL is the sixth most prevalentcancer in the United States. NHL occurs when lymphatic cells divide too muchand too fast. Growth control is lost, and the lymphatic cells may overcrowd,invade and destroy lymphoid tissues and spread to other organs. There are twobroad subtypes of NHL—indolent, also referred to as slow growing or low-grade,and aggressive. Indolent disease may “transform” into a more aggressivecondition. According to the American Cancer Society, there were almost 63,000new cases of NHL in the U.S. in 2007; nearly 19,000 die from the diseaseannually.

TREANDA is a novel hybrid cytotoxic alkylating agentthat differs from conventional compounds in its apparent multi-functionalmechanism of action. In addition to killing cells by damaging their DNA andtriggering apoptosis—which is typical of alkylating agents—researchersdemonstrated that TREANDA also causes the disruption of cell division.Bendamustine hydrochloride is currently marketed in Germany by a third partyfor the treatment of NHL, chronic lymphocytic leukemia (CLL), multiple myeloma,metastatic breast cancer and other solid tumors.

In a Phase 2 study ofpatients with advanced indolent NHL who were previously exposed to multiplecourses of therapy, 74 percent responded to TREANDA, including35 percent with a complete response. All study participants hadprogressive disease after prior treatment with the antibody therapy rituximab(Rituxan®); a subgroup also had not responded to traditional alkylating agents.Rituximab and alkylators are commonly prescribed to treat NHL. In another Phase2 study, TREANDA in combination with rituximab in patients with refractory andrelapsed NHL produced a high overall response rate (87 percent) withminimal toxicity and no hair loss. We are conducting a Phase 3 trial ofTREANDA in indolent NHL refractory to rituximab at sites in the United Statesand Canada and are targeting study completion for late 2007. If results fromthis study are positive, we would expect to file an NDA for TREANDA in thefourth quarter of 2007. We also are planning to study TREANDA for the treatmentof CLL, mantle cell lymphoma and small cell lung cancer.

*IntellectualProperty Position*

We own method of treatmentand formulation patent applications that, if issued, we expect will protectthis product until 2025 and 2026, respectively. In addition, we expect toreceive a five year New Chemical Entity exclusivity which prevents the FDA fromaccepting an ANDA for this product for a period of five years from the date ofapproval (four years if the ANDA contains a Paragraph IV certification). Wealso own rights to the TREANDA trademark.

*Manufacturing andProduct Supply*

We have one third party supplier of the active drugsubstance bendamustine hydrochloride and one third party supplier of finishedsupplies of TREANDA for our use in clinical trials. If TREANDA is approved bythe FDA, we expect to qualify our current manufacturers of the active drugsubstance and the finished supplies and to qualify additional manufacturers asmay be necessary to meet commercial demands and to protect against supplydisruptions.

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*Competition*

If approved, TREANDA wouldcompete with traditional methods of treating indolent NHL, including treatmentsinvolving chemotherapy with a combination of drugs such as cyclophosphamide,vincristine and prednisolone and with drugs currently marketed (such as BEXXAR®(131-I tositumomab) by GlaxoSmithKline) or being developed to treatindolent NHL refractory to rituximab.

**ADDICTION**

Our addiction therapeutic focuscurrently consists of one product, VIVITROL. In June 2006, welaunched VIVITROL, which was approved by the FDA in April 2006. VIVITROLis indicated for alcohol dependent patients who are able to abstain fromalcohol in an outpatient setting and are not actively drinking when initiatingtreatment. Treatment with VIVITROL should be used in combination withpsychosocial support, such as counseling or group therapy. VIVITROL utilizes Alkermes’ proprietary Medisorb®drug delivery technology in a once-a-month injectable formulationof naltrexone. Naltrexone is a FDA-approved drug that is currentlyavailable in daily oral dosage form for the treatment of alcohol dependence andfor the blockade of effects of exogenously administered opioids.

In the United States, approximately 18 millionpeople are dependent on or abuse alcohol and an estimated 2.3 millionadults seek treatment each year. Even among individuals currently seekingtreatment, the majority relapse. Taking prescribed medication, an important determinantin therapeutic outcomes, is particularly challenging for patients withaddictive disorders such as alcohol dependence. Alcohol is causally related tomore than 60 medical conditions, including heart disease, liver disease,infectious disease and cancer, and contributes to more than 100,000 deaths inthe United States each year.

A VIVITROL injectionprovides continuous medication for one month; therefore, patients do not needto make a decision to take their medication every day. VIVITROL works by bindingto opioid receptors in the brain. Although the mechanism responsible for thereduction in alcohol consumption observed with VIVITROL treatment is notentirely understood, preclinical data suggests that occupation of the opioidreceptors results in the blockade of the neurotransmitters in the brain thatare believed to be involved with alcohol dependence. This blockade may resultin the reduction in alcohol consumption observed in patients treated withVIVITROL.

*License andCollaboration Agreement with Alkermes*

In June 2005, we entered into a license andcollaboration agreement with Alkermes to develop and commercialize VIVITROL inthe United States for the treatment of alcohol dependence. Under the terms ofthe collaboration agreement, we made an initial payment of $160 million toAlkermes and an additional $110 million payment following FDA approval ofVIVITROL. Alkermes could receive up to an additional $220 million inmilestone payments that are contingent on attainment of certain agreed-uponsales levels of VIVITROL. We have formed a joint commercialization team withAlkermes, and the parties will share responsibility for developing thecommercial strategy for VIVITROL. We have primary responsibility for allmarketing and sale efforts and currently have approximately 135 persons focusedon the marketing and sale of VIVITROL; Alkermes is augmenting this effort witha team of 28 managers of market development. Alkermes also is responsible formanufacturing the supply of VIVITROL. Until December 31, 2007, Alkermes isresponsible for any cumulative losses up to $120 million and we areresponsible for any cumulative losses in excess of $120 million. Pre-taxprofit, as adjusted for certain items, and losses incurred after December 31,2007 will be split equally between the parties. We began recognizing revenuefor VIVITROL effective in the third quarter of 2006.

In October 2006, weamended the existing license and collaboration agreement with Alkermes toprovide that we would be responsible for our own VIVITROL-related costs duringthe period August 1, 2006 through December 31, 2006 and, for thatperiod, such costs will not be chargeable to the 

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collaborationand against the $120 million cumulative loss cap. The parties also amended theexisting supply agreement to provide that we will purchase from Alkermes twoVIVITROL manufacturing lines (and related equipment). At December 31,2006, we incurred approximately $25.4 million related to the construction ofthese two manufacturing lines. We expect to incur up to an additional $45.6million for certain future capital improvements related to these twomanufacturing lines. We also have granted Alkermes an option, exercisable aftertwo years, to purchase these manufacturing lines at the then-current net bookvalue of the assets.

*IntellectualProperty Position*

Through our collaborationwith Alkermes, we have a license to several U.S. patents and patentapplications directed to VIVITROL that will expire between 2013 and 2024. Mostof the patents and patent applications are directed generally to the processesinvolved in the Alkermes microsphere technology, while several are directed tothe naltrexone drug product and to the injectable solution. We also hold rightsto the VIVITROL trademark in the United States.

*Manufacturing andProduct Supply*

Concurrent with theexecution of the collaboration agreement, we entered into a supply agreement,as amended as described above, under which Alkermes will provide to us finishedcommercial supplies of VIVITROL. Alkermes has limited experience inmanufacturing products for commercial sale. If Alkermes is unable to continueto successfully manufacture VIVITROL at commercial scale, there could be ashortage in supply of such product, which would have a negative impact on salesof VIVITROL. In addition, Alkermes is responsible for the entire supply chainfor VIVITROL, including the sourcing of raw materials and active pharmaceuticalagents from third parties. Any issues with its supply sources could have anadverse effect on the commercial prospects for VIVITROL.

*Competition*

VIVITROL faces competitionfrom CAMPRAL by Forest Laboratories and currently marketed drugs alsoformulated from naltrexone, such as REVIA® by Duramed Pharmaceuticals, NALOREX®by Bristol-Myers Squibb and DEPADE® by Mallinckrodt. Other pharmaceuticalcompanies are investigating product candidates that have shown some promise intreating alcohol dependence and that, if approved by the FDA, would competewith VIVITROL.

**EUROPEAN OPERATIONS**

*Commercial Products*

We market and sell over 25 products in nearly 20European markets. For the year ended December 31, 2006, aggregate netsales in Europe accounted for approximately 16% of our total consolidated netsales. In 2006, our five largest products in terms of net product sales inEurope were SPASFON® (phloroglucinol), PROVIGIL, MYOCET, ACTIQ and ABELCET.Together, these products accounted for 64% of our total European net sales.

Following our acquisition of Zeneus in December 2005,we now have the sales, marketing, regulatory and clinical infrastructurenecessary to grow our commercial presence in Europe and we have supplementedour growing presence in oncology. We have a strong presence in the five keyEuropean pharmaceutical markets: France, Germany, Italy, Spain and the UnitedKingdom.

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Thefollowing is a summary of the most significant products we market and sell inEurope as of December 31, 2006:
| Product                                            | ** ** | ** **                                                                    | ** ** | **Indication**                       | ** ** | **Key Market(s)** |
|----------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------|
| ABELCET  (amphotericin B lipid complex)(1)         | ** ** | Anti-fungal                                                                   |       | France, Germany, Italy,  Spain, U.K. |       |
| ACTIQ (oral transmucosal fentanyl citrate)         |       | Breakthrough  cancer pain                                                     |       | France, Germany,  U.K.               |       |
| FONZYLANE® (buflomedil)                       |       | Cerebral vascular  disorders                                                  |       | France                               |       |
| GABITRIL (tiagabine hydrochloride)                 |       | Partial seizures                                                              |       | France, Germany,  U.K.               |       |
| MYOCET (liposomal doxorubicin)                     |       | Late stage breast  cancer                                                     |       | France, Germany,  Italy, Spain, U.K. |       |
| NAXY® and MONO-NAXY® (clarithromycin)(2) |       | Antibiotic                                                                    |       | France                               |       |
| PROVIGIL (modafinil)(3)                            |       | Excessive  sleepiness associated with narcolepsy and certain other conditions |       | France, Germany,  U.K.               |       |
| SPASFON® (phloroglucinol)                     |       | Biliary/urinary  tract spasm and irritable bowel syndrome                     |       | France                               |       |
| TARGRETIN  (bexarotene)(4)                         |       | Cutaneous T-cell  lymphoma                                                    |       | France, Germany, U.K.                |       |
|                                                    |            |                                                                               |            |                                      |            |                   |  |  |  |  |

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(1)             ABELCET is licensed from Bristol Myers Squibb.

(2)             NAXY and MONO-NAXY are licensed from Abbott France.

(3)             Marketed under the name MODIODAL® (modafinil) in Franceand under the name VIGIL® (modafinil) in Germany.

(4)             TARGRETIN is licensed from Ligand Pharmaceuticals.

In early 2006, we andNovartis agreed to terminate our exclusive collaboration arrangementestablished in November 2000. Under this collaboration agreement, we hadmarketed PROVIGIL, TEGRETOL® (carbamazepine), RITALIN® (methylphenidate),ANAFRANIL® (clomipramine) and LIORESAL® (baclofen) in the United Kingdom andhad shared with Novartis the earnings from sales of the four Novartis productsand PROVIGIL in the United Kingdom.

*ManufacturingOperations*

At our manufacturingfacility in Mitry-Mory, France, we produce modafinil, which is used in theproduction of PROVIGIL and NUVIGIL. We manufacture certain other products atthis facility and at our other facilities in France for sale in Europe and alsoperform warehousing, packaging and distribution activities for certain productssold in France and other export territories from these facilities. NAXY,MONO-NAXY, MYOCET, ABELCET, TARGRETIN and GABITRIL are among our Europeanproducts that are manufactured for us by third party manufacturers. For theseand most of our other European products, we depend on single sources for themanufacture of both the active drug substances contained in our products andfor finished commercial supplies.

*EuropeanCompetitive and Regulatory Environment*

In Europe, we face competition from generic versionsof a number of the branded products we market. In addition, European Unionpricing laws also allow the parallel importation of branded drugs betweenmember countries. Due to pricing variations within the European Union, it ispossible that our overall margins on our branded drugs could be impactednegatively as a result of the importation of product from relatively lower-marginmember countries to relatively higher-margin member countries.

In addition, themanufacture and sale of our products in Europe are subject to extensiveregulation by European governmental authorities. Government efforts to controlhealthcare costs may result in further growth of generic competition to ourproprietary products or a decrease in the selling prices of any of our 

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proprietaryproducts due to associated decreases in the amount the government health careauthority will reimburse for any of those products. For example, we are awareof governmental efforts in France to limit or eliminate reimbursement for some ofour products, particularly FONZYLANE, FONLIPOL and OLMIFON, which could impactrevenues from our French operations.

**RESEARCH ANDDEVELOPMENT**

In addition to ongoing clinical programs supportingour marketed products, our research and development efforts focus primarily ontwo therapeutic areas: disorders of the central nervous system and cancers. Formany years, our research efforts were targeted at a family of CNS disorderstermed “Neurodegenerative disorders,” which include Alzheimer’s and Parkinson’sDiseases, among others. These disorders are characterized by the death ofneurons, the specialized conducting cells of the nervous system, which, inturn, results in the loss of many functions, including memory, mood and motorcoordination. We have recently expanded our therapeutic and research interestsin CNS disorders and are exploring new therapeutic approaches in sleepmedicine, psychiatry, pain, ADHD and cognition.

Our efforts in oncology grew from our interests inunderstanding pathways involved in cell survival and death. Cancers arecharacterized by the uncontrolled survival and proliferation of cells that formtumors. Our research has focused on kinases, key intracellular messengersystems integral to cellular integrity, cellular proliferation and survival. Wehave developed a proprietary library of novel, small, orally-activesynthetic kinase inhibitors that specifically target key kinases involved intumor growth, the inhibition of which can promote tumor regression.

We expect these approachesin CNS and oncology to provide a risk balanced, expanded pipeline oftherapeutic opportunity in the future.

**CNS Disorders**

Within the category of CNSdisorders, our research programs in neurodegenerative diseases have been thefoundation on which to grow our overall research strategies. The objective ofthis work was to discover therapies that would halt the progress ofneurodegenerative disease.  We identifiedthe stress activated protein kinase pathway as integral to the cell deathprocess, targeting the mixed lineage kinase family as integral to this process.We identified and developed proprietary compounds, like CEP-1347, thatare efficacious in preclinical models of disease. As research inneurodegeneration is relatively high risk given how little is known aboutdisease etiology and progression, we have taken advantage of what we havelearned from the commercialization of products in sleep medicine, pain andpsychiatry to compliment and balance our ongoing discovery efforts targetingunique GPCR’s (G-Protein Coupled Receptors), proteins that represent thetargets through which many CNS drugs act. This research is focused ondiscovering the next generation of medicines to treat psychiatric, cognitiveand sleep disorders and pain.

**Oncology**

Our current oncology research program includes twomain therapeutic targets: solid tumors, which are associated with a broad rangeof cancers, and hematological cancers, including AML and multiple myeloma.

In normal tissues, cellular proliferation is balancedby cellular death. Generally, both processes are controlled in part by a classof molecules (known as growth factors) that bind to cell surface receptors(many of which are kinases). Kinases control the lifecycle of a cell byregulating when it should replicate, cease replication, perform its functionsin a healthy state, or undergo programmed cell death. In cancer, the normalmechanisms of cell death are either blocked or overactive, allowing cells toescape programmed death and leaving cell proliferation unchecked.

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Current cancer therapiesare designed to arrest and kill rapidly dividing cells non-selectively. Thus,traditional chemotherapy and radiation therapy kill all rapidly dividing cells,including both normal and cancerous cells, and the benefits of these therapiesare often limited by their toxicity to normal cells. We believe that bydiscovering the mechanisms blocking cell-death programs and developingcompounds to inhibit those mechanisms, our researchers can deliver moreselective therapies to the marketplace and reduce toxic side effects associatedwith current cancer treatments.

*Solid Tumors*

Solid tumors account for roughly 80 to 90 percentof all cancers. Cancers of the lung, breast, colon, and prostate—each of whichinvolves the formation and spread of tumors—are among the most prevalent anddeadly forms of cancer. Given this broad impact, one of our current researchefforts is the development of anti-angiogenic compounds for treatment of solidtumors. Angiogenesis, the natural process used by the human body to produceblood vessels, occurs as a pathological process in the development of solidtumors such as breast and lung cancers. All living organisms, including tumors,need blood vessels to supply nutrients to survive and grow.

In studying the cell signaling pathways that regulateangiogenesis, in collaboration with Sanofi-Aventis, we have targeted areceptor family responsible for survival of individual capillary cells: aprotein receptor kinase called VEGF. Our scientists have synthesized a numberof proprietary, orally active molecules that are potent and selectiveinhibitors of the VEGF receptor. These molecules have been shown to inhibit theformation of blood vessels and thereby slow the growth of a variety of tumorsin preclinical models.

Our researchers also are investigating the Tie-2receptor kinase as an anti-angiogenic target. The Tie-2 receptor kinaseworks in concert with VEGF receptor systems to form new blood vessels.Inhibition of this kinase also may become another important weapon used tofight tumor angiogenesis.

From this research, apotential drug candidate has been identified incorporating both of theseimportant mechanisms. Pre-clinical development activities are underway with theexpectation of initiating human trials of this candidate in 2007.

*HematologicalCancers*

Hematologic (blood) cancers such as leukemia, lymphomaand multiple myeloma continue to have a significant impact on human life.Hematologic cancers arise due to errors in the genetic information of animmature blood cell. As a consequence of these errors, the cell’s developmentis arrested so that it does not mature further, but is instead replicated overand over again, resulting in a proliferation of abnormal blood cells thateventually crowd out and destroy normal blood cells.

For patients suffering from AML, a malignant cancerthat originates in the bone marrow cells, there is an uncontrolledproliferation of myeloid cells of the blood and bone marrow. The lack of normalwhite cells impairs the body’s ability to fight infections. A shortage ofplatelets results in bruising and easy bleeding. According to the AmericanCancer Society, in 2006, approximately 12,000 people in the United States willbe diagnosed with AML, making it the most common form of adult leukemia and thesecond most common childhood leukemia.

Our researchers, with our collaborators, found that ina subset of patients, their AML is caused by a mutation in a kinase called flt-3.Normally, flt-3 is involved in the growth and maturation of healthy bloodcells. In AML patients with flt-3 mutations, the cell signaling pathwayspromote uncontrolled cell growth. Our compound, CEP-701, has been shownto block the signaling ability of the mutant flt-3 kinase in preclinicalstudies. We are currently conducting Phase 2/3 clinical trials with CEP-701in combination with current standard of care therapies, to study its effect inpatients suffering from AML.

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In addition, we areactively pursuing the development of novel inhibitors of the proteosome, amultifunctional protease integral to normal cellular functioning. Clinical andpre-clinical studies provide a strong rationale for the utility of proteosomeinhibitors in hematological cancers. We have identified proprietary proteosomeinhibitors that in preclinical models of cancer display greater efficacy andtolerability than currently available therapies. Clinical investigations of oneof these inhibitors are expected to begin in 2007.

**Neurotrophic Factors**

Under a collaboration withChiron Corporation that was terminated in February 2001, we conductedclinical trials using IGF-I, also known as MYOTROPHIN® (mecasermin) Injection,in patients in North America and Europe suffering from amyotrophic lateralsclerosis (ALS). ALS is a fatal disorder of the nervous system characterized bythe chronic, progressive degeneration of motor neurons, which leads to muscleweakness, muscle atrophy and, eventually, to the patient’s death. In February 1997,we submitted an NDA to the FDA for approval to market MYOTROPHIN in the UnitedStates for the treatment of ALS. In May 1998, the FDA issued a letterstating that the NDA was “potentially approvable,” under certain conditions. Wedo not believe those conditions can be met without conducting an additionalPhase 3 clinical study, and we have no plans to conduct such a study at thistime. However, certain physicians have obtained governmental andnon-governmental funding to be used to conduct such a study. We have agreedwith these physicians to allow reference to our IND and have agreed to supplyMYOTROPHIN in quantities sufficient for them to conduct the study in exchangefor the right to use any clinical data generated by such study in support ofFDA approval of our pending NDA. These physicians commenced the study in mid-2003and enrollment was completed in August 2005. The study should be completedin mid-2007. Even if positive, the results of this study may not besufficient to obtain regulatory approval to market the product. Furthermore, wedo not have a source for finished commercial supply of MYOTROPHIN in the eventregulatory approval is obtained.

**Other Discovery Research Efforts**

Since our inception, wehave been engaged in research to discover innovative medicines. This researchhas resulted in the discovery of compounds that could potentially be useful intreating important clinical conditions beyond those for which we have activedevelopment programs. In these and other cases, we often seek to establishcollaborative partnerships with companies whose clinical development andmarketing capabilities will maximize the value of these discoveries. Forexample, we have a collaboration with Euroscreen s.a. to discover and developsmall molecule therapeutics targeting G-Protein Coupled Receptors, or GPCR, afamily of receptors that play a major role in cell signaling. We are workingwith Pharmacopeia Drug Discovery, Inc. to identify new chemical entitiesas candidates for drug development in various therapeutic areas. We also have acollaboration with AMBIT Biosciences Inc, a biotechnology company withspecialized technology in interrogating the kinome, that portion of the humangenome that codes for protein kinases, that we believe will amplify and enhanceour internal discovery programs  Thesecollaborations strengthen our internal efforts to provide a more diversetherapeutic breadth and depth to our research efforts. In addition, we sponsora number of external research collaborations with academic laboratories tocompliment our internal expertise.

**Drug Delivery Research and Development**

We pursue collaborative relationships withpharmaceutical companies that leverage the capabilities of these partners withour drug delivery and manufacturing capabilities to deliver new products incorporatingour ORASOLV® or DURSOLV® orally disintegrating drug delivery technologies orour ORAVESCENT® drug delivery technology. Revenues from these arrangementsconsist of net sales of manufactured products to partners, product developmentand licensing fees and royalties, and totaled approximately 3.9% of our totalconsolidated revenue for the year ended December 31, 2006. We currentlycollaborate with many partners, including AstraZeneca, Novartis, Organon,Schering-Plough and Wyeth. 

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We have three manufacturinglines at our Eden Prairie, Minnesota facility for product requiring blisterpackaging and a manufacturing line at our Brooklyn Park, Minnesota facility forbottled product. We also have granulation and taste masking capabilities at ourEden Prairie facility. We believe that our production capacity will be adequateto meet our partners’ needs for the foreseeable future.

Drug delivery technologies have been developed for avariety of therapeutic compounds, improving safety, efficacy, ease of patient useand patient compliance. In addition, drug delivery technologies can be used toexpand markets for existing products, as well as to develop new products. Wehave focused our research and development efforts on developing new productapplications using two primary drug delivery technologies: OrallyDisintegrating Tablet (“ODT”) technologies and Oral Transmucosal (“OTM”)technologies.

ODT technology hasemerged as an important drug delivery technology that enables tablets todisintegrate quickly in the mouth without the use of water or chewing. ODT mayimprove compliance with a prescribed drug regimen, may improve dosing accuracyrelative to liquid formulations and often is preferred by patients toconventional tablets and other formulations. Our two primary ODT technologiesare ORASOLV® and DURASOLV®. Our ORASOLV technology incorporates taste maskedactive drug ingredients in orally disintegrating tablets. The low level ofcompaction pressure applied to ORASOLV tablets allows higher porosity, fasterdisintegration time and larger amounts of taste masked active drug ingredientsto be compressed into the tablets. The U.S. patent for our ORASOLV technologyexpires in 2010.

Our DURASOLV technology uses higher compaction forcesthan ORASOLV to produce orally disintegrating tablets incorporating active drugingredients in a more durable orally disintegrating tablet. Due to theirgreater durability, DURASOLV tablets are easier to handle and package, and maycost less to produce and package. The U.S. patents for our DURASOLV technologyexpire in 2018.

In addition to our ORASOLV and DURASOLV technologies,we continue to develop our LYOC® technology to create ODT using freeze dryingmethods to manufacture tablets. We have a fully dedicated LYOC manufacturingsite in Nevers, France, which we expect to expand to increase capacity. Oncecomplete, we will have additional capacity for both in-house and third partymanufacturing. We currently manufacture and sell several drugs in France usingour LYOC technology, including SPASFON LYOC®, PARALYOC®, PROXALYOC® andLOPERAMIDE LYOC®.

OTM technologies are designed to increase theabsorption of active drug ingredients across the mucosal membranes lining theoral cavity, gastrointestinal tract and colon. In the area of OTM technologies,we are investing in research and development of our proprietary ORAVESCENTtechnologies. Our ORAVESCENT drug delivery technologies include ORAVESCENT SLfor drug delivery under the tongue (“sublingual”) and ORAVESCENT BL for drugdelivery between the gum and the cheek (“buccal”). The U.S. patents for ourORAVESCENT technology begin to expire in 2019. In addition to our ORAVESCENTtechnologies, we continue to assess the potential uses of certain otherproprietary buccal delivery systems in several therapeutic areas in which wefocus.

**CUSTOMERS**

Our principal customersare wholesale drug distributors. These customers comprise a significant part ofthe distribution network for all pharmaceutical products in the United States.Three large wholesale drug distributors, Cardinal Health, Inc., McKessonCorporation and AmerisourceBergen Corporation, control a significant share ofthis network. These three wholesale customers, in the aggregate, accounted for71% of our total consolidated gross sales for the year ended December 31,2006. The loss or bankruptcy of any of these customers could have an adverseaffect on our results of operation and financial condition.

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**COMPETITION**

We face intensecompetition and rapid technological change in the pharmaceutical marketplace.Large and small companies, academic institutions, governmental agencies, andother public and private research organizations conduct research, seek patentprotection and establish collaborative arrangements for product development incompetition with us. Products developed by any of these entities may competedirectly with those we develop or sell. In addition, many of the companies andinstitutions that compete against us have substantially greater capitalresources, research and development staffs and facilities than we have, andsubstantially greater experience in conducting clinical trials, obtainingregulatory approvals and manufacturing and marketing pharmaceutical products.These entities represent significant competition for us. Our products also facepotential competition from companies seeking to develop and sell genericformulations of our products at a substantial price discount to the currentprice of our products. In addition, competitors who are developing products forthe treatment of neurological or oncological disorders might succeed indeveloping technologies and products that are more effective than any that wedevelop or sell or that would render our technology and products obsolete ornoncompetitive. Competition and innovation from these or other sourcespotentially could negatively affect sales of our products or make themobsolete. Advances in current treatment methods also may adversely affect themarket for such products. In addition, we may be at a competitive marketingdisadvantage against companies that have broader product lines and whose salespersonnel are able to offer more complementary products than we can. Anyfailure to maintain our competitive position could adversely affect ourbusiness and results of operations.

As discussed in moredetail above, our products face competition in the marketplace. We cannot besure that we will be able to demonstrate the potential advantages of ourproducts to prescribing physicians and their patients on an absolute basisand/or in comparison to other presently marketed products. We also need todemonstrate to physicians, patients and third party payers that the cost of ourproducts is reasonable and appropriate in the light of their safety andefficacy, the price of competing products and the related health care benefitsto the patient.

**GOVERNMENT REGULATION**

The manufacture and saleof therapeutics are subject to extensive regulation by U.S. and foreigngovernmental authorities. In particular, pharmaceutical products are subject torigorous preclinical and clinical trials and other approval requirements aswell as other post-approval requirements by the FDA under the Federal Food,Drug, and Cosmetic Act and by analogous agencies in countries outside theUnited States.

As an initial step in theFDA regulatory approval process, preclinical studies are typically conducted inanimals to identify potential safety problems and, in some cases, to evaluatepotential efficacy. The results of the preclinical studies are submitted toregulatory authorities as a part of an IND that is filed with regulatoryagencies prior to beginning studies in humans. However, for several of our drugcandidates, no animal model exists that is potentially predictive of results inhumans. As a result, no in vivo indication of efficacy is available until thesedrug candidates progress to human clinical trials.

Clinical trials aretypically conducted in three sequential phases, although the phases mayoverlap. Phase 1 typically begins with the initial introduction of the druginto human subjects prior to introduction into patients. In Phase 1, thecompound is tested for safety, dosage tolerance, absorption, biodistribution, metabolism,excretion and clinical pharmacology, as well as, if possible, to gain earlyinformation on effectiveness. Phase 2 typically involves studies in a smallsample of the intended patient population to assess the efficacy of the drugfor a specific indication, determine dose tolerance and the optimal dose range,and to gather additional information relating to safety and potential adverseeffects. Phase 3 trials are undertaken to further evaluate clinical safety andefficacy in an expanded patient population, generally at multiple study sites,to determine the overall risk-benefit ratio of the drug and to provide anadequate 

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basisfor product labeling. Each trial is conducted in accordance with certainstandards under protocols that detail the objectives of the study, theparameters to be used to monitor safety and the efficacy criteria to beevaluated. In the United States, each protocol must be submitted to the FDA aspart of the IND. Further, one or more independent Institutional Review Boardsmust evaluate each clinical study. The Institutional Review Board considers,among other things, ethical factors, the safety of the study, the adequacy ofinformed consent by human subjects and the possible liability of theinstitution. Similar procedures and requirements must be fulfilled to conductstudies in other countries. The process of completing clinical trials for a newdrug is likely to take a number of years and require the expenditure ofsubstantial resources.

Promising data frompreclinical and clinical trials are submitted to the FDA in an NDA formarketing approval and to foreign regulatory authorities under applicablerequirements. Preparing an NDA or foreign application involves considerabledata collection, verification, analyses and expense, and there can be noassurance that the applicable regulatory authority will accept the applicationor grant an approval on a timely basis, if at all. The marketing or sale ofpharmaceuticals in the United States may not begin without FDA approval. Theapproval process is affected by a number of factors, including primarily thesafety and efficacy demonstrated in clinical trials and the severity of thedisease. Regulatory authorities may deny an application if, in their solediscretion, they determine that applicable regulatory criteria have not beensatisfied or if, in their judgment, additional testing or information isrequired to ensure the efficacy and safety of the product. One of theconditions for initial marketing approval, as well as continued post-approvalmarketing, is that a prospective manufacturer’s quality control andmanufacturing procedures conform to the current Good Manufacturing Practiceregulations of the regulatory authority. In complying with these regulations, amanufacturer must continue to expend time, money and effort in the area ofproduction, quality control and quality assurance to ensure full compliance.Manufacturing establishments, both foreign and domestic, also are subject toinspections by or under the authority of the FDA and by other federal, state,local or foreign agencies. Discovery of previously unknown problems with aproduct or manufacturer may result in restrictions on such product ormanufacturer, including withdrawal of the product from the market.

After regulatory approvalhas been obtained, further studies, including Phase 4 post-marketing studies,may be required to provide additional data on safety, to validate surrogateefficacy endpoints, or for other reasons, and the failure of such studies canresult in a range of regulatory actions, including withdrawal of the productfrom the market. Further studies will be required to gain approval for the useof a product as a treatment for clinical indications other than those for whichthe product was initially approved. Results of post-marketing programs maylimit or expand the further marketing of the products. Further, if there areany modifications to the drug, including any change in indication,manufacturing process, labeling or manufacturing facility, it may be necessaryto submit an application seeking approval of such changes to the FDA or foreignregulatory authority. Finally, the FDA can place restrictions on approval andmarketing utilizing its authority under applicable regulations. For example,ACTIQ was approved under subpart H of FDA approval regulations, which gives theFDA the authority to pre-approve promotional materials and permits an expeditedmarket withdrawal procedure if issues arise regarding the safe use of ACTIQ.Moreover, marketed products are subject to continued regulatory oversight bythe Office of Medical Policy Division of Drug Marketing, Advertising, andCommunications, and the failure to comply with applicable regulations couldresult in marketing restrictions, financial penalties and/or other sanctions.

Whether or not FDAapproval has been obtained, approval of a product by regulatory authorities inforeign countries must be obtained prior to the commencement of commercialsales of the product in such countries. The requirements governing the conductof clinical trials and product approvals vary widely from country to country,and the time required for approval may be longer or shorter than that requiredfor FDA approval. Although there are procedures for unified filings for mostEuropean countries, in 

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general,each country also has its own additional procedures and requirements,especially related to pricing of new pharmaceuticals. Further, the FDA andother federal agencies regulate the export of products produced in the UnitedStates and, in some circumstances, may prohibit or restrict the export even ifsuch products are approved for sale in other countries.

In the United States, theOrphan Drug Act provides incentives to drug manufacturers to develop andmanufacture drugs for the treatment of rare diseases, currently defined asdiseases that affect fewer than 200,000 individuals in the United States, orfor a disease that affects more than 200,000 individuals in the United States,where the sponsor does not realistically anticipate its product becomingprofitable. For example, the FDA has designated CEP-701 as an orphan drugfor use in treating AML, because this disease currently affects fewer than200,000 individuals in the United States. Under the Orphan Drug Act, amanufacturer of a designated orphan product can seek certain tax benefits, andthe holder of the first FDA approval of a designated orphan product will begranted a seven-year period of marketing exclusivity for that product for theorphan indication. While the marketing exclusivity of an orphan drug wouldprevent other sponsors from obtaining approval of the same drug compound forthe same indication unless the subsequent sponsors could demonstrate clinicalsuperiority or a market shortage occurs, it would not prevent other sponsorsfrom obtaining approval of the same compound for other indications or the useof other types of drugs for the same use as the orphan drug. Orphan drugdesignation generally does not confer any special or preferential treatment inthe regulatory review process. The U.S. Congress has considered, and mayconsider in the future, legislation that would restrict the duration or scopeof the market exclusivity of an orphan drug and, thus, we cannot be sure thatthe benefits of the existing statute will remain in effect. Additionally, wecannot be sure that other governmental regulations applicable to our productswill not change.

In addition to the marketexclusivity period under the Orphan Drug Act, the U.S. Drug Price Competitionand Patent Term Restoration Act of 1984 permits a sponsor to petition for anextension of the term of a patent for a period of time following the initialFDA approval of an NDA. The statute specifically allows a patent owner actingwith due diligence to extend the term of the patent for a period equal toone-half the period of time elapsed between the approval of the IND and thefiling of the corresponding NDA, plus the period of time between the filing ofthe NDA and FDA approval, up to a maximum of five years of patent term extension.Any such extension, however, cannot extend the patent term beyond a maximumterm of fourteen years following FDA approval and is subject to otherrestrictions. Additionally, under this statute, five years of marketingexclusivity is granted for the first approval of a New Chemical Entity (“NCE”).During this period of exclusivity, an ANDA or a 505(b)(2) applicationcannot be submitted to the FDA for a drug product equivalent or identical tothe NCE. An ANDA is the application form typically used by manufacturersseeking approval of a generic version of an approved drug. There is also apossibility that Congress will revise the underlying statute in the next fewyears, which may affect these provisions in ways that we cannot foresee.Additionally, the FDA regulates the labeling, storage, record keeping,advertising and promotion of prescription pharmaceuticals. Drug manufacturingestablishments must register with the FDA and list their products with the FDA.

The Controlled SubstancesAct imposes various registration, record-keeping and reportingrequirements, procurement and manufacturing quotas, labeling and packagingrequirements, security controls and a restriction on prescription refills oncertain pharmaceutical products. A principal factor in determining theparticular requirements of this act, if any, applicable to a product is itsactual or potential abuse profile. A pharmaceutical product may be listed as aSchedule II, III, IV or V substance, with Schedule II substancesconsidered to present the highest risk of substance abuse and Schedule Vsubstances the lowest. Modafinil, the active drug substance in PROVIGIL, hasbeen scheduled under the Controlled Substances Act as a Schedule IVsubstance. Schedule IV substances are subject to special handling proceduresrelating to the storage, shipment, inventory control and disposal of theproduct. 

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Fentanyl,the active ingredient in FENTORA, ACTIQ and generic OTFC, is a Schedule IIcontrolled substance. Schedule II substances are subject to even stricterhandling and record keeping requirements and prescribing restrictions thanSchedule III or IV products. In addition to federal scheduling, PROVIGIL,FENTORA, ACTIQ and generic OTFC are subject to state controlled substanceregulation, and may be placed in more restrictive schedules than thosedetermined by the DEA and FDA. However, to date, neither modafinil nor fentanylhas been placed in a more restrictive schedule by any state.

In addition to thestatutes and regulations described above, we also are subject to regulationunder the Occupational Safety and Health Act, the Environmental Protection Act,the Toxic Substances Control Act, the Resource Conservation and Recovery Actand other federal, state and local regulations.

**LEGAL MATTERS**

For a summary of legal matters,see Note 13 of the Consolidated Financial Statements included in Part II,Item 8 of this Annual Report on Form 10-K, which is incorporatedherein by reference.

**EMPLOYEES**

As of December 31,2006, we had a total of 2,895 full-time employees, of which 2,088 were employedin the United States and 807 were located at our various facilities in Europe.We believe that we have been successful in attracting skilled and experiencedpersonnel; however, competition for such personnel is intense.

**ITEM1A.**        RISK FACTORS

*You should carefully consider the risks describedbelow, in addition to the other information contained in this report, beforemaking an investment decision. Our business, financial condition or results ofoperations could be harmed by any of these risks. The risks and uncertaintiesdescribed below are not the only ones we face. Additional risks not presentlyknown to us or other factors not perceived by us to present significant risksto our business at this time also may impair our business operations.*

**Asignificant portion of our revenue is derived from our two largest products,and our future success will depend on the continued growth and acceptance ofPROVIGIL and the growth of FENTORA.**

Forthe year ended December 31, 2006, approximately 34% and 43% of our totalconsolidated net sales were derived from sales of ACTIQ and PROVIGIL,respectively. In September 2006, Barr entered the market with generic OTFC.Since that time, we have experienced meaningful erosion of ACTIQ sales in theUnited States and we expect this will continue during 2007. For FENTORA, whichwe launched in the fourth quarter of 2006 as our next-generation pain product,we cannot be sure that it will achieve projected levels of growth. With respectto PROVIGIL, we cannot be certain that it will continue to be accepted in itsmarket. Specifically, the following factors, among others, could affect thelevel of market acceptance of these products:

·       achange in the perception of the healthcare community of the safety and efficacyof the products, both in an absolute sense and relative to that of competingproducts;

·       thelevel and effectiveness of our sales and marketing efforts and, with respect toPROVIGIL, those of Takeda;

·       anyunfavorable publicity regarding these or similar products;

·       theprice of the products relative to other competing drugs or treatments,including the impact of the availability of generic OTFC on market acceptanceof FENTORA;

·       any changes in government and otherthird-party payer reimbursement policies and practices; and

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·       regulatorydevelopments affecting the manufacture, marketing or use of these products,including, for example, any changes to the PROVIGIL label resulting from theSPARLON clinical studies and the finalization of the NUVIGIL label.

Any adverse developmentswith respect to the sale or use of PROVIGIL or FENTORA could significantlyreduce our product revenues and have a material adverse effect on our abilityto generate net income and positive net cash flow from operations.

**Wemay not be able to maintain adequate protection for our intellectual propertyor market exclusivity for our key products and, therefore, competitors maydevelop competing products, which could result in a decrease in sales andmarket share, cause us to reduce prices to compete successfully and limit ourcommercial success.**

We place considerableimportance on obtaining patent protection for new technologies, products andprocesses. To that end, we file applications for patents covering thecompositions or uses of our drug candidates or our proprietary processes. Thepatent positions of pharmaceutical and biotechnology companies can be highlyuncertain and involve complex legal, scientific and factual questions.Accordingly, the patents and patent applications relating to our products,product candidates and technologies may be challenged, invalidated orcircumvented by third parties and might not protect us against competitors withsimilar products or technology. Patent disputes in our industry are frequentand can preclude commercialization of products. If we ultimately engage in andlose any such disputes, we could be subject to competition or significantliabilities, we could be required to enter into third party licenses or wecould be required to cease using the technology or product in dispute. Inaddition, even if such licenses are available, the terms of any licenserequested by a third party could be unacceptable to us.

*PROVIGIL / NUVIGIL*

The U.S. composition ofmatter patent for modafinil expired in 2001. We own U.S. and foreign patentrights that expire between 2014 and 2015 and cover pharmaceutical compositionsand uses of modafinil, specifically, certain particle sizes of modafinilcontained in the pharmaceutical composition of PROVIGIL. With respect to NUVIGIL, we successfully obtainedissuance of a U.S. patent in November 2006 claiming the Form Ipolymorph of armodafinil, the active drug substance in NUVIGIL. This patent iscurrently set to expire in 2023. Foreign patent applications directed to theuse of the Form I polymorph of armodafinil in treating sleep disorders arepending in Europe and elsewhere. Ultimately, these patents might befound invalid as the result of a challenge by a third party, or a potentialcompetitor could develop a competing product or product formulation that avoidsinfringement of these patents. While we intend to vigorously defend thevalidity of these patents and prevent infringement, these efforts will be bothexpensive and time consuming and, ultimately, may not be successful. The lossof patent protection for PROVIGIL would significantly and negatively impactfuture PROVIGIL sales.

As of the filing date ofthis Annual Report on Form 10-K, we are aware of seven ANDAs on filewith the FDA for pharmaceutical products containing modafinil. Each of theseANDAs contains a Paragraph IV certification in which the ANDA applicantcertified that the U.S. particle-size modafinil patent covering PROVIGIL eitheris invalid or will not be infringed by the ANDA product. In March 2003, wefiled a patent infringement lawsuit against four companies—Teva PharmaceuticalsUSA, Inc., Mylan Pharmaceuticals, Inc., Ranbaxy Laboratories Limitedand Barr Laboratories, Inc.—based upon the ANDAs filed by each of thesecompanies with the FDA seeking approval to market a generic form of modafinil.We believe that these four companies were the first to file ANDAs withParagraph IV certifications and thus are eligible for the 180-dayexclusivity provided by the provisions of the Federal Food, Drug and CosmeticAct.

In late 2005 and early2006, we entered into settlement agreements with each of these four defendants.As part of these separate settlements, we agreed to grant to each of Teva,Mylan, Ranbaxy and 

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Barr anon-exclusive royalty-bearing right to market and sell a generic version ofPROVIGIL in the United States. These licenses will become effective in April 2012.An earlier entry may occur based upon the entry of another generic version ofPROVIGIL. Each of these settlements, as well as the ACTIQ settlement agreementdescribed below, has been filed with both the FTC and the Antitrust Division ofthe DOJ as required by the Medicare Modernization Act. The FTC has requestedfrom us, and we have provided, certain information in connection with itsreview of the settlements. In July 2006, the FTC requested that wevoluntarily submit additional information and documents in connection with itsinvestigation of the PROVIGIL settlements. We are cooperating fully with thisrequest. The FTC could challenge in an administrative or judicial proceedingany or all of the settlements if they believe that the agreements violate theantitrust laws, although we believe that such a challenge would take years toresolve.

We also are aware of anumber of civil antitrust complaints, purportedly filed as class actions, filedby private parties in U.S. District Court for the Eastern District ofPennsylvania, each naming Cephalon, Barr, Mylan, Teva and Ranbaxy asco-defendants and claiming, among other things, that the patent litigationsettlements concerning PROVIGIL violate the antitrust laws of the United Statesand certain state laws. The proposed consolidated class action complaints havebeen designated by plaintiffs, each of which seeks to certify separate,purported classes of plaintiffs: direct purchasers of PROVIGIL, and consumersand other indirect purchasers of PROVIGIL. The plaintiffs in both cases areseeking monetary damages and/or equitable relief. Separately, in June 2006,Apotex, Inc., a subsequent ANDA filer seeking FDA approval of a genericform of modafinil, filed suit against us also in the U.S. District Court forthe Eastern District of Pennsylvania alleging similar violations of antitrustlaws and state law. Apotex asserts that the PROVIGIL settlement agreementsimproperly prevent it from obtaining FDA approval of its ANDA, and seeksmonetary and equitable remedies, including a declaratory judgment that our U.S.Patent No. RE37,516 (the “‘516 Patent”) is invalid and unenforceable. Wefiled a motion to dismiss the Apotex case in late September 2006. Webelieve that both the purported class action cases and the Apotex case arewithout merit. While we intend to vigorously defend ourselves and the proprietyof the settlement agreements, these efforts will be both expensive and timeconsuming and, ultimately, due to the nature of litigation, there can be noassurance that these efforts will be successful.

In early 2005, we alsofiled a patent infringement lawsuit against Carlsbad Technology, Inc.based upon the Paragraph IV ANDA filed related to modafinil that Carlsbad filedwith the FDA. In August 2006, we entered into a settlement agreement withCarlsbad and its development partner, Watson Pharmaceuticals, Inc., whichwe understand has the right to commercialize the Carlsbad modafinil product ifapproved by FDA. As part of this settlement, we agreed to grant to Watson anon-exclusive royalty-bearing right to market and sell a generic version ofPROVIGIL in the United States. This license will become effective on or after April 6,2012, subject to applicable regulatory considerations. An earlier entry mayoccur based upon the entry of another generic version of PROVIGIL. Thisagreement has been filed with both the FTC and DOJ, as required by the MedicareModernization Act.

In November 2005 and March 2006,we received notice that Caraco Pharmaceutical Laboratories, Ltd. andApotex, Inc., respectively, also filed Paragraph IV ANDAs with theFDA in which each firm is seeking to market a generic form of PROVIGIL. We havenot filed patent infringement lawsuits against either Caraco or Apotex as ofthe filing date of this report, although Apotex has filed suit against us, asdescribed above.

*ACTIQ*

With respect to ACTIQ, theU.S. patents covering the currently marketed compressed powder pharmaceuticalcomposition and methods for administering fentanyl via this composition expiredon September 5, 2006. Corresponding patents in foreign countries are setto expire between 2009 and 2010. Our patent protection with respect to theACTIQ formulation we sold prior to June 2003 expired in May 2005.

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Under two separateagreements with Barr Laboratories, Inc., we licensed to Barr our U.S.rights to any intellectual property related to ACTIQ. The rights we granted toBarr became effective on September 5, 2006 and Barr entered the marketwith generic OTFC on September 27, 2006. As a result, ACTIQ sales havebeen meaningfully eroded and we expect this erosion will continue during 2007. Moreover,sales of our own generic OTFC could be significantly impacted by the entranceinto the market of additional generic OTFC products, which could occur at anytime.

We also rely on tradesecrets, know-how and continuing technological advancements to support ourcompetitive position. Although we have entered into confidentiality andinvention rights agreements with our employees, consultants, advisors andcollaborators, these parties could fail to honor such agreements or we could beunable to effectively protect our rights to our unpatented trade secrets andknow-how. Moreover, others could independently develop substantially equivalentproprietary information and techniques or otherwise gain access to our tradesecrets and know-how. In addition, many of our scientific and managementpersonnel have been recruited from other biotechnology and pharmaceuticalcompanies where they were conducting research in areas similar to those that wenow pursue. As a result, we could be subject to allegations of trade secretviolations and other claims.

**Ouractivities and products are subject to significant government regulations andapprovals, which are often costly and could result in adverse consequences toour business if we fail to comply.**

Wecurrently have a number of products that have been approved for sale in theUnited States, foreign countries or both. All of our approved products aresubject to extensive continuing regulations relating to, among other things,testing, manufacturing, quality control, labeling, and promotion. The failureto comply with any rules and regulations of the FDA or any foreign medicalauthority, or the post-approval discovery of previously unknown problemsrelating to our products, could result in, among other things:

·       fines,recalls or seizures of products;

·       totalor partial suspension of manufacturing or commercial activities;

·       non-approvalof product license applications;

·       restrictionson our ability to enter into strategic relationships; and

·       criminalprosecution.

Over the past few years, asignificant number of pharmaceutical and biotechnology companies have been thetarget of inquiries and investigations by various federal and state regulatory,investigative, prosecutorial and administrative entities, including the DOJ andvarious U.S. Attorney’s Offices, the Office of Inspector General of the Departmentof Health and Human Services, the FDA, the FTC and various state AttorneysGeneral offices. These investigations have alleged violations of variousfederal and state laws and regulations, including claims asserting antitrustviolations, violations of the Food, Drug and Cosmetic Act, the False ClaimsAct, the Prescription Drug Marketing Act, anti-kickback laws, and other allegedviolations in connection with off-label promotion of products, pricing andMedicare and/or Medicaid reimbursement.

Because of the broad scope and complexity of theselaws and regulations, the high degree of prosecutorial resources and attentionbeing devoted to the sales practices of pharmaceutical companies by lawenforcement authorities, and the risk of potential exclusion from federalgovernment reimbursement programs, numerous companies have determined that itis highly advisable that they enter into settlement agreements in thesematters, particularly those brought by federal authorities and even where suchcompanies believe the investigations are without merit. Companies that havechosen to settle these alleged violations have typically paid multi-milliondollar fines to the government and agreed to abide by corporate integrityagreements.

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In September 2004, we announced that we hadreceived subpoenas from the U.S. Attorney’s Office in Philadelphia. That samemonth, we received a voluntary request for information from the Office of theConnecticut Attorney General. Both the subpoenas and the voluntary request forinformation appear to be focused on Cephalon’s sales and promotional practiceswith respect to ACTIQ, GABITRIL and PROVIGIL, including the extent of off-labelprescribing of our products by physicians. We are cooperating with the U.S.Attorney’s Office and the Office of the Connecticut Attorney General, areproviding documents and other information to both offices in response to theseand additional requests and are engaged in ongoing discussion with bothparties. These matters may involve the bringing of criminal charges and fines,and/or civil penalties. We cannot predict or determine the outcome of thesematters or reasonably estimate the amount or range of amounts of any fines orpenalties that might result from a settlement or an adverse outcome. However, asettlement or an adverse outcome could have a material adverse effect on ourfinancial position, liquidity and results of operations.

It is both costly and time-consuming for us to complywith these inquiries and with the extensive regulations to which we aresubject. Additionally, incidents of adverse drug reactions, unintended sideeffects or misuse relating to our products could result in additionalregulatory controls or restrictions, or even lead to withdrawal of a product fromthe market.

With respect to our product candidates, we conductresearch, preclinical testing and clinical trials, each of which requires us tocomply with extensive government regulations. We cannot market these productcandidates or these new indications in the United States or other countrieswithout receiving approval from the FDA or the appropriate foreign medicalauthority. The approval process is highly uncertain and requires substantialtime, effort and financial resources. Ultimately, we may never obtain approvalin a timely manner, or at all. Without these required approvals, our ability tosubstantially grow revenues in the future could be adversely affected.

In addition, because our products PROVIGIL, FENTORA,ACTIQ and generic OTFC and our product candidate NUVIGIL contain activeingredients that are controlled substances, we are subject to regulation by theDEA and analogous foreignorganizations relating to the manufacture, shipment, sale and use of theapplicable products. These regulations also are imposed on prescribingphysicians and other third parties, making the storage, transport and use ofsuch products relatively complicated and expensive. With the increased concernfor safety by the FDA and the DEA with respect to products containingcontrolled substances and the heightened level of media attention given to thisissue, it is possible that these regulatory agencies could impose additionalrestrictions on marketing or even withdraw regulatory approval for suchproducts. In addition, adverse publicity may bring about a rejection of theproduct by the medical community. If the DEA, FDA or a foreign medicalauthority withdrew the approval of, or placed additional significantrestrictions on the marketing of any of our products, our ability to promoteour products and product sales could be substantially affected.

We rely on third partiesfor the timely supply of specified raw materials, equipment, contractmanufacturing, formulation or packaging services, product distributionservices, customer service activities and product returns processing. Althoughwe actively manage these third party relationships to ensure continuity andquality, some events beyond our control could result in the complete or partialfailure of these goods and services. Any such failure could have a materialadverse effect on our financial condition and result of operations.

**Manufacturing, supply and distribution problems maycreate supply disruptions that could result in a reduction of product salesrevenue and an increase in costs of sales, and damage commercial prospects forour products.**

The manufacture, supply and distribution ofpharmaceutical products, both inside and outside the United States, is highlyregulated and complex. We, and the third parties we rely upon for the 

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manufacturing anddistribution of our products, must comply with all applicable regulatoryrequirements of the FDA and foreign authorities, including current GoodManufacturing Practice (“cGMP”) regulations.

We also must comply with all applicable regulatoryrequirements of the DEA and analogous foreign authorities for certain of ourproducts that contain controlled substances. The DEA also has authority togrant or deny requests for quota of controlled substances such as the fentanylcitrate that is the active ingredient in ACTIQ. Under our license and supplyagreement with Barr, we are obligated to sell generic OTFC to Barr for itsresale in the United States. While we currently have available fentanyl quotato produce ACTIQ and generic OTFC, in the future we could face shortages ofquota that could negatively impact our ability to supply product to Barr or toproduce ACTIQ or our generic OTFC product. If we are unable to provide productto Barr, it is possible that either Barr or the FTC could claim that such afailure would constitute a breach of our agreements with these parties.

The facilities used to manufacture, store anddistribute our products also are subject to inspection by regulatoryauthorities at any time to determine compliance with regulations. Theseregulations are complex, and any failure to comply with them could lead toremedial action, civil and criminal penalties and delays in production ordistribution of material.

For certain of our products in the United States andabroad, we depend upon single sources for the manufacture of both the activedrug substances contained in our products and for finished commercial supplies.The process of changing or adding a manufacturer or changing a formulationrequires prior FDA and/or European medical authority approval and is verytime-consuming. If we are unable to manage this process effectively or if anunforeseen event occurs at any facility, we could face supply disruptions thatwould result in significant costs and delays, undermine goodwill establishedwith physicians and patients, damage commercial prospects for our products andadversely affect operating results.

With respect to VIVITROL,Alkermes is obligated to provide to us finished commercial supplies of theproduct under the terms of a supply agreement. We cannot be sure that they willbe able to continue to successfully manufacture VIVITROL at a commercial scalein a timely or economical manner. If Alkermes is unable to successfullymanufacture VIVITROL, the commercial prospects for the product could beimpacted. In addition, Alkermes is responsible for the entire supply chain forVIVITROL, including the sourcing of raw materials and active pharmaceuticalagents from third parties. Any issues with its supply sources could impair itsability to supply VIVITROL under the supply agreement and have a materialadverse effect on the commercial prospects for VIVITROL.

**As our products are used commercially, unintended sideeffects, adverse reactions or incidents of misuse may occur that could resultin additional regulatory controls, changes to product labeling, adversepublicity and reduced sales of our products.**

During research and development, the use ofpharmaceutical products, such as ours, is limited principally to clinical trialpatients under controlled conditions and under the care of expert physicians.The widespread commercial use of our products could identify undesirable orunintended side effects that have not been evident in our clinical trials orthe commercial use as of the filing date of this report. For example, in February 2005,working with the FDA, we updated our prescribing information for GABITRIL toinclude a bolded warning describing the risk of new onset seizures innon-induced patients without epilepsy. In addition, in patients who takemultiple medications, drug interactions could occur that can be difficult topredict. Additionally, incidents of product misuse, product diversion or theftmay occur, particularly with respect to products such as FENTORA, ACTIQ and PROVIGIL,which contain controlled substances. More recently, an FDA Advisory Committeereviewing SPARLON expressed concern regarding a possible case of SJS in a childwho participated in one of the Phase 3 clinical trials. In light of the FDA’s ongoingreview of our NUVIGIL NDA, we expect that the safety information in the 

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PROVIGIL label will beappropriately modified to reflect the final NUVIGIL label and we are indiscussions with the FDA to reach agreement on the final safety language.

These events, amongothers, could result in adverse publicity that harms the commercial prospectsof our products or lead to additional regulatory controls that could limit thecircumstances under which the product is prescribed or even lead to thewithdrawal of the product from the market. In particular, FENTORA and ACTIQhave been approved under regulations concerning drugs with certain safetyprofiles, under which the FDA has established special restrictions to ensuresafe use. Any violation of these special restrictions could lead to theimposition of further restrictions or withdrawal of the product from themarket.

**We may be unsuccessful in our efforts to obtainregulatory approval for new products or for new formulations of our existingproducts, which would significantly hamper future sales and earnings growth.**

Our long-term prospects,particularly with respect to the growth of our future sales and earnings,depend to a large extent on our ability to obtain FDA approval for our productcandidates, including NUVIGIL. There can be no assurance that our applicationsto market our product candidates will be reviewed in a timely manner or thatour applications will be approved by the FDA on the basis of the data containedin the applications. Should approval be granted to market a product candidate,there can be no assurance that we will be able to successfully commercializethe product or achieve a profitable level of sales. With respect to NUVIGIL, wedo not know whether we will succeed in obtaining final regulatory approval tomarket NUVIGIL or, if approved, what level of market acceptance NUVIGIL mayachieve.

**We face significant product liability risks, which mayhave a negative effect on our financial performance.**

The administration ofdrugs to humans, whether in clinical trials or commercially, can result inproduct liability claims whether or not the drugs are actually at fault forcausing an injury. Furthermore, our products may cause, or may appear to havecaused, adverse side effects (including death) or potentially dangerous druginteractions that we may not learn about or understand fully until the drug hasbeen administered to patients for some time. As our products are used morewidely and in patients with varying medical conditions, the likelihood of an adversedrug reaction, unintended side effect or incidence of misuse may increase.Product liability claims can be expensive to defend and may result in largejudgments or settlements against us, which could have a negative effect on ourfinancial performance. The cost of product liability insurance has increased inrecent years, and the availability of coverage has decreased. Nevertheless, wemaintain product liability insurance in amounts we believe to be commerciallyreasonable but which would be unlikely to cover the potential liabilityassociated with a significant unforeseen safety issue. Any claims could easilyexceed our current coverage limits. Even if a product liability claim is notsuccessful, the adverse publicity and time and expense of defending such aclaim may interfere with our business.

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**Our product sales and related financial results willfluctuate, and these fluctuations may cause our stock price to fall, especiallyif investors do not anticipate them.**

A number ofanalysts and investors who follow our stock have developed models to attempt toforecast future product sales and expenses, and have established earningsexpectations based upon those models. These models, in turn, are based in parton estimates of projected revenue and earnings that we disclose publicly.Forecasting future revenues is difficult, especially when we only have a fewyears of commercial history and when the level of market acceptance of ourproducts is changing rapidly. As a result, it is reasonably likely that our productsales will fluctuate to an extent, that may not meet with market expectationsand that also may adversely affect our stock price. There are a number of otherfactors that could cause our financial results to fluctuate unexpectedly,including:

·       costof product sales;

·       achievementand timing of research and development milestones;

·       collaborationrevenues;

·       costand timing of clinical trials, regulatory approvals and product launches;

·       marketingand other expenses;

·       manufacturingor supply disruptions; and

·       costs associated with theoperations of recently-acquired businesses and technologies.

**We may be unable to repay our substantial indebtednessand other obligations.**

Nearly all of ourindebtedness outstanding contain restricted conversion prices that are eitherbelow or close to our stock price as of the date of the filing of this Form 10-K.As a result, certain of our convertible notes have been classified as currentliabilities on our consolidated balance sheet at December 31, 2006. Underthe terms of the indentures governing the notes, we are obligated to repay incash the aggregate principal balance of any such notes presented forconversion. As of the filing date of this report, we do not have availablecash, cash equivalents and investments sufficient to repay all of theconvertible notes, if presented. In addition, there are no restrictions on ouruse of this cash and the cash available to repay indebtedness may decline overtime. If we do not have sufficient funds available to repay the principalbalance of notes presented for conversion, we will be required to raiseadditional funds. Because the financing markets may be unwilling to providefunding to us or may only be willing to provide funding on terms that we wouldconsider unacceptable, we may not have cash available or be able to obtainfunding to permit us to meet our repayment obligations, thus adverselyaffecting the market price for our securities.

**Our research and development and marketing efforts areoften dependent on corporate collaborators and other third parties who may notdevote sufficient time, resources and attention to our programs, which maylimit our efforts to develop and market potential products.**

To maximize our growth opportunities, we have enteredinto a number of collaboration agreements with third parties. For example, inthe United States, we have an agreement with Takeda under which it willco-promote PROVIGIL for up to three years. Our ability to increase PROVIGILsales in the future will depend to a significant degree on the efforts of ourpartner. If Takeda fails to meet its obligations under the co-promotionagreement, is ineffective in its efforts, or determines to terminate theagreement prior to the end of its term, the growth of PROVIGIL sales could bematerially and negatively impacted.

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Incertain countries outside the United States, we have entered into agreementswith a number of partners with respect to the development, manufacturing andmarketing of our products. In some cases, our collaboration agreements call forour partners to control:

·       thesupply of bulk or formulated drugs for use in clinical trials or for commercialuse;

·       thedesign and execution of clinical studies;

·       theprocess of obtaining regulatory approval to market the product; and/or

·       marketingand selling of an approved product.

In each of these areas,our partners may not support fully our research and commercial interestsbecause our program may compete for time, attention and resources with theinternal programs of our corporate collaborators. As such, our program may notmove forward as effectively, or advance as rapidly, as it might if we hadretained complete control of all research, development, regulatory andcommercialization decisions. We also rely on some of these collaborators andother third parties for the production of compounds and the manufacture andsupply of pharmaceutical products. Additionally, we may find it necessary fromtime to time to seek new or additional partners to assist us in commercializingour products, though we ultimately might not be successful in establishing anysuch new or additional relationships.

**Theefforts of government entities and third party payers to contain or reduce thecosts of health care may adversely affect our sales and limit the commercialsuccess of our products.**

In certain foreignmarkets, pricing or profitability of pharmaceutical products is subject tovarious forms of direct and indirect governmental control, including thecontrol over the amount of reimbursements provided to the patient who isprescribed specific pharmaceutical products. For example, we are aware ofgovernmental efforts in France to limit or eliminate reimbursement for some ofour products, particularly FONZYLANE, FONLIPOL and OLMIFON, which could impactrevenues from our French operations.

In the United States,there have been, and we expect there will continue to be, various proposals toimplement similar controls. The commercial success of our products could belimited if federal or state governments adopt any such proposals. In addition,in the United States and elsewhere, sales of pharmaceutical products depend inpart on the availability of reimbursement to the consumer from third partypayers, such as government and private insurance plans. These third partypayers are increasingly utilizing their significant purchasing power tochallenge the prices charged for pharmaceutical products and seek to limitreimbursement levels offered to consumers for such products. Moreover, manygovernments and private insurance plans have instituted reimbursement schemesthat favor the substitution of generic pharmaceuticals for more expensivebrand-name pharmaceuticals. In the United States in particular, genericsubstitution statutes have been enacted in virtually all states and permit orrequire the dispensing pharmacist to substitute a less expensive generic druginstead of an original branded drug. These third party payers could focus theircost control efforts on our products, especially with respect to prices of andreimbursement levels for products prescribed outside their labeled indications.In these cases, their efforts could negatively impact our product sales andprofitability.

**Weexperience intense competition in our fields of interest, which may adverselyaffect our business.**

Large and small companies,academic institutions, governmental agencies and other public and privateresearch organizations conduct research, seek patent protection and establishcollaborative arrangements for product development in competition with us.Products developed by any of these entities may compete directly with those wedevelop or sell.

The conditions that ourproducts treat, and some of the other disorders for which we are conductingadditional studies, are currently treated with many drugs, several of whichhave been available for a 

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numberof years or are available in inexpensive generic forms. With respect toPROVIGIL, and, if approved, NUVIGIL, there are several other products used forthe treatment of excessive sleepiness or narcolepsy in the United States,including methylphenidate products such as RITALIN® by Novartis, and in ourother territories, many of which have been available for a number of years andare available in inexpensive generic forms. With respect to FENTORA, we facecompetition from numerous short-and long-acting opioid products, includingthree products—Johnson & Johnson’s DURAGESIC® and PurduePharmaceutical’s OXYCONTIN® and MS-CONTIN®—that dominate the market. Inaddition, we are aware of numerous other companies developing othertechnologies for rapidly delivering opioids to treat breakthrough pain thatwill compete against FENTORA. In addition, it is possible that the existence ofgeneric OTFC could negatively impact the growth of FENTORA. With respect toACTIQ, generic competition from Barr has meaningfully eroded branded ACTIQsales and impacted sales of our own generic OTFC through Watson. Our genericsales also could be significantly impacted by the entrance into the market ofadditional generic OTFC products. With respect to VIVITROL, we face competitionfrom CAMPRAL® and oral naltrexone. With respect to TRISENOX, the pharmaceuticalmarket for the treatment of patients with relapsed or refractory APL is servedby a number of available therapeutics, such as VESANOID® by Roche incombination with chemotherapy.

For all of our products,we need to demonstrate to physicians, patients and third party payers that thecost of our products is reasonable and appropriate in the light of their safetyand efficacy, the price of competing products and the related health carebenefits to the patient.

Many of our competitorshave substantially greater capital resources, research and development staffsand facilities than we have, and substantially greater experience in conductingclinical trials, obtaining regulatory approvals and manufacturing and marketingpharmaceutical products. These entities represent significant competition forus. In addition, competitors who are developing products for the treatment ofneurological or oncological disorders might succeed in developing technologiesand products that are more effective than any that we develop or sell or thatwould render our technology and products obsolete or noncompetitive.Competition and innovation from these or other sources, including advances incurrent treatment methods, could potentially affect sales of our productsnegatively or make our products obsolete. Furthermore, we may be at acompetitive marketing disadvantage against companies that have broader productlines and whose sales personnel are able to offer more complementary productsthan we can. Any failure to maintain our competitive position could adverselyaffect our business and results of operations.

**Weplan to consider and, as appropriate, make acquisitions of technologies,products and businesses, which may subject us to a number of risks and/orresult in us experiencing significant charges to earnings that may adverselyaffect our stock price, operating results and financial condition.**

As part of our efforts toacquire businesses 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, we might not realize the intended advantages of theacquisition. If we fail to realize the expected benefits from acquisitions wemay consummate in the future, whether as a result of unidentified risks,integration difficulties, regulatory setbacks or other events, our business,results of operations and financial condition could be adversely affected. Forexample, in connection with our acquisitions in 2005 of Zeneus, Salmedix andTRISENOX and the license and collaboration agreement with Alkermes, weestimated the values of these transactions by making certain assumptions about,among other things, likelihood of regulatory approval for unapproved productsand the market potential for each of the marketed products and the productcandidates. Ultimately, our assumptions may prove to be incorrect, which couldcause us to fail to realize the anticipated benefits of these transactions.

In addition, we haveexperienced, and will likely continue to experience, significant charges toearnings related to our efforts to consummate acquisitions. For transactionsthat ultimately are not 

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consummated,these charges 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 the elimination of duplicateoperations and facilities and acquired in-process research and developmentcharges. In either case, the incurrence of these charges could adversely affectour results of operations for particular quarterly or annual periods.

**Wemay be unable to successfully consolidate and integrate the operations of businesseswe acquire, which may adversely affect our stock price, operating results andfinancial condition.**

We must consolidate andintegrate the operations of acquired businesses with our business. Integrationefforts often take a significant amount of time, place a significant strain onour managerial, operational and financial resources and could prove to be moredifficult and expensive than we predicted. The diversion of our management’sattention and any delays or difficulties encountered in connection with theserecent acquisitions, and any future acquisitions we may consummate, couldresult in the disruption of our ongoing business or inconsistencies instandards, controls, procedures and policies that could negatively affect ourability to maintain relationships with customers, suppliers, employees andothers with whom we have business dealings.

**Theresults and timing of our research and development activities, including futureclinical trials, are difficult to predict, subject to potential future setbacksand, ultimately, may not result in viable pharmaceutical products, which mayadversely affect our business.**

In order to sustain ourbusiness, we focus substantial resources on the search for new pharmaceuticalproducts. These activities include engaging in discovery research and processdevelopment, conducting preclinical and clinical studies and seeking regulatoryapproval in the United States and abroad. In all of these areas, we haverelatively limited resources and compete against larger, multinationalpharmaceutical companies. Moreover, even if we undertake these activities in aneffective and efficient manner, regulatory approval for the sale of newpharmaceutical products remains highly uncertain because the majority ofcompounds discovered do not enter clinical studies and the majority oftherapeutic candidates fail to show the human safety and efficacy necessary forregulatory approval and successful commercialization.

In the pharmaceuticalbusiness, the research and development process generally takes 12 years orlonger, from discovery to commercial product launch. During each stage of thisprocess, there is a substantial risk of failure. Preclinical testing andclinical trials must demonstrate that a product candidate is safe and efficacious.The results from preclinical testing and early clinical trials may not bepredictive of results obtained in subsequent clinical trials, and theseclinical trials may not demonstrate the safety and efficacy necessary to obtainregulatory approval for any product candidates. A number of companies in thebiotechnology and pharmaceutical industries have suffered significant setbacksin advanced clinical trials, even after obtaining promising results in earliertrials. For ethical reasons, certain clinical trials are conducted withpatients having the most advanced stages of disease and who have failedtreatment with alternative therapies. During the course of treatment, thesepatients often die or suffer other adverse medical effects for reasons that maynot be related to the pharmaceutical agent being tested. Such events can have anegative impact on the statistical analysis of clinical trial results.

The completion of clinicaltrials of our product candidates may be delayed by many factors, including therate of enrollment of patients. Neither we nor our collaborators can controlthe rate at which patients present themselves for enrollment, and the rate ofpatient enrollment may not be consistent with our expectations or sufficient toenable clinical trials of our product candidates to be completed in a timelymanner or at all. In addition, we may not be permitted by regulatoryauthorities to undertake additional clinical trials for one or more of ourproduct candidates. Even if such trials are conducted, our product candidatesmay not prove to be safe and efficacious or receive regulatory approvals. Anysignificant delays in, or termination of, clinical trials of our productcandidates could impact our ability to generate product sales from theseproduct candidates in the future.

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**Theprice of our common stock has been and may continue to be highly volatile,which may make it difficult for stockholders to sell our common stock whendesired or at attractive prices.**

Themarket price of our common stock is highly volatile, and we expect it tocontinue to be volatile for the foreseeable future. For example, from January 1,2006 through February 15, 2007 our common stock traded at a high price of$82.92 and a low price of $51.58. Negative announcements, including, amongothers:

·       adverseregulatory decisions;

·       disappointingclinical trial results;

·       disputesand other developments concerning our patents or other proprietary products; or

·       salesor operating results that fall below the market’s expectations

could trigger significantdeclines in the price of our common stock. In addition, external events, suchas news concerning economic conditions, our competitors or our customers,changes in government regulations impacting the biotechnology or pharmaceuticalindustries or the movement of capital into or out of our industry, also arelikely to affect the price of our common stock, regardless of our operatingperformance.

**Ourinternal controls over financial reporting may not be considered effective,which could result in possible regulatory sanctions and a decline in our stockprice.**

Section 404of the Sarbanes-Oxley Act of 2002 requires us to furnish annually a report onour internal controls over financial reporting. The internal control reportmust contain an assessment by our management of the effectiveness of ourinternal control over financial reporting (including the disclosure of anymaterial weakness) and a statement that our independent auditors have attestedto and reported on management’s evaluation of such internal controls. The Sarbanes-OxleyAct requires, among other things, that we maintain effective disclosurecontrols and procedures and internal controls over financial reporting. Inorder for management to evaluate our internal controls, we must regularlyreview and document our internal control processes and procedures and test suchcontrols. Ultimately, we or our independent auditors could conclude that ourinternal control over financial reporting may not be effective if, among othersthings:

·       anymaterial weakness in our internal controls over financial reporting exist; or

·       wefail to remediate assessed deficiencies.

During 2007, we expect toexpand our SAP® implementation to include additional capabilities. Thisexpansion will require changes to certain aspects of our existing system ofinternal controls over financial reporting. Due to the number of controls to beexamined, both with respect to this phase of the implementation and our otherinternal controls over financial reporting, the complexity of our processes,and the subjectivity involved in determining the effectiveness of controls, wecannot be certain that, in the future, all of our controls will continue to beconsidered effective by management or, if considered effective by ourmanagement, that our auditors will agree with such assessment.

If, in the future, we areunable to assert that our internal control over financial reporting iseffective, or if our auditors are unable to attest that our management’s reportis fairly stated or they are unable to express an opinion on our management’sevaluation, we could be subject to regulatory sanctions or lose investorconfidence in the accuracy and completeness of our financial reports, either ofwhich could have an adverse effect on the market price for our securities.

**Aportion of our revenues and expenses is subject to exchange rate fluctuationsin the normal course of business, which could adversely affect our reportedresults of operations.**

Historically, a portion ofour revenues and expenses has been earned and incurred, respectively, incurrencies other than the U.S. dollar. For the year ended December 31,2006, approximately 17% of our revenues were denominated in currencies otherthan the U.S. dollar. We translate revenues earned and 

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expensesincurred into U.S. dollars at the average exchange rate applicable during therelevant period. A weakening of the U.S. dollar would, therefore, increase bothour revenues and expenses. Fluctuations in the rate of exchange between theU.S. dollar and the euro and other currencies may affect period-to-periodcomparisons of our operating results. Historically, we have not hedged ourexposure to these fluctuations in exchange rates.

**Ourcustomer base is highly concentrated.**

Our principal customersare wholesale drug distributors. These customers comprise a significant part ofthe distribution network for pharmaceutical products in the United States.Three large wholesale distributors, Cardinal Health, Inc., McKessonCorporation and AmerisourceBergen Corporation, control a significant share ofthis network. These three wholesaler customers, in the aggregate, accounted for71% of our total consolidated gross sales for the year ended December 31,2006. Fluctuations in the buying patterns of these customers, which may resultfrom seasonality, wholesaler buying decisions or other factors outside of ourcontrol, could significantly affect the level of our net sales on a period toperiod basis. Because of this, the amounts purchased by these customers duringany quarterly or annual period may not correlate to the level of underlyingdemand evidenced by the number of prescriptions written for such products, asreported by IMS Health Incorporated. Furthermore, the loss or bankruptcy of anyof these customers could materially and adversely affect our results ofoperations and financial condition.

**Weare involved, or may become involved in the future, in legal proceedings that,if adversely adjudicated or settled, could materially impact our financialcondition.**

As a biopharmaceuticalcompany, we are or may become a party to litigation in the ordinary course ofour business, including, among others, matters alleging employmentdiscrimination, product liability, patent or other intellectual property rightsinfringement, patent invalidity or breach of commercial contract. In general,litigation claims can be expensive and time consuming to bring or defendagainst and could result in settlements or damages that could significantlyimpact results of operations and financial condition. We currently arevigorously defending ourselves against certain litigation matters in additionto those matters specifically described in Note 13 of the ConsolidatedFinancial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.While we currently do not believe that the settlement or adverse adjudicationof these other litigation matters would materially impact our results ofoperations or financial condition, the final resolution of these matters andthe impact, if any, on our results of operations, financial condition or cashflows is unknown but could be material.

**Ourdependence on key executives and scientists could impact the development andmanagement of our business.**

We are highly dependentupon our ability to attract and retain qualified scientific, technical andmanagerial personnel. There is intense competition for qualified personnel inthe pharmaceutical and biotechnology industries, and we cannot be sure that wewill be able to continue to attract and retain the qualified personnel necessaryfor the development and management of our business. Although we do not believethe loss of one individual would materially harm our business, our businessmight be harmed by the loss of the services of multiple existing personnel, aswell as the failure to recruit additional key scientific, technical andmanagerial personnel in a timely manner. Much of the know-how we have developedresides in our scientific and technical personnel and is not readilytransferable to other personnel. While we have employment agreements with ourkey executives, we do not ordinarily enter into employment agreements with ourother key scientific, technical and managerial employees. We do not maintain “keyman” life insurance on any of our employees.

**Wemay be required to incur significant costs to comply with environmental lawsand regulations, and our related compliance may limit any future profitability.**

Our research anddevelopment activities involve the controlled use of hazardous, infectious andradioactive materials that could be hazardous to human health and safety or theenvironment. We store 

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thesematerials, and various wastes resulting from their use, at our facilitiespending ultimate use and disposal. We are subject to a variety of federal,state and local laws and regulations governing the use, generation,manufacture, storage, handling and disposal of these materials and wastes, andwe may be required to incur significant costs to comply with related existingand future environmental laws and regulations.

While we believe that oursafety procedures for handling and disposing of these materials comply withforeign, federal, state and local laws and regulations, we cannot completelyeliminate the risk of accidental injury or contamination from these materials.In the event of an accident, we could be held liable for any resulting damages,which could include fines and remedial costs. These damages could requirepayment by us of significant amounts over a number of years, which couldadversely affect our results of operations and financial condition.

**Anti-takeoverprovisions may delay or prevent changes in control of our management or deter athird party from acquiring us, limiting our stockholders’ ability to profitfrom such a transaction.**

Our board of directors hasthe authority to issue up to 5,000,000 shares of preferred stock, $0.01 parvalue, of which 1,000,000 have been reserved for issuance in connection withour stockholder rights plan, and to determine the price, rights, preferencesand privileges of those shares without any further vote or action by ourstockholders. Our stockholder rights plan could have the effect of making itmore difficult for a third party to acquire a majority of our outstandingvoting stock.

We are subject to theanti-takeover provisions of Section 203 of the Delaware GeneralCorporation Law, which prohibits us from engaging in a “business combination”with an “interested stockholder” for a period of three years after the date ofthe transaction in which the person becomes an interested stockholder, unlessthe business combination is approved in a prescribed manner. The application ofSection 203 could have the effect of delaying or preventing a change ofcontrol of Cephalon. Section 203, the rights plan, and certain provisionsof our certificate of incorporation, our bylaws and Delaware corporate law, mayhave the effect of deterring hostile takeovers, or delaying or preventingchanges in control of our management, including transactions in whichstockholders might otherwise receive a premium for their shares overthen-current market prices.

**ITEM1B.**       UNRESOLVED STAFF COMMENTS

None.

**ITEM2.**                PROPERTIES

We lease our corporateheadquarters, which is located in Frazer, Pennsylvania and consists ofapproximately 190,000 square feet of administrative office space. We ownapproximately 160,000 square feet of research and office space in West Chester,Pennsylvania, at the site of our former corporate headquarters. We also leaseapproximately 215,000 square feet of office, administrative, research andwarehouse space that is near our Frazer and West Chester facilities. In SaltLake City, Utah, we own approximately 200,000 square feet of manufacturing,warehousing and laboratory space and lease approximately 123,000 square feetfor administrative, research and pilot plant functions. At our facilities inEden Prairie and Brooklyn Park, Minnesota, we own approximately 200,000 squarefeet of space, most of which is dedicated to our manufacturing and warehousingoperations.

We lease office space forour European operations in the U.K. as well as space for our satellite officesin a number of major European countries. In France, we own administrativefacilities, an executive and development facility, a manufacturing facility, apackaging facility and various warehouses totaling approximately 326,000 squarefeet. We also lease the site of our other manufacturing facility in Francetotaling approximately 29,000 square feet. We believe that our currentfacilities are adequate for our present purposes.

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**ITEM3.**                LEGAL PROCEEDINGS

The information set forthin Note 13 of the Consolidated Financial Statements included in Part II,Item 8 of this Annual Report on Form 10-K is incorporatedherein by reference.

**ITEM4.**                SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS

We did not submit anymatters to the vote of security holders during the fourth quarter of 2006.

**Executive Officers of the Registrant**

Thenames, ages and positions held by our executive officers as of the filing dateof this Annual Report on Form 10-K are as follows:

| **Name**                         | ** ** | ** ** | ** ** | **Age**                                                                | ** ** | **Position** |
|----------------------------------|------------|------------|------------|------------------------------------------------------------------------|------------|--------------|
| Frank Baldino, Jr.,  Ph.D.  |       | 53         |       | Chairman and Chief  Executive Officer                                  |
| J. Kevin Buchi                   |       | 51         |       | Executive Vice  President and Chief Financial Officer                  |
| Peter E. Grebow, Ph.D.           |       | 60         |       | Executive Vice  President, Worldwide Technical Operations              |
| John E. Osborn                   |       | 49         |       | Executive Vice  President, General Counsel and Secretary               |
| Robert P.  Roche, Jr.       |       | 51         |       | Executive Vice  President, Worldwide Pharmaceutical Operations         |
| Lesley Russell,  MB.Ch.B., MRCP. |       | 46         |       | Executive Vice  President, Worldwide Medical and Regulatory Operations |
| Carl A. Savini                   |       | 57         |       | Executive Vice  President and Chief Administrative Officer             |
| Jeffry L. Vaught, Ph.D.          |       | 56         |       | Executive Vice President  and President, Research and Development      |

 

All executive officers areelected by the Board of Directors to serve in their respective capacities untiltheir successors are elected and qualified or until their earlier resignationor removal.

Dr. Baldinofounded Cephalon and has served as Chief Executive Officer and a director sinceits inception. He was appointed Chairman of the Board of Directors in December 1999.Dr. Baldino received his Ph.D. degree from Temple University, holdsseveral adjunct academic appointments and is a trustee of Temple University. Dr. Baldinocurrently serves as a director of Pharmacopeia, Inc., a developer ofproprietary technology platforms for pharmaceutical companies, Acusphere, Inc.,a specialty pharmaceutical company, NicOx S.A., a company engaged in theresearch, development and commercialization of nitric oxide therapeutics and,until May 2006, ViroPharma, Inc., a biopharmaceutical company.

Mr. Buchi joinedCephalon in March 1991 and has held the position of Chief FinancialOfficer since 1996. Between 1985 and 1991, Mr. Buchi served in a number offinancial positions with E.I. du Pont de Nemours and Company. Mr. Buchireceived a master of management degree from the J.L. Kellogg Graduate School ofManagement, Northwestern University in 1982. Mr. Buchi serves as a memberof the board of directors of Lorus Therapeutics Inc., a publicly-tradedCanadian biotechnology company, and Encysive Pharmaceuticals Inc., apublicly-traded pharmaceutical company.

Dr. Grebow joinedCephalon in January 1991, and since February 2005 has served asExecutive Vice President, Worldwide Technical Operations. Dr. Grebow alsohas served as Senior Vice President, Worldwide Technical Operations, SeniorVice President, Business Development, and Vice President, Drug Development.From 1988 to 1990, Dr. Grebow served as Vice President of Drug Developmentfor Rorer Central Research, a division of Rhone-Poulenc RorerPharmaceuticals Inc., a pharmaceutical company. Dr. Grebow received aPh.D. in chemistry from the University of California, Santa Barbara.

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Mr. Osborn joined Cephalon in March 1997 andwas appointed Senior Vice President, General Counsel and Secretary in 1998, andExecutive Vice President in 2006. From 1992 to 1997, Mr. Osborn wasemployed by The DuPont Merck Pharmaceutical Company, most recently as VicePresident and Associate General Counsel. Prior to that, he served in the GeorgeH.W. Bush administration with the U.S. Department of State, practiced corporatelaw in Boston with the firm of Hale and Dorr, and clerked for a U.S. Court ofAppeals judge. He holds a visiting research appointment in politics atPrinceton University, and has been elected to membership in the American LawInstitute and the Council on Foreign Relations. Mr. Osborn is a member ofthe board of governors of the East-West Center in Honolulu, an education andresearch organization established by the U.S. Congress to study the AsiaPacific region and its relationship with the United States. He also serves as amember of the board of directors of Incept BioSystems, Inc., aprivately-held biomedical device company in Ann Arbor, Michigan. Mr. Osbornearned a law degree from the University of Virginia and a master’s degree ininternational public policy from The Johns Hopkins University.

Mr. Roche joined Cephalon in January 1995and has served as Executive Vice President, Worldwide Pharmaceutical Operationssince February 2005. From November 2000 to February 2005, Mr. Rochewas Senior Vice President, Pharmaceutical Operations. In June 1999, he wasappointed to Senior Vice President of Sales and Marketing, and prior to thatwas Vice President, Sales and Marketing. Previously, Mr. Roche served asDirector and Vice President, Worldwide Strategic Product Development, forSmithKline Beecham’s central nervous system and gastrointestinal productsbusiness, and held senior marketing and management positions with that companyin the Philippines, Canada and Spain. Mr. Roche serves as a member of theboard of directors of LifeCell Corporation, a publicly-tradedbiotechnology company. Mr. Roche graduated from Colgate University andreceived a master of business administration degree from The Wharton School,University of Pennsylvania.

Dr. Russell joined Cephalon in January 2000,and since November 2006, has served as Executive Vice President, WorldwideMedical and Regulatory Operations. Dr. Russell was Senior Vice President,Worldwide Medical and Regulatory Operations from August 2006 to October 2006,Senior Vice President of Worldwide Clinical Research from February 2005 toAugust 2006, and Vice President, Clinical Research prior to such time. FromJuly 1996 to January 2000, Dr. Russell was employed by USBioscience Inc./ MedImmune Oncology, most recently as Vice President ClinicalResearch. In that capacity, Dr. Russell was responsible for directing andimplementing the clinical programs in oncology and HIV research. Prior to this,Dr. Russell was a Clinical Research Physician at Eli Lilly UK where shefocused on oncology clinical programs. Before joining the pharmaceuticalindustry, Dr. Russell studied in Hematology/Oncology at Royal Infirmary ofEdinburgh, and Royal Hospital for Sick Children Edinburgh UK and was a ResearchFellow at University of Edinburgh Faculty of Medicine. Dr. Russellreceived MB.Ch.B. from****Universityof Edinburgh, Scotland, Faculty of Medicine and is a member of the Royal Collegeof Physicians, UK.

Mr. Savini joinedCephalon in June 1993, was appointed Senior Vice President in 1999, andhas served as Executive Vice President and Chief Administrative Officer since February 2006.Mr. Savini has served in various capacities with the Company, includingSenior Vice President, Administration and Senior Vice President, HumanResources. From 1983 to 1993, Mr. Savini was employed by Bristol-MyersSquibb Company and from 1981 to 1983 he was employed by Johnson &Johnson’s McNeil Pharmaceuticals. Mr. Savini graduated from ThePennsylvania State University and received a master of business administrationdegree from La Salle College.

Dr. Vaught joinedCephalon in August 1991, and since that time has been responsible fordirecting Cephalon’s research operations. He currently serves as Executive VicePresident and President, Research and Development. Prior to joining Cephalon, Dr. Vaughtwas employed by the R. W. Johnson Pharmaceutical Research Institute, asubsidiary of Johnson & Johnson. Dr. Vaught received a Ph.D. inpharmacology from the University of Minnesota.

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**PART II**

**ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATEDSTOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES**

Ourcommon stock is quoted on the NASDAQ Stock Market under the symbol “CEPH.” Thefollowing table sets forth the range of high and low sale prices for the commonstock as reported on the NASDAQ Stock Market for the periods indicated below.

| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2005**       |       |     |       |    |       |
| First Quarter  |       | $        | 52.24      |    | $          | 45.44 |   |
| Second Quarter |       | 47.54    |       | 37.35   |       |
| Third Quarter  |       | 48.75    |       | 38.24   |       |
| Fourth Quarter |       | 66.92    |       | 43.50   |       |
| **2006**       |       |     |       |    |       |
| First Quarter  |       | $        | 82.92      |    | $          | 59.55 |   |
| Second Quarter |       | 68.40    |       | 51.58   |       |
| Third Quarter  |       | 67.25    |       | 53.70   |       |
| Fourth Quarter |       | 78.38    |       | 61.42   |       |

 

As of February 15, 2007 there were 537 holders ofrecord of our common stock. On February 15, 2007, the last reported saleprice of our common stock as reported on the NASDAQ Stock Market was $75.22 pershare.

We have not paid anydividends on our common stock since our inception and do not anticipate payingany dividends on our common stock in the foreseeable future.

**Issuer Purchases of Equity Securities**

| **Period**                     | ** ** | ** ** | ** ** | **Total Number  of Shares of  Common Stock  Purchased(1)** | ** ** | **Average Price  Paid Per Share(2)** | ** ** | **Total Number of  Shares of Common  Stock Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Approximate  Dollar Value of  Common Stock  that May Yet Be  Purchased Under  the Plans or  Programs** | ** ** |
|--------------------------------|------------|------------|------------|--------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| October 1–31, 2006   |       |       | —     |                                                                           |       |                                                | $          | —                                                                                                                                                      |       |                                                                                                                                                  |       | — |   |   |   | — |   |   |
| November 1–30,  2006 |       |       | —     |                                                                           |       |                                                | —     |                                                                                                                                                        |       |                                                                                                                                                  | —     |   |   |   | — |   |   |
| December 1–31,  2006 |       |       | 54,791     |                                                                           |       |                                                | 72.72      |                                                                                                                                                        |       |                                                                                                                                                  | —     |   |   |   | — |   |   |
| December 1–31,  2006 |       |       | 1,823,847  |                                                                           |       |                                                | 71.02      |                                                                                                                                                        |       |                                                                                                                                                  | —     |   |   |   | — |   |   |
| Total                          |       |       | 1,878,638  |                                                                           |       |                                                | $          | 71.07                                                                                                                                                       |       |                                                                                                                                                  |       | — |   |   |   | — |   |   |

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(1)          This column reflects thefollowing transactions during the fourth quarter of 2006: (i) thesurrender to Cephalon of 54,791 shares of common stock to satisfy taxwithholding obligations in connection with the vesting of restricted stockunits issued to employees and (ii) the receipt of 1,823,847 sharesassociated with the exchange of $436.9 million aggregate principal of ourconvertible notes and concurrent termination of a portion of the convertiblenote hedge and warrant agreements. For a description of these notes, seeNote 10 to our Consolidated Financial Statements included in Part II,Item 8 of this Annual Report on Form 10-K.

(2)          Pricepaid per share is a weighted average based on the closing price of our commonstock on the various vesting dates.

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**SecuritiesAuthorized for Issuance Under Equity Compensation Plans**

The following table givesinformation about our common stock that may be issued upon the exercise ofstock options, warrants and rights under all of our existing equitycompensation plans as of December 31, 2006, including the 1987 StockOption Plan (which expired in 1997) (the “1987 Plan”), the 2004 EquityCompensation Plan (the “2004 Plan”) and the 2000 Equity Compensation Plan forEmployees and Key Advisors (the “2000 Plan”).

**EquityCompensation Plan Information**

| **Plan Category**                                     | ** ** | ** ** | ** ** | **(a)  Number of Securities to  be Issued Upon Exercise  of Outstanding Options,  Warrants and Rights(1)** | ** ** | **(b)  Weighted Average  Exercise Price of  Outstanding  Options, Warrants  and Rights(1)** | ** ** | **(c)  Number of Securities  Remaining Available for  Future Issuance (Excludes  Securities Reflected in  Column (a))(2)** | ** ** |
|------------------------------------------------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by stockholders        |       |       | 5,823,382  | (3)                                                                                                                                                          |       |                                                                                                                 | $          | 46.19                                                                                                                                                                   |       |   |   | 1,005,019 |   |   |
| Equity compensation  plans not approved by stockholders(4) |       |       | 2,549,088  |                                                                                                                                                         |       |                                                                                                                 | $          | 59.85                                                                                                                                                                   |       |   |   | 76,475 |   |   |
| Total                                                      |       |       | 8,372,470  |                                                                                                                                                         |       |                                                                                                                 | $          | 50.35                                                                                                                                                                   |       |   |   | 1,081,494 |   |   |

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(1)          The foregoing does notinclude stock options assumed under the Anesta Corp. 1993 Stock Option Plan(the “Anesta Plan”) as a result of our acquisition of Anesta Corp. in 2000. Asof December 31, 2006, there were 31,728 shares of common stock subject tooutstanding stock options under the Anesta Plan, with a weighted averageexercise price of these stock options of $27.07 per share. No additional sharesare reserved for issuance under the Anesta Plan.

(2)          The 2004 Plan permitsour Board of Directors or the Stock Option and Compensation Committee of ourBoard to award stock options to participants. Up to 286,209 of the securitiesremaining available for issuance under equity compensation plans approved bystockholders may be issued as restricted stock units. Restricted stock unitawards are not permitted to be made under the terms of the 2000 Plan.

(3)          Includes awards covering709,900 shares of unvested restricted stock units that are outstanding underthe 2004 Plan. Also includes 2,700 shares to be issued upon exercise ofoutstanding stock options granted under the 1987 Plan. There are no securitiesthat remain available for grant under the 1987 Plan.

(4)          Issuedunder the 2000 Plan, which does not require the approval of, and has not beenapproved by, Cephalon stockholders.

**2000 EquityCompensation Plan for Employees and Key Advisors**

On December 13, 2000, our Board of Directors adoptedthe 2000 Plan. The 2000 Plan has been amended several times since its adoption,with the most recent amendment to the 2000 Plan on July 25, 2002. The 2000Plan provides that stock options may be granted to our employees who are notofficers or directors of Cephalon and consultants and advisors who performservices for Cephalon. At the time of its initial approval, the 2000 Plan wasnot submitted to, nor was it required to be submitted to, our stockholders forapproval. Amendments to the 2000 Plan, including amendments increasing thenumber of shares of Common Stock reserved for issuance under the 2000 Plan,also did not require approval of the Company’s stockholders. In light ofchanges to the NASDAQ shareholder approval requirements for stock option plans,our Board of Directors has decided that it will not further increase the numberof shares 

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authorized for issuanceunder the 2000 Plan, but will continue to use any shares authorized forissuance under the 2000 Plan for future grants until the 2000 Plan expiresaccording to its terms in 2010.

The purpose of the 2000 Plan is to promote our successby linking the personal interests of our non-executive employees andconsultants and advisors to those of our stockholders and by providingparticipants with an incentive for outstanding performance. The 2000 Plancurrently authorizes the granting of “non-qualified stock options” (“NQSOs”)only. The 2000 Plan is administered and interpreted by the Stock Option andCompensation Committee of the Board of Directors. The Stock Option andCompensation Committee determines the individuals who will receive a NQSO grantunder the 2000 Plan, the number of shares of Common Stock subject to the NQSO,the period during which the NQSO becomes exercisable, the term of the NQSO (butnot to exceed 10 years from the date of grant) and the other terms andconditions of the NQSO consistent with the terms of the 2000 Plan. All of theNQSOs that are currently outstanding under the 2000 Plan become exercisableratably over a four-year period beginning on the date of grant and expire tenyears from the date of grant. The exercise price of a NQSO granted under the2000 Plan will be determined by the Stock Option and Compensation Committee,but may not be less than the fair market value of the underlying stock on thedate of grant. A grantee may exercise a NQSO granted under the 2000 Plan bydelivering notice of exercise to the Stock Option and Compensation Committeeand pay the exercise price (i) in cash, (ii) with approval of theStock Option and Compensation Committee, by delivering shares of common stockalready owned by the grantee and having a fair market value on the date ofexercise equal to the exercise price, or through attestation to ownership ofsuch shares, or (iii) through such other method as the Stock Option andCompensation Committee may approve. In the event of a “Corporate Transaction,”(e.g., a merger in which 50% or more of the common stock is transferred to athird party), all outstanding stock options will automatically accelerate andbecome immediately exercisable, subject to certain limitations.

The Board of Directors has the authority to amend orterminate the 2000 Plan at any time without stockholder approval. The 2000 Planwill terminate on December 12, 2010, unless it is terminated earlier orextended by the Board of Directors. No amendment or termination of the 2000Plan may adversely affect any stock option previously granted under the 2000Plan without the written consent of the participant, unless required byapplicable law.

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**ITEM 6.**                SELECTEDFINANCIAL DATA

Wecompleted the acquisitions of issued share capital of Zeneus Holdings Limitedon December 22, 2005, substantially all assets related to the TRISENOXinjection business from CTI and CTI Technologies, Inc., a wholly-ownedsubsidiary of CTI on July 18, 2005, outstanding capital stock of Salmedix, Inc.on June 14, 2005 and the outstanding shares of capital stock of CIMA LABSon August 12, 2004. These acquisitions have been accounted for either asbusiness combinations or asset purchases.

| ***(In thousands, except per share data)***         | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **Statement of operations data**                              | ** ** | ** **                                 | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Sales                                                                        |       | $                                          | 1,720,172  |   | $ | 1,156,518 |   | $ | 980,375 |   | $ | 685,250 |   | $ | 465,943 |   |
| Other revenues                                                               |       | 43,897                                     |       | 55,374 |   | 35,050 |   | 29,557 |   | 40,954 |   |
| Total revenues                                                               |       | 1,764,069                                  |       | 1,211,892 |   | 1,015,425 |   | 714,807 |   | 506,897 |   |
| Impairment charges                                                           |       | 12,417                                     |       | 20,820 |   | 30,071 |   | — |   | — |   |
| Acquired in-process research and development                                 |       | 5,000                                      |       | 366,815 |   | 185,700 |   | — |   | — |   |
| Debt exchange expense                                                        |       | 48,122                                     |       | — |   | 28,230 |   | — |   | — |   |
| Write-off of deferred debt issuance costs                                    |       | 13,105                                     |       | 27,109 |   | — |   | — |   | — |   |
| Income tax expense (benefit)                                                 |       | 93,438                                     |       | (70,164 | ) | 45,629 |   | 46,456 |   | (112,629 | ) |
| Income (loss) before cumulative effect of a change in  accounting principle  |       | $                                          | 144,816    |   | $ | (174,954 | ) | $ | (73,813 | ) | $ | 83,858 |   | $ | 175,062 |   |
| Cumulative effect of a change in accounting principle                        |       | —                                     |       | — |   | — |   | — |   | (3,534 | ) |
| Net income (loss)                                                            |       | $                                          | 144,816    |   | $ | (174,954 | ) | $ | (73,813 | ) | $ | 83,858 |   | $ | 171,528 |   |
| Basic income  (loss) per common share:                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Income (loss) before cumulative effect of a change in  accounting principle  |       | $                                          | 2.39       |   | $ | (3.01 | ) | $ | (1.31 | ) | $ | 1.49 |   | $ | 3.14 |   |
| Cumulative effect of a change in accounting principle                        |       | —                                     |       | — |   | — |   | — |   | (0.06 | ) |
|                                                                         |       | $                                          | 2.39       |   | $ | (3.01 | ) | $ | (1.31 | ) | $ | 1.49 |   | $ | 3.08 |   |
| Weighted average number of common shares outstanding                         |       | 60,507                                     |       | 58,051 |   | 56,489 |   | 55,560 |   | 55,104 |   |
| Diluted income  (loss) per common share:                                     |       |                                       |       |   |   |   |   |   |   |   |   |
| Income (loss) before cumulative effect of a change in  accounting principle  |       | $                                          | 2.08       |   | $ | (3.01 | ) | $ | (1.31 | ) | $ | 1.42 |   | $ | 2.82 |   |
| Cumulative effect of a change in accounting principle                        |       | —                                     |       | — |   | — |   | — |   | (0.05 | ) |
|                                                                         |       | $                                          | 2.08       |   | $ | (3.01 | ) | $ | (1.31 | ) | $ | 1.42 |   | $ | 2.77 |   |
| Weighted average  number of common shares outstanding—assuming dilution |       | 69,672                                     |       | 58,051 |   | 56,489 |   | 64,076 |   | 66,856 |   |
|                                                                              |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ***(In thousands)***                  | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| **Balance sheet data**           | ** ** | ** **            | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| Cash, cash equivalents and investments     |       | $                     | 521,724    |   | $ | 484,090 |   | $ | 791,676 |   | $ | 1,155,163 |   | $ | 582,688 |   |
| Total assets                               |       | 3,045,497             |       | 2,819,206 |   | 2,396,922 |   | 2,381,656 |   | 1,689,090 |   |
| Current portion of long-term debt          |       | 1,023,312             |       | 933,160 |   | 5,114 |   | 9,637 |   | 15,402 |   |
| Long-term debt (excluding current portion) |       | 224,992               |       | 763,097 |   | 1,284,410 |   | 1,409,417 |   | 860,897 |   |
| Accumulated deficit                        |       | (425,256              | )          | (570,072 | ) | (395,118 | ) | (321,305 | ) | (405,163 | ) |
| Stockholders’  equity                 |       | 1,309,460             |       | 612,171 |   | 830,044 |   | 770,370 |   | 642,585 |   |
|                                            |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM 7.   MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

*Management’s Discussion and Analysis of FinancialCondition and Results of Operations (“MD&A”) is intended to provideinformation to assist you in better understanding and evaluating our financialcondition and results of operations. We encourage you to read this MD&A inconjunction with our consolidated financial statements included in Part II,Item 8 of this Annual Report on Form 10-K.*

**EXECUTIVE SUMMARY**

Cephalon is an international biopharmaceutical companydedicated to the discovery, development and marketing of innovative products totreat human diseases. We currently focus our efforts in four core therapeuticareas: central nervous system (“CNS”) disorders, pain, cancer and addiction. Inaddition to conducting an active research and development program, we marketsix products in the United States and numerous products in various countriesthroughout Europe. Consistent with our core therapeutic areas, we have alignedour 829-person U.S. field sales and sales management teams by area. InEurope, we have a sales and marketing organization numbering approximately 412persons that supports our presence in nearly 20 European countries, includingFrance, the United Kingdom, Germany, Italy and Spain.

Our most significant product is PROVIGIL, whichcomprised approximately 43% of our total consolidated net sales for the yearended December 31, 2006, of which approximately 94% was in the U.S. market.For the year ended December 31, 2006, consolidated net sales of PROVIGILincreased 43% over the year ended December 31, 2005. Under ourco-promotion agreement with Takeda Pharmaceuticals North America, Inc.,500 Takeda sales representatives began promoting PROVIGIL in the secondposition to primary care physicians and other appropriate health careprofessionals in the United States beginning July 1, 2006. Effective January 1,2007, an additional 250 Takeda sales representatives were added, all of whomare detailing PROVIGIL in the first position. Together with our CNS field salesand sales management teams, we now have nearly 1,200 persons focused ondetailing PROVIGIL in the United States.

Our second most significant product in 2006 was ACTIQ,which comprised approximately 34% of our total consolidated net sales for theyear ended December 31, 2006, of which approximately 95% was in the U.S.market. In late September 2006, Barr Laboratories, Inc. entered theU.S. market with generic version of ACTIQ (“generic OTFC”) pursuant to ourlicense and supply agreement. As a result, ACTIQ sales have been meaningfullyeroded by generic OTFC products sold by Barr and by us through our sales agent,Watson Pharmaceuticals, Inc., and we expect this erosion will continueduring 2007. In addition, under our license and supply agreement with Barr, weare obligated to sell generic OTFC to Barr for its resale in the United States.While we currently have available fentanyl quota to produce ACTIQ and genericOTFC, in the future we could face shortages of quota that could negativelyimpact our ability to supply product to Barr or to produce ACTIQ or our genericOTFC product. If we are unable to provide product to Barr, it is possible thateither Barr or the FTC could claim that this failure is a breach of ouragreements with these parties.

During 2006, two of our products were approved by the FDA. In late September 2006, wereceived FDA approval of our next-generation proprietary pain product, FENTORA,and launched the product in the United States in early October. FENTORA isindicated for the management of breakthrough pain in patients with cancer whoare already receiving and are tolerant to opioid therapy for their underlyingpersistent cancer pain. We are focusing our longer-term clinical strategy ondeveloping FENTORA for patients with breakthrough pain associated with otherconditions, including neuropathic pain and back pain. In October 2006 and January 2007,we announced that data from Phase 3 clinical trials of FENTORA demonstratedefficacy in the management of breakthrough pain in opioid-tolerant patientswith chronic low back pain and chronic neuropathic pain, respectively. Pendingpositive data from an 

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ongoing study in patientswith non-cancer breakthrough pain, our goal is to submit a sNDA to the FDA inlate 2007. This sNDA would seek to expand the labeled indications for FENTORAbeyond breakthrough pain in patients with cancer.

In April 2006, the FDA approved VIVITROL, and welaunched the product in June. VIVITROL is indicated for the treatment ofalcohol dependent patients who are able to abstain from alcohol in anoutpatient setting and are not actively drinking when initiating treatment.Treatment with VIVITROL should be used in combination with psychosocialsupport, such as counseling or group therapy. Under the license andcollaboration agreement we signed with Alkermes, Inc. in June 2005,Alkermes is responsible for manufacturing commercial supplies of VIVITROL andwe have primary responsibility for the marketing and sale of the product.

We also made progress in 2006 toward the approval ofNUVIGIL with an anticipated indication for excessive sleepiness. NUVIGIL is asingle-isomer version of modafinil, the active ingredient in PROVIGIL. In May 2006,we received an approvable letter from the FDA; we currently expect a finalapproval decision from the FDA on or before March 31, 2007. The FDA iscontinuing to evaluate the single case of serious rash reported in a SPARLONclinical study. We have provided additional information to the FDA to help theagency place this isolated case in the context of the safety profile formodafinil that has been established over more than a decade of commercial use.The reviewing division has not requested any additional information related toNUVIGIL and is working with us to finalize the product’s label. Since NUVIGILis derived from the active ingredient in PROVIGIL, we expect that the safetyinformation in the PROVIGIL label will be appropriately modified to reflect thesafety information in the final NUVIGIL label. NUVIGIL is protected by acomposition of matter patent that will expire on December 18, 2023 andcovers a novel polymorphic form of armodafinil, the active pharmaceuticalingredient in NUVIGIL.

In March 2006, we announced that the FDA’s PsychopharmacologicDrugs Advisory Committee voted not to recommend approval of SPARLON for thetreatment of attention deficit/hyperactivity disorder (“ADHD”) in children andadolescents. This recommendation was the result of concerns expressed by theadvisory committee regarding a possible case of Stevens-Johnson syndrome (“SJS”),a rare but serious skin rash condition, in a child who participated in one ofthe Phase 3 clinical trials. In August 2006, we announced that the FDA hadissued a letter indicating that the SPARLON sNDA was “not approvable.’’ Inlight of the FDA’s decision, we currently are not pursuing development ofSPARLON.

As a biopharmaceutical company, our future success ishighly dependent on obtaining and maintaining patent protection for ourproducts and technology. We intend to vigorously defend the validity, andprevent infringement, of our patents. The loss of patent protection on any ofour existing products, whether by third-party challenge, invalidation,circumvention, license or patent expiration, could materially impact ourresults of operations. In late 2005 and early 2006, we entered into settlementagreements with each of Teva Pharmaceuticals USA, Inc., MylanPharmaceuticals Inc., Ranbaxy Laboratories Limited and Barr Laboratories, Inc.As part of these separate settlements, we agreed to grant to each of theseparties a non-exclusive royalty-bearing right to market and sell a genericversion of PROVIGIL in the United States. These licenses generally will becomeeffective in April 2012. For more information concerning thesesettlements, please see Central Nervous Systems Disorders—Modafinil Productsand Product Candidates—Intellectual Property Position” in Part I, Item 1of this Annual Report on Form 10-K.

In connection with the Barr, Ranbaxy and Tevasettlements, we also entered into a series of business arrangements related tomodafinil with Barr, Ranbaxy and Teva. We received licenses to certainmodafinil-related intellectual property developed by each party and in exchangefor these licenses, we agreed to make payments to these three companiescollectively totaling up to $136.0 million, consisting of upfront payments,milestones and royalties on net sales of our modafinil products. In order tomaintain an 

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adequate supply of theactive drug substance modafinil, we entered into agreements with threemodafinil suppliers whereby we will purchase an annual minimum amount ofmodafinil over a six year period beginning in 2006, with the aggregate paymentsover that period totaling approximately $82.6 million.

Our activities and operations are subject tosignificant government regulations and oversight. In September 2004, weannounced that we had received subpoenas from the U.S. Attorney’s Office inPhiladelphia. That same month, we received a voluntary request for informationfrom the Office of the Connecticut Attorney General. Both the subpoenas and thevoluntary request for information appear to be focused on our sales andpromotional practices with respect to ACTIQ, GABITRIL and PROVIGIL, includingthe extent of off-label prescribing of our products by physicians. We arecooperating with the U.S. Attorney’s Office and the Office of the ConnecticutAttorney General, are providing documents and other information to both officesin response to these and additional requests and are engaged in ongoingdiscussions with both parties. These matters may involve the bringing ofcriminal charges and fines, and/or civil penalties. We cannot predict ordetermine the outcome of these matters or reasonably estimate the amount orrange of amounts of any fines or penalties that might result from a settlementor an adverse outcome. However, a settlement or an adverse outcome could have amaterial adverse effect on our financial position, liquidity and results ofoperations.

We have significant levels of indebtednessoutstanding, nearly all of which consists of convertible notes. Under the termsof the indentures governing the notes, we are obligated to repay in cash theaggregate principal balance of any such notes presented for conversion. For amore complete description of these notes, see Note 10 to our ConsolidatedFinancial Statements included in Part II, Item 8 of this AnnualReport on Form 10-K. We do not have available cash, cash equivalentsand investments sufficient to repay all of the convertible notes, if presented.In addition, there are no restrictions on our use of this cash, and the cashavailable to repay indebtedness may decline over time.

As of December 31, 2006, the fair value of boththe 2.0% Notes and the Zero Coupon Notes is greater than the value of theshares into which such notes are convertible. We believe that the share priceof our common stock would have to significantly increase over the market priceas of the filing date of this report before the fair value of the convertiblenotes would be less than the value of the common stock shares underlying thenotes. As such, we believe it is highly unlikely that holders of the 2.0% Notesor Zero Coupon Notes will present significant amounts of such notes forconversion under the current terms. In the unlikely event that a significantconversion did occur, we believe that we have the ability to raise sufficientcash to repay the principal amounts due through a combination of utilizing our existingcash on hand, raising money in the capital markets or selling our note hedgeinstruments for cash. Because the financing markets may be unwilling to providefunding to us or may only be willing to provide funding on terms that we wouldconsider unacceptable, we may not have cash available or be able to obtainfunding to permit us to meet our repayment obligations, thus adverselyaffecting the market price for our securities.

While we seek to increaseprofitability and cash flow from operations, we will need to continue toachieve growth of product sales and other revenues sufficient for us to attainthese objectives. The rate of our future growth will depend, in part, upon ourability to obtain and maintain adequate intellectual property protection forour currently marketed products, and to successfully develop or acquire andcommercialize new product candidates.

**RECENT ACQUISITIONSAND TRANSACTIONS**

*For additional information related to each of thefollowing acquisitions and transactions, please see Note 2 to the ConsolidatedFinancial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.*

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**Co-PromotionAgreement with Takeda**

On June 12, 2006, weentered into a co-promotion agreement with Takeda with respect to PROVIGIL inthe United States. We also have an option to utilize the Takeda sales force forthe promotion of NUVIGIL, assuming FDA approval of this product candidate. Theco-promotion agreement has a three-year term. If we undergo a change of controlduring the three-year term, we have the option to terminate the co-promotionagreement, subject to our obligation to make certain specified payments toTakeda. We will pay Takeda a royalty based on certain sales criteria forPROVIGIL and NUVIGIL during the three-year term and, if specified sales levelsare reached, during the three calendar years following the expiration of theco-promotion agreement.

**Zeneus HoldingsLimited Acquisition**

On December 22, 2005,we completed our acquisition of all of the issued share capital of Zeneus HoldingsLimited. Total consideration paid in connection with the acquisition wasapproximately $365.8 million, net of cash acquired.

**TRISENOXAcquisition**

On July 18, 2005, wecompleted our acquisition of substantially all assets related to TRISENOX fromCell Therapeutics, Inc. and CTI Technologies, Inc., a wholly-ownedsubsidiary of CTI. The results of operations of TRISENOX have been included inthe consolidated statements of operations since the acquisition date.

**VIVITROL Licenseand Collaboration**

In June 2005, we entered into a license andcollaboration agreement with Alkermes to develop and commercialize VIVITROL inthe United States. Concurrent with the execution of this agreement, we enteredinto a supply agreement under which Alkermes provides to us finished commercialsupplies of VIVITROL. We made an initial payment of $160 million toAlkermes upon execution of this agreement. In April 2006, we made anadditional payment of $110 million to Alkermes following FDA approval ofthe product. Alkermes also could receive up to an additional $220 millionin milestone payments that are contingent on attainment of certain agreed-uponsales levels of VIVITROL. Until December 31, 2007, Alkermes is responsiblefor any cumulative losses up to $120 million, and we are responsible forany cumulative losses in excess of $120 million. Pre-tax profit, asadjusted for certain items, and losses incurred after December 31, 2007will be split equally between the parties. We began recognizing revenue forVIVITROL effective in the third quarter of 2006.

In October 2006, weamended the existing license and collaboration agreement with Alkermes toprovide that we would be responsible for our own VIVITROL-related costs duringthe period August 1, 2006 through December 31, 2006 and, for thatperiod, such costs will not be chargeable to the collaboration and against the$120 million cumulative loss cap. The parties also agreed to amend the existingsupply agreement to provide that we will purchase from Alkermes two VIVITROLmanufacturing lines (and related equipment). At December 31, 2006, weincurred approximately $25.4 million related to the construction of these twomanufacturing lines. We expect to incur up to an additional $45.6 million forcertain future capital improvements related to these two manufacturing lines. Wealso have granted Alkermes an option, exercisable after two years, to purchasethese manufacturing lines at the then-current net book value of the assets.

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**Salmedix, Inc.Acquisition**

On June 14, 2005, wecompleted our acquisition of Salmedix, Inc. As a result of theacquisition, we obtained the rights to market TREANDAÔ(bendamustine hydrochloride). The results of operations for Salmedix have beenincluded in our consolidated financial statements as of the acquisition date.

**RESULTS OF OPERATIONS***(In thousands)*

**Year ended December 31, 2006 compared to yearended December 31, 2005:**

| ** **     | ** ** | **Year Ended December 31,** | ** ** | ** ** | ** ** | ** **                          | ** ** | ** **         | ** ** |
|----------------|------------|--------------------------------------------|------------|------------|------------|-------------------------------------|------------|--------------------|------------|
| ** **     | ** ** | **2006**                                   | ** ** | **2005**   | ** ** | **% Increase (Decrease)** | ** ** |
| ** **     | ** ** | **United  States**                         | ** ** | **Europe** | ** ** | **Total**                           | ** ** | **United  States** | ** ** | **Europe** | ** ** | **Total** | ** ** | **United  States** | ** ** | **Europe** | ** ** | **Total** | ** ** |
| Sales:         |       |                                       |       |       |       |                                |       |               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| PROVIGIL       |       | $                                          | 691,779    |       | $          | 43,052                              |       | $                  | 734,831    |   | $ | 475,557 |   | $ | 37,248 |   | $ | 512,805 |   |   | 45 | % |   |   | 16 | % |   |   | 43 | % |   |
| GABITRIL       |       | 54,971                                     |       | 4,316      |       | 59,287                              |       | 66,517             |       | 5,741 |   | 72,258 |   |   | (17 | )% |   |   | (25 | )% |   |   | (18 | )% |   |
| CNS            |       | 746,750                                    |       | 47,368     |       | 794,118                             |       | 542,074            |       | 42,989 |   | 585,063 |   |   | 38 | % |   |   | 10 | % |   |   | 36 | % |   |
| ACTIQ          |       | 550,390                                    |       | 27,252     |       | 577,642                             |       | 394,676            |       | 17,102 |   | 411,778 |   |   | 39 | % |   |   | 59 | % |   |   | 40 | % |   |
| Generic OTFC   |       | 54,801                                     |       | —     |       | 54,801                              |       | —             |       | — |   | — |   |   | 100 | % |   |   | — | % |   |   | 100 | % |   |
| FENTORA        |       | 29,250                                     |       | —     |       | 29,250                              |       | —             |       | — |   | — |   |   | 100 | % |   |   | — | % |   |   | 100 | % |   |
| Pain           |       | 634,441                                    |       | 27,252     |       | 661,693                             |       | 394,676            |       | 17,102 |   | 411,778 |   |   | 61 | % |   |   | 59 | % |   |   | 61 | % |   |
| Other          |       | 56,084                                     |       | 208,277    |       | 264,361                             |       | 49,695             |       | 109,982 |   | 159,677 |   |   | 13 | % |   |   | 89 | % |   |   | 66 | % |   |
| Total Sales    |       | 1,437,275                                  |       | 282,897    |       | 1,720,172                           |       | 986,445            |       | 170,073 |   | 1,156,518 |   |   | 46 | % |   |   | 66 | % |   |   | 49 | % |   |
| Other Revenues |       | 35,399                                     |       | 8,498      |       | 43,897                              |       | 47,587             |       | 7,787 |   | 55,374 |   |   | (26 | )% |   |   | 9 | % |   |   | (21 | )% |   |
| Total Revenues |       | $                                          | 1,472,674  |       | $          | 291,395                             |       | $                  | 1,764,069  |   | $ | 1,034,032 |   | $ | 177,860 |   | $ | 1,211,892 |   |   | 42 | % |   |   | 64 | % |   |   | 46 | % |   |

 

*Sales—**In*the United States,we sell our products to pharmaceutical wholesalers, the largest three of whichaccounted for 71% of our total consolidated gross sales for the year ended December 31,2006. Decisions made by these wholesalers regarding the levels of inventorythey hold (and thus the amount of product they purchase from us) can materiallyaffect the level of our sales in any particular period and thus may notnecessarily correlate to the number of prescriptions written for our productsas reported by IMS Health Incorporated.

In 2005, we finalized distribution service agreementswith our major wholesaler customers. These agreements obligate the wholesalersto provide us with periodic retail demand information and current inventorylevels for our products held at their warehouse locations; additionally, thewholesalers have agreed to manage the variability of their purchases andinventory levels within specified limits based on product demand.

As of December 31, 2006, we received informationfrom substantially all of our U.S. wholesaler customers about the levels ofinventory they held for our U.S. branded products. Based on this information,which we have not independently verified, we believe that total inventory heldat these wholesalers is approximately two weeks supply of our U.S. brandedproducts at our current sales levels. During the fourth quarter of 2006, weshipped launch quantities of our generic OTFC. At December 31, 2006, webelieve that generic OTFC inventory held at wholesalers and retailers isapproximately two to three months.

Sales of our generic OTFC product to wholesalers andretailers include both the right of return of expired product and retroactiveprice reductions under certain conditions, while sales of FENTORA also includethe right of return of expired product. Based on the sales levels and theprescription data during the fourth quarter of 2006, and based on the number ofunits on hand in the pipeline at December 31, 2006 relative to the overalldemand for the products, we have estimated and recorded all applicable product 

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sales allowances relatedto generic OTFC and FENTORA as of December 31, 2006. We have thereforerecognized revenues for generic OTFC and FENTORA based on a fixed anddeterminable sales price in 2006.

For the year ended December 31,2006, sales were impacted by changes in the product sales allowances deductedfrom gross sales as described further below and by changes in the relativelevels of the number of units of inventory held at wholesalers and retailers.For the year ended December 31, 2006, total sales increased by 49% overthe prior year. The other key factors that contributed to the increase in salesare summarized by product as follows:

·       InCNS, sales of PROVIGIL increased 43 percent. Demand for PROVIGIL increased asevidenced by an increase in U.S. prescriptions for PROVIGIL of 18%, accordingto IMS Health. For the year ended December 31, 2006, sales of PROVIGILalso were impacted by domestic price increases of approximately 12% from periodto period.

·       InPain, sales increased 61 percent. Sales of ACTIQ were impacted by an increasein domestic prices of approximately 68% from period to period, offset slightlyby a decline in demand for ACTIQ as evidenced by a 17% decrease in U.S.prescriptions, according to IMS Health. For the year ended December 31,2006, we recognized $54.8 million of revenue related to shipments of ourgeneric OTFC to Barr and sales of our own generic OTFC and $29.3 million ofrevenue related to sales of FENTORA. In 2007, we expect overall sales of ourPain products to decrease based on a shift in market share from ACTIQ togeneric OTFC and the potential for further generic entrants into the market,partially offset by the anticipated growth in FENTORA.

·       Othersales, which consist primarily of sales of other products and certain thirdparty products, increased 66 percent. This increase is attributable to sales ofproducts acquired in the TRISENOX® and Zeneus acquisitions in July 2005and December 2005, respectively.

*OtherRevenues—**The*decrease of 21% from period toperiod is primarily due to a decrease in partner reimbursements on our CEP-1347program, which was halted in 2006, and a decrease in revenues from clinicalstudies performed for collaborators.

*Analysisof gross sales to net sales—*The following tablepresents the product sales allowances deducted from gross sales to arrive at anet sales figure:

| ** **                                               | ** ** | **Year Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                               | ** ** | **2006**                                   | ** ** | **2005**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Gross sales:                                             |       | $                                          | 1,890,836  |       | $          | 1,335,602  |       | $ | 555,234 |   |   | 42 | % |   |
| Product sales  allowances:                               |       |                                       |       |       |       |       |       |   |   |   |   |
| Prompt payment discounts                                 |       | 32,384                                     |       | 22,284     |       | 10,100     |       |   | 45 | % |   |
| Wholesaler discounts                                     |       | 2,939                                      |       | 24,373     |       | (21,434    | )          |   | (88 | )% |   |
| Returns                                                  |       | 24,735                                     |       | 15,853     |       | 8,882      |       |   | 56 | % |   |
| Coupons                                                  |       | 26,853                                     |       | 23,313     |       | 3,540      |       |   | 15 | % |   |
| Medicaid discounts                                       |       | 45,267                                     |       | 67,245     |       | (21,978    | )          |   | (33 | )% |   |
| Medicare Part D discounts                           |       | 2,217                                      |       | —     |       | 2,217      |       |   | 100 | % |   |
| Managed care and governmental contracts                  |       | 36,269                                     |       | 26,016     |       | 10,253     |       |   | 39 | % |   |
|                                                     |       | 170,664                                    |       | 179,084    |       | (8,420     | )          |   |   |   |   |
| Net sales                                                |       | $                                          | 1,720,172  |       | $          | 1,156,518  |       | $ | 563,654 |   |   | 49 | % |   |
| Product sales allowances  as a percentage of gross sales |       | 9.0                                        | %          | 13.4       | %          |       |       |   |   |   |   |

 

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Prompt payment discounts and returns allowancesincreased for the year ended December 31, 2006 as compared to the yearended December 31, 2005 due to the increase in sales. Wholesaler discountsdecreased due to the fact that fewer incremental wholesaler discounts wererequired for the year ended December 31, 2006 as a result of 2006 priceincreases. Decreases in product sales allowances were also caused by lowerMedicaid discounts resulting from a significant number of participantstransferring to the new Part D of the Medicare Prescription DrugImprovement and Modernization Act of 2003 (“Medicare Part D”) programeffective January 1, 2006. Managed care and governmental contractsincreased for the year ended December 31, 2006 as compared to the yearended December 31, 2005 due to additional rebates for certain managed careand governmental programs, offset by a reduction of $13.3 million recognized inthe third quarter of 2006, representing amounts paid to the U.S. Department ofDefense (“DoD”) under the Tricare program from October 2004 throughJune 30, 2006. In October 2006, the DoD announced that it wouldreimburse all companies that had voluntarily made such payments under theTricare program due to the U.S. Court of Appeals September 2006 ruling. Inthe future, we expect product sales allowances as a percentage of gross salesto trend upward due to the impact of potential future price increases onMedicaid discounts and potential increases related to Medicaid, MedicarePart D, managed care and governmental contracts sales.

Wealso recorded discounts for Medicare Part D for the year endedDecember 31, 2006 of $2.2 million. This reserve was established based onthe number of Medicare Part D contracts that we have signed and anestimate of the amounts expected to be incurred under each contract based onexpected enrollment and usage. These estimates are based on preliminary dataand may change significantly in the future based on actual experience.

| ** **                                    | ** ** | **Year Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                    | ** ** | **2006**                                   | ** ** | **2005**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Costs and expenses:                           |       |                                       |       |       |       |       |       |   |   |
| Cost of sales                                 |       | $                                          | 257,061    |       | $          | 164,223    |       | $ | 92,838 |   |   | 57 | % |   |
| Research and  development                     |       | 403,367                                    |       | 354,826    |       | 48,541     |       |   | 14 | % |   |
| Selling, general  and administrative          |       | 675,576                                    |       | 443,861    |       | 231,715    |       |   | 52 | % |   |
| Depreciation and  amortization                |       | 116,511                                    |       | 84,305     |       | 32,206     |       |   | 38 | % |   |
| Impairment charge                             |       | 12,417                                     |       | 20,820     |       | (8,403     | )          |   | (40 | )% |   |
| Acquired  in-process research and development |       | 5,000                                      |       | 366,815    |       | (361,815   | )          |   | (99 | )% |   |
|                                          |       | $                                          | 1,469,932  |       | $          | 1,434,850  |       | $ | 35,082 |   |   | 2 | % |   |

 

*Costof Sales—**The*cost of sales was 14.9% of netsales for the year ended December 31, 2006 and 14.2% of net sales for theyear ended December 31, 2005. The increase is primarily due to an$8.6 million inventory reserve related to SPARLON recorded in the secondquarter of 2006 (see Note 6 of the Consolidated Financial Statementsincluded in Part II, Item 8 of this Annual Report on Form 10-K),a $8.9 million inventory reserve related to NUVIGIL recorded throughout 2006 asa result of FDA postponement of their final approval decision until 2007, theinclusion of Zeneus’ product sales for the year ended December 31, 2006for which the margins are lower than the average margin of our other products,as well as additional royalty expenses for the year ended December 31,2006 for PROVIGIL. These increases were partially offset by the net effect ofprice increases and lower product sales allowances on our three major U.S.products.

*Researchand Development Expenses—**Research*anddevelopment expenses increased $48.5 million, or 14%, for the year ended December 31,2006 as compared to the year ended December 31, 2005. This increase isprimarily attributable to $80.5 million of payments for four research anddevelopment collaborations and the recognition of $15.3 million of stock-basedcompensation expense (representing one-half of the total stock-basedcompensation expense recorded during the year ended December 31, 

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2006 based on theemployees’ compensation allocation) as a result of the adoption of FinancialAccounting Standards Board (“FASB”) Statement No. 123(R), “Share BasedPayment” (“SFAS 123(R)”), partially offset by lower expenses associated withreduced levels of clinical activity in 2006.

*Selling,General and Administrative Expenses—**Selling,***general and administrative expenses increased $231.7million, or 52%, for the year ended December 31,2006as compared to the year ended December 31,2005. Approximately $138.6 million of the increase was due to higher selling and marketing costs in the United Statesresulting from the expansion of our sales force, increased promotional spendingon PROVIGIL, VIVITROL and FENTORA and expenses under our agreements with Takedaand Watson. The increase was also due to the inclusion of Zeneus selling,general and administrative expenses (approximately $51.5 million) for the year ended December 31, 2006. In addition, we recognized $15.3 million of stock-based compensation expense (representingone-half of the total stock-based compensation expense recorded duringthe year ended December 31, 2006 basedon the employees’ compensation allocation) as a result of the adoption of SFAS123(R).

*Depreciationand Amortization Expenses—**Depreciation***and amortization expenses increased $32.2 million, or 38%,for the year ended December 31, 2006, primarily as a result of additionalamortization expense resulting from intangible assets acquired during the lastquarter of 2005 and during 2006, and the inclusion of Zeneus depreciation andamortization expenses (approximately $14.8 million) for the year ended December 31,2006.

*Impairmentcharges—**In*June 2006, we announcedthat data from our Phase 3 clinical program evaluating GABITRIL for thetreatment of generalized anxiety disorder (“GAD”) did not reach statisticalsignificance on the primary study endpoints. We have no plans to continue furtherstudy of GABITRIL for the treatment of GAD. As a result, we performed a test ofimpairment on the carrying value of our investment in GABITRIL product rightsand recorded an impairment charge of $12.4 million in the second quarter of2006 related to our European rights. Forthe year ended December 31, 2005, werecorded an impairment charge of $20.8 million for the write-off of anintangible asset resulting from the termination of a distribution agreement inthe United Kingdom.

*Acquired in-process researchand development—**For***theyear ended December 31, 2005, we recorded acquired in-process research anddevelopment expense of $71.2 million for Zeneus, $130.1 million forSalmedix and $160.0 million for VIVITROL.

| ** **                                | ** ** | **Year Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                | ** ** | **2006**                                   | ** ** | **2005**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Other income (expense):                   |       |                                       |       |       |       |       |       |   |   |   |   |
| Interest income                           |       | $                                          | 25,438     |       | $          | 26,171     |       | $ | (733 | ) |   | (3 | )% |   |
| Interest expense                          |       | (18,922                                    | )          | (25,235    | )          | 6,313      |       |   | 25 | % |   |
| Debt exchange expense                     |       | (48,122                                    | )          | —     |       | (48,122    | )          |   | (100 | )% |   |
| Write-off of deferred debt issuance costs |       | (13,105                                    | )          | (27,109    | )          | 14,004     |       |   | 52 | % |   |
| Gain on early extinguishment of debt      |       | —                                     |       | 2,085      |       | (2,085     | )          |   | (100 | )% |   |
| Other income (expense), net               |       | (1,172                                     | )          | 1,928      |       | (3,100     | )          |   | (161 | )% |   |
|                                      |       | $                                          | (55,883    | )          | $          | (22,160    | )          | $ | (33,723 | ) |   | (152 | )% |   |

 

*Other Income (Expense)—**Other*income(expense), net decreased $33.7 million, or 152%, for the year ended December 31,2006 as compared to the year ended December 31,2005. The decrease was attributable to thefollowing factors:

·       adecrease in interest income for the year ended December 31, 2006 due tolower average investment balances, partially offset by higher investmentreturns.

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·       Adecrease in interest expense for the year ended December 31, 2006 dueprimarily to the repurchase of substantially all of our 2.5% convertible subordinatednotes in July 2005 and to the write-off of deferred debt issuance costsrelated to our 2.0% Notes in December 2005 and our Zero Coupon Notes in January 2006.This decrease was partially offset by a full year of interest expense on our2.0% Notes, which were issued in June 2005.

·       A$48.1 million charge resulting from the exchange of $336.9 million of ZeroCoupon Notes and $100.0 million of 2.0% Notes in December 2006.

·       A$13.1 million write-off in 2006 of deferred debt issuance costs related to ourZero Coupon Notes, as compared to a $27.1 million write-off in 2005 of deferreddebt issuance costs related to our 2.0% Notes.

·       A$2.1 million net gain on early extinguishment of debt in 2005 related to the2.5% convertible subordinated notes.

·       A $3.1 million decrease inother income (expense), net primarily due to fluctuations in foreign currencygains and losses in the comparable periods.

| ** **                    | ** ** | **Year Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|------------|------------|------------|------------|
| ** **                    | ** ** | **2006**                                   | ** ** | **2005**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Income tax  expense (benefit) |       | $                                          | 93,438     |       | $          | (70,164    | )          | $ | 163,602 |   |   | 233 | % |   |
|                               |            |                                            |            |            |            |            |            |  |  |  |  |  |  |  |

 

*Income Taxes—**For*the year ended December 31,2006, we recognized $93.4 million of income tax expense on income before incometaxes of $238.3 million, resulting in an overall effective tax rate of 39.2percent. This compared to income tax benefit for the year ended December 31,2005 of $70.2 million on loss before income taxes of $245.1 million, resultingin an effective tax rate of (28.6) percent. The2006 effective tax rate was impacted by an increase in the valuation allowance.The 2005 effective tax rate was impacted by non-deductible acquired in-processresearch and development charges related to the Salmedix and Zeneusacquisitions for which no tax benefit was recorded, offset by a decrease in thevaluation allowance. See Note 14 to our Consolidated Financial Statementsincluded in Part II, Item 8 of this Annual Report on Form 10-Kfor a reconciliation of the United States Federal statutory rate to oureffective tax rate.

**Year ended December 31, 2005 compared to yearended December 31, 2004:**
|                | ** ** | **Year Ended December 31,** | ** ** | ** ** | ** ** | ** **                          | ** ** | ** **         | ** ** |
|----------------|------------|--------------------------------------------|------------|------------|------------|-------------------------------------|------------|--------------------|------------|
| ** **     | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **% Increase (Decrease)** | ** ** |
| ** **     | ** ** | **United  States**                         | ** ** | **Europe** | ** ** | **Total**                           | ** ** | **United  States** | ** ** | **Europe** | ** ** | **Total** | ** ** | **United  States** | ** ** | **Europe** | ** ** | **Total** | ** ** |
| Sales:         |       |                                       |       |       |       |                                |       |               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| PROVIGIL       |       | $                                          | 475,557    |       | $          | 37,248                              |       | $                  | 512,805    |   | $ | 406,238 |   | $ | 33,429 |   | $ | 439,667 |   |   | 17 | % |   |   | 11 | % |   |   | 17 | % |   |
| GABITRIL       |       | 66,517                                     |       | 5,741      |       | 72,258                              |       | 87,349             |       | 6,815 |   | 94,164 |   |   | (24 | )% |   |   | (16 | )% |   |   | (23 | )% |   |
| CNS            |       | 542,074                                    |       | 42,989     |       | 585,063                             |       | 493,587            |       | 40,244 |   | 533,831 |   |   | 10 | % |   |   | 7 | % |   |   | 10 | % |   |
| Pain           |       | 394,676                                    |       | 17,102     |       | 411,778                             |       | 337,072            |       | 7,925 |   | 344,997 |   |   | 17 | % |   |   | 116 | % |   |   | 19 | % |   |
| Other          |       | 49,695                                     |       | 109,982    |       | 159,677                             |       | 13,270             |       | 88,277 |   | 101,547 |   |   | 274 | % |   |   | 25 | % |   |   | 57 | % |   |
| Total Sales    |       | 986,445                                    |       | 170,073    |       | 1,156,518                           |       | 843,929            |       | 136,446 |   | 980,375 |   |   | 17 | % |   |   | 25 | % |   |   | 18 | % |   |
| Other Revenues |       | 47,587                                     |       | 7,787      |       | 55,374                              |       | 28,749             |       | 6,301 |   | 35,050 |   |   | 66 | % |   |   | 24 | % |   |   | 58 | % |   |
| Total Revenues |       | $                                          | 1,034,032  |       | $          | 177,860                             |       | $                  | 1,211,892  |   | $ | 872,678 |   | $ | 142,747 |   | $ | 1,015,425 |   |   | 18 | % |   |   | 25 | % |   |   | 19 | % |   |

p

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*Sales—**In*the United States,we sell our products to pharmaceutical wholesalers, the largest three of whichaccounted for 75% of our total consolidated gross sales for the year ended December 31,2005. Decisions made by these wholesalers regarding the levels of inventorythey hold (and thus the amount of product they purchase from us) can materiallyaffect the level of our sales in any particular period and thus may notnecessarily correlate to the number of prescriptions written for our productsas reported by IMS Health. We believe that speculative buying of product,particularly in anticipation of possible price increases, has been the historicpractice of many pharmaceutical wholesalers. In past years, we attempted tominimize these fluctuations both by providing, from time to time, discounts toour customers to stock normal amounts of inventory (which we had historicallydefined as approximately one month’s supply at our current sales level) and bycanceling orders if we believe a particular customer is speculatively buyinginventory in anticipation of possible price increases.

In 2004 and 2005, our wholesaler customers, as well asothers in the industry, began modifying their business models from arrangementswhere they derive profits from the management of various discounts and rebates,to arrangements where they charge a fee for their services. In connection withthis new wholesaler business model, we finalized distribution serviceagreements in the third quarter of 2005 with our major wholesaler customers.These agreements obligate the wholesalers to provide us with periodic retaildemand information and current inventory levels for our products held at theirwarehouse locations; additionally, the wholesalers have agreed to manage thevariability of their purchases and inventory levels within specified limitsbased on product demand.

As of December 31, 2005, we received informationfrom our three largest U.S. wholesaler customers about the levels of inventorythey held for our products. Based on this information, which we have notindependently verified, we believe that total inventory held at thesewholesalers is approximately two weeks supply at our current sales levels.

For the year ended December 31,2005, total sales increased by 18% over the prior year. This change wasimpacted by changes in the relative levels of the number of units of inventoryheld at wholesalers and retailers and by changes in the product salesallowances deducted from gross sales. The other key factors that contributed tothe increase in sales are summarized by product as follows:

·       InCNS Disorders, sales of PROVIGIL increased 17 percent. Demand for PROVIGILincreased as evidenced by an increase in U.S. prescriptions for PROVIGIL of16%, according to IMS Health. For the year ended December 31, 2005, salesof PROVIGIL also were impacted by domestic price increases of approximately 21%from period to period.

·       Salesof GABITRIL decreased 23 percent. U.S. prescriptions for GABITRIL decreased 19%according to IMS Health. This decrease was driven primarily by our decision toreduce our sales and marketing efforts following an update in February 2005to the label information for GABITRIL. For the year ended December 31,2005, sales of GABITRIL also were impacted by domestic price increases ofapproximately 32% from period to period.

·       InPain, sales increased 19 percent. Demand for ACTIQ increased as evidenced by anincrease in U.S. prescriptions for ACTIQ of 8%, according to IMS Health. Forthe year ended December 31, 2005, sales of ACTIQ also were impacted by anincrease in domestic prices of approximately 18% from period to period.

·       Othersales, which consist primarily of sales of other products and certain thirdparty products, increased 57 percent. The most significant increases in thiscategory are sales of products manufactured and sold to pharmaceutical partnersby CIMA LABS, which we acquired in August 2004, sales of NAXY®(clarithromycin), which we acquired in December 2004 and sales ofTRISENOX® which we acquired in July 2005.

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*OtherRevenues—**The*increase of 58% from period toperiod is primarily due to the inclusion of product development and licensingfees and royalties attributable to CIMA LABS of $33.8 million for the yearended December 31, 2005, compared to $15.1 million from theacquisition date of August 12, 2004 to December 31, 2004.

*Analysisof gross sales to net sales—**The*following tablepresents the product sales allowances deducted from gross sales to arrive at anet sales figure:

| ** **                                               | ** ** | **Year Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                               | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Gross sales:                                             |       | $                                          | 1,335,602  |       | $          | 1,080,408  |       | $ | 255,194 |   |   | 24 | % |   |
| Product sales  allowances:                               |       |                                       |       |       |       |       |       |   |   |   |   |
| Prompt payment discounts                                 |       | 22,284                                     |       | 18,443     |       | 3,841      |       |   | 21 | % |   |
| Wholesaler discounts                                     |       | 24,373                                     |       | —     |       | 24,373     |       |   | 100 | % |   |
| Returns                                                  |       | 15,853                                     |       | 11,247     |       | 4,606      |       |   | 41 | % |   |
| Coupons                                                  |       | 23,313                                     |       | 16,521     |       | 6,792      |       |   | 41 | % |   |
| Medicaid discounts                                       |       | 67,245                                     |       | 41,274     |       | 25,971     |       |   | 63 | % |   |
| Managed care and governmental contracts                  |       | 26,016                                     |       | 12,548     |       | 13,468     |       |   | 107 | % |   |
|                                                     |       | 179,084                                    |       | 100,033    |       | 79,051     |       |   |   |   |   |
| Net sales                                                |       | $                                          | 1,156,518  |       | $          | 980,375    |       | $ | 176,143 |   |   | 18 | % |   |
| Product sales  allowances as a percentage of gross sales |       | 13.4                                       | %          | 9.3        | %          |       |       |   |   |   |   |

 

Increasesin the product sales allowances as a percentage of gross sales from 2004 to2005 primarily reflect the establishment of a wholesaler discount reserve in2005 to provide for fees consistent with the terms of the distribution serviceagreements, increased Medicaid discounts resulting from both increased usageand increased rebate percentages due to price increases, and additional rebatesfor certain governmental programs. In the future, we expect product salesallowances as a percentage of gross sales to continue to trend upward due tothe impact of potential future price increases on Medicaid discounts andpotential increases related to Medicaid, managed care and governmentalcontracts sales.

| ** **                                    | ** ** | **Year Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                    | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Costs and expenses:                           |       |                                       |       |       |       |       |       |   |   |   |   |
| Cost of sales                                 |       | $                                          | 164,223    |       | $          | 119,973    |       | $ | 44,250 |   |   | 37 | % |   |
| Research and  development                     |       | 354,826                                    |       | 273,972    |       | 80,854     |       |   | 30 | % |   |
| Selling, general  and administrative          |       | 443,861                                    |       | 339,477    |       | 104,384    |       |   | 31 | % |   |
| Depreciation and  amortization                |       | 84,305                                     |       | 52,798     |       | 31,507     |       |   | 60 | % |   |
| Impairment charge                             |       | 20,820                                     |       | 30,071     |       | (9,251     | )          |   | (31 | )% |   |
| Acquired  in-process research and development |       | 366,815                                    |       | 185,700    |       | 181,115    |       |   | 98 | % |   |
|                                          |       | $                                          | 1,434,850  |       | $          | 1,001,991  |       | $ | 432,859 |   |   | 43 | % |   |

 

*Costof Sales—**The*cost of sales was approximately14.2% of net sales for the year ended December 31, 2005 and 12.2% of netsales for the year ended December 31, 2004. The increase is primarily duethe inclusion of twelve months of CIMA LABS’ product sales for which the marginis lower than our other products instead of only approximately 4.5 monthsin 2004. This increase was also impacted by the net effect of price increaseson our three major US products effective February 2005 and July 2005and increases in our product sales allowances.

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*Researchand Development Expenses—**Research***and development expenses increased $80.9 million, or30%, for the year ended December 31, 2005 as compared to the year ended December 31,2004. Of this increase, $50.0 million is due to an increase in headcountand headcount-related expenditures necessary to support higher levels ofclinical activities and expenditures. The remainder of the increase is largelydue to increased research and development expenditures related to theexploration of the utility of GABITRIL in GAD and Phase 3 studies of FEBT,increased research and development expenditures related to facilities andoperations and the inclusion of a full year of CIMA LABS. These increases werepartially offset by a decrease in clinical research costs due to the conclusionin 2005 of four double-blind studies in our NUVIGIL program.

*Selling,General and Administrative Expenses—**Selling,***general and administrative expenses increased$104.4 million, or 31%, for the year ended December 31, 2005 ascompared to the year ended December 31, 2004, primarily due toexpenditures associated with an increase in headcount, the inclusion of a fullyear of CIMA LABS, which was acquired in August 2004 and increased salesand marketing costs in France to support NAXY® and MONO-NAXY®, which weacquired from Sanofi-Synthelabo France in December 2004. Theseincreases were partially offset by a reduction in GABITRIL marketing activity.

*Depreciationand Amortization Expenses—**Depreciation***and amortization expenses increased $31.5 million, or60%, for the year ended December 31, 2005 as compared to the year ended December 31,2004. This increase is primarily the result of increased capital investments insoftware, buildings, and leasehold and laboratory improvements at our WestChester and Frazer locations, increased spending on manufacturing equipment atour Salt Lake City location and the acquisition of property, plant andequipment associated with the CIMA LABS acquisition. Amortization expenseincreased due to the amortization of technology, trademark and marketing rightsacquired from CIMA LABS in the third quarter of 2004, the amortization ofFrench marketing rights to NAXY® and MONO-NAXY® and the amortization ofTRISENOX technology acquired in July 2005.

*Impairmentcharges—**For***theyear ended December 31, 2005, we recorded an impairment charge of$20.8 million for the write-off of an intangible asset resulting from thetermination of a distribution agreement in the United Kingdom in March 2006.For the year ended December 31, 2004, we recorded an impairment charge of$30.1 million for the write-off of an investment in MDS Proteomics, Inc.

*Acquiredin-process research and development—**Acquired***in-process research and development increased$181.1 million, or 98%, for the year ended December 31, 2005 ascompared to the year ended December 31, 2004. The increase in acquiredin-process research and development expense in 2005 as compared to 2004 isprimarily due to our acquisitions of Zeneus and Salmedix and the license andcollaboration agreement we entered into with Alkermes for VIVITROL. In 2005, werecorded acquired in-process research and development expense of$71.2 million for Zeneus, $130.1 million for Salmedix and$160.0 million for VIVITROL. In 2004, in connection with our acquisitionof CIMA LABS in August 2004, we allocated approximately$185.7 million of purchase price to in-process research and developmentprojects.

| ** **                                      | ** ** | **Year Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                      | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Other income (expense):                         |       |                                       |       |       |       |       |       |   |   |   |   |
| Interest income                                 |       | $                                          | 26,171     |       | $          | 16,486     |       | $ | 9,685 |   |   | 59 | % |   |
| Interest expense                                |       | (25,235                                    | )          | (22,186    | )          | (3,049     | )          |   | (14 | )% |   |
| Debt exchange expense                           |       | —                                     |       | (28,230    | )          | 28,230     |       |   | 100 | % |   |
| Write-off of deferred debt issuance costs       |       | (27,109                                    | )          | —     |       | (27,109    | )          |   | (100 | )% |   |
| Gain (charge) on early extinguishment of   debt |       | 2,085                                      |       | (2,313     | )          | 4,398      |       |   | 190 | % |   |
| Other income (expense), net                     |       | 1,928                                      |       | (5,375     | )          | 7,303      |       |   | 136 | % |   |
|                                            |       | $                                          | (22,160    | )          | $          | (41,618    | )          | $ | 19,458 |   |   | 47 | % |   |

 

55

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*Other Income (Expense)—**Other***income (expense), net increased $19.5 million, or 47%,for the year ended December 31, 2005 as compared to the year ended December 31,2004. The increase was attributable to the following factors:

·       a$9.7 million increase in interest income in 2005 due to higher investmentreturns partially offset by lower average investment balances. This increasewas partially offset by a $3.0 million increase in interest expense due tohigher average debt balances.

·       a$28.2 million decrease in debt exchange expense which was recognized in2004 related to the exchange of $78.3 million of our 2.5% convertiblesubordinated notes.

·       a$27.1 million increase in write-off of deferred debt issuance costs wererecognized in 2005 related to the 2.0% convertible senior subordinated notes.

·       anet gain (charge) on early extinguishment of debt of $2.1 million in 2005compared to ($2.3) million in 2004. The net gain in 2005 includes a$7.4 million gain on the repurchase of approximately $512 million ofthe 2.5% convertible subordinated notes and a net loss of $5.3 million onthe termination of the interest rate swap agreement associated with$200 million notional amount of the 2.5% convertible subordinated notes.The charge in 2004 relates to the repurchase of $10.0 million and$33.0 million of our 3.875% convertible subordinated notes in privatetransactions in March 2004 and August 2004, respectively.

·       a $7.3 millionincrease in other income period over period primarily due to gains recorded inforeign currency transactions.

| ** **                    | ** ** | **Year Ended December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|------------|------------|------------|------------|
| ** **                    | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Income tax expense  (benefit) |       | $                                          | (70,164    | )          | $          | 45,629     |       | $ | (115,793 | ) |   | (254 | )% |   |
|                               |            |                                            |            |            |            |            |            |  |  |  |  |  |  |  |

 

*Income Taxes—**For*the year endedDecember 31, 2005, we recognized $70.2 million of income tax benefiton a loss before income taxes of $245.1 million, resulting in an overalleffective tax rate of (28.6)%. This compared to the year endedDecember 31, 2004 tax expense of $45.6 million on a loss before incometaxes of $28.2 million, yielding an effective tax rate of 162%. The changein effective tax rates between 2005 and 2004 is primarily due to$201.3 million non-deductible acquired in-process research and developmentcharges related to the Salmedix and Zeneus acquisitions for which no taxbenefit was recorded. For tax reporting purposes, these acquisitions weretreated as stock purchases. In addition, we recorded a decrease in thevaluation allowance by $46.0 million and recognized a research anddevelopment tax credit of $11.8 million.

**LIQUIDITY AND CAPITAL RESOURCES***(Inthousands)*

Cash, cash equivalents and investments atDecember 31, 2006 were $521.7 million, representing 17% of totalassets, as compared to $484.1 million, representing 17% of total assets,at December 31, 2005 and as compared to $791.7 million, representing33% of total assets, at December 31, 2004.

Working capital is calculated as current assets lesscurrent liabilities. Our convertible subordinated notes contain conversionterms that will impact whether these notes are classified as current orlong-term liabilities and consequently affect our working capital position. AtDecember 31, 2006 and 2005, $1,019.8 million and $920.0 million,respectively, of our convertible subordinated notes were convertible into cashand shares of common stock and were therefore classified as current liabilitieson our consolidated balance sheets.

56

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Thechange in cash and cash equivalents is as follows:

| ** **                                                    | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net cash provided by  operating activities                    |       | $                                          | 319,917    |   | $ | 185,731 |   | $ | 178,604 |   |
| Net cash used for  investing activities                       |       | (20,376                                    | )          | (780,480 | ) | (685,214 | ) |
| Net cash provided by  (used for) financing activities         |       | (22,624                                    | )          | 231,841 |   | (41,022 | ) |
| Effect of exchange rate  changes on cash and cash equivalents |       | 14,535                                     |       | (6,276 | ) | 6,177 |   |
| Net increase (decrease)  in cash and cash equivalents         |       | $                                          | 291,452    |   | $ | (369,184 | ) | $ | (541,455 | ) |
| Working capital surplus (deficit)                             |       | $                                          | (179,511   | ) | $ | (229,766 | ) | $ | 936,981 |   |

 

The increase in cash andcash equivalents in 2006 is due to continued growth in income from productsales combined with a reduction in the use of cash and cash equivalents forinvesting and financing activities. The net decrease in cash and cashequivalents during 2005 and 2004 is due primarily to significant investments inbusinesses, technologies and product rights. The decrease in 2005 was partiallyoffset by net proceeds received from our sale of 2.0% convertible seniorsubordinated notes.

*Net Cash Provided by Operating Activities*

Cash provided by operatingactivities is primarily driven by growth in income from sales of our productsoffset by the timing of receipts and payments in the ordinary course ofbusiness. While income from sales of PROVIGIL and ACTIQ accounted for asignificant portion of the growth in sales in 2006, sales of generic OTFC,FENTORA, TRISENOX and the portfolio of products obtained from the acquisitionof Zeneus, all of which are new sources of sales income in 2006, alsocontributed to our growth in operating income over the prior year. In 2005 and2004, growth in sales of PROVIGIL and ACTIQ provided the most significantsource of income from operations.

In conjunction with ouracquisition of certain businesses in 2005 and 2004, we recorded acquiredin-process research and development expense of $201.8 million and $185.7million, respectively. These amounts are shown in the statements of cash flowsfor those years as adjustments to reconcile the net loss to net cash providedby operating activities since they are reflected in investing activities asacquisition of businesses. Conversely, aggregate cash payments of $165.0million made in 2005 were recorded directly to acquired in-process research anddevelopment expense and are reflected within the net loss from operations.

*Net Cash Used for Investing Activities*

Cash used in investingactivities primarily relates to acquisitions of business, technologies andproduct rights and funds invested in our administrative and manufacturingfacilities to accommodate our growth.

In 2006, we made capitalexpenditures of $159.9 million, which included the purchase of a manufacturingline from Alkermes, expenditures associated with our worldwide implementationof SAP, and continued facility expansion and improvements. The other primaryuse of funds for investing activities in 2006 was a payment of $110.0 millionmade to Alkermes following FDA approval of VIVITROL. These uses of cash werelargely offset by cash provided from sales and maturities of our investmentportfolio.

In 2005, we invested fundsto acquire Salmedix for $130.7 million and Zeneus for $365.8 million, both netof cash acquired. Additionally, we purchased substantially all assets relatedto TRISENOX from Cell Therapeutics, Inc. for $69.7 million and used fundsto improve and expand our facilities primarily in Pennsylvania, Utah andFrance.

In 2004, we acquired CIMALABS for $482.5 million; net of cash acquired, and purchased the Frenchmarketing rights to NAXY and MONO-NAXY from Sanofi-Synthelabo France for $44.3million. We also 

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increasedour purchases of available-for-sale investments in order to benefit from risinginterest rates on longer-term investments.

*Net Cash Provided by (Used for) Financing Activities*

Financing activities forthe years presented above primarily relate to proceeds and payments onlong-term debt and employee stock option activity.

In 2006, we paid $175.3million in connection with our exchange of $437.3 million of our outstandingconvertible notes for cash and common stock and retired the remainingobligation of $10.0 million of our 2.5% convertible subordinated notes due December 2006.These uses of cash were largely offset by proceeds received from exercises ofemployee stock options.

In 2005, we received netproceeds of $892.0 million from the sale of 2.0% convertible seniorsubordinated notes. Concurrent with the sale of the 2.0% Notes, we purchased aconvertible note hedge for $382.3 million and also sold warrants topurchase an aggregate of 19,700,214 shares of our common stock for net proceedsof $217.1 million. The net proceeds from the combined issuance of thenotes, sale of warrants and purchase of convertible note hedge was partiallyoffset by our tender offer whereby we purchased a significant portion of our2.5% convertible subordinated notes for $499.0 million in cash.

During 2004, cash used forfinancing activities was primarily related to the repurchase of$43.0 million of then-outstanding 3.875% convertible subordinated notes.

*Commitments andContingencies*

*—Legal Proceedings*

For a complete descriptionof legal proceedings, see Note 13 of the Consolidated Financial Statementsincluded in Part II, Item 8 of this Annual Report on Form 10-K.

*—Other Commitmentsand Contingencies*

Thefollowing table summarizes our obligations to make future payments undercurrent contracts:
|                                    | ** ** | **Payments due by period** | ** ** |
|------------------------------------|------------|-------------------------------------------|------------|
| **Contractual obligations**   | ** ** | ** **                                | ** ** | **Total** | ** ** | **2007** | ** ** | **2008 and 2009** | ** ** | **2010 and 2011** | ** ** | **2012 and  thereafter** | ** ** |
| Debt obligations                   |       | $                                         | 11,027     |   | $ | 1,515 |   |   | $ | 4,606 |   |   |   | $ | 2,358 |   |   |   | $ | 2,548 |   |   |
| Convertible notes                  |       | 1,233,490                                 |       | 1,019,810 |   |   | 213,680 |   |   |   | — |   |   |   | — |   |   |
| Purchase obligations               |       | 137,943                                   |       | 44,165 |   |   | 61,790 |   |   |   | 31,988 |   |   |   | — |   |   |
| Capital lease obligations          |       | 3,787                                     |       | 1,987 |   |   | 1,800 |   |   |   | — |   |   |   | — |   |   |
| Interest payments on  debt         |       | 132,644                                   |       | 16,988 |   |   | 33,408 |   |   |   | 32,962 |   |   |   | 49,286 |   |   |
| Operating leases                   |       | 89,584                                    |       | 18,596 |   |   | 30,160 |   |   |   | 15,902 |   |   |   | 24,926 |   |   |
| Pension obligations                |       | 7,691                                     |       | 197 |   |   | 350 |   |   |   | 900 |   |   |   | 6,244 |   |   |
| Total contractual cash obligations |       | $                                         | 1,616,166  |   | $ | 1,103,258 |   |   | $ | 345,794 |   |   |   | $ | 84,110 |   |   |   | $ | 83,004 |   |   |
|                                    |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At December 31, 2006,our 2.0% Notes and Zero Coupon Notes first putable June 15, 2010 areconsidered to be current liabilities and are presented in current portion oflong-term debt on our consolidated balance sheet. For a discussion of ourobligations under our convertible notes, see “—Outlook—Indebtedness” below.

In addition to the above,we have committed to make potential future “milestone” payments to third partiesas part of our in-licensing and development programs primarily in the area ofresearch and development agreements. Payments generally become due and payableonly upon the achievement of certain developmental, regulatory and/orcommercial milestones. Because the achievement of these milestones is neitherprobable nor reasonably estimable, we have not recorded a liability on ourbalance 

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sheetfor any such contingencies. As of December 31, 2006, the potentialmilestone and other contingency payments due under current contractualagreements are approximately $857.5 million.

**Outlook**

We expect to use ourremaining cash, cash equivalents and investments for working capital andgeneral corporate purposes, including the acquisition of businesses, products,product rights, or technologies, the payment of contractual obligations,including scheduled interest payments on our convertible notes and regulatoryor sales milestones that may become due, and/or the purchase, redemption orretirement of our convertible notes. However, we expect that sales of ourcurrently marketed products, together with sales of our near-term productcandidates, assuming approval in the anticipated time frames, should allow usto continue to generate positive cash flow from operations in 2007. At thistime, we cannot accurately predict the effect of certain developments on therate of sales growth in 2008 and beyond, such as the degree of marketacceptance, patent protection and exclusivity of our products, the impact ofcompetition, the effectiveness of our sales and marketing efforts and theoutcome of our current efforts to develop, receive approval for andsuccessfully launch our near-term product candidates.

Based on our current levelof operations, projected sales of our existing products and estimated salesfrom our product candidates, if approved, combined with other revenues andinterest income, we also believe that we will be able to service our existingdebt and meet our capital expenditure and working capital requirements in the nearterm. However, we cannot be sure that our anticipated revenue growth will berealized or that we will continue to generate significant positive cash flowfrom operations. We may need to obtain additional funding for future significant strategictransactions, to repay our outstanding indebtedness, particularly if suchindebtedness is presented for conversion by holders (see “—Indebtedness” below), or for our future operational needs, and we cannot becertain that funding will be available on terms acceptable to us, or at all.

*Marketed Products*

Continued sales growth ofPROVIGIL depends, in part, on the continued effectiveness of the varioussettlement agreements we entered into in late 2005 and early 2006, as well asour maintenance of protection in the United States and abroad of the modafinilparticle-size patent through its expiration beginning in 2014. See Note 13 tothe Consolidated Financial Statements included in Part II, Item 8 of thisAnnual Report on Form 10-K. In addition, future growth of PROVIGILmay depend on the success of the efforts of our co-promotion partner, Takeda.Finally, growth of our modafinil-based product sales in 2007 and beyond maydepend in part on our ability to achieve final FDA approval of NUVIGIL, whichwe anticipate on or before March 31, 2007.

The growth of our painfranchise depends in large part on our ability to successfully market FENTORA,which we launched in the United States in October 2006. Sales of our otherpain product, ACTIQ, have been meaningfully eroded by the entry of genericcompetition in late September 2006 and we expect this erosion willcontinue during 2007. In addition, sales of our own generic OTFC could besignificantly impacted by the entrance into the market of additional genericOTFC products, which could occur at any time.

For VIVITROL, our abilityto achieve commercial success with this product in 2007 and thereafter will beimpacted by our success in building awareness and acceptance of the productamong the 2,000—3,000 addiction specialists and physicians who have been activelytreating alcohol dependence with pharmacotherapy and our work towards educatingthe counseling community about VIVITROL. During the first few months of launch,we focused our efforts on establishing the logistical platform to effectivelydeliver the product to patients. In 2007, we will be focusing more of our salesand marketing efforts on driving product demand by educating physicians aboutVIVITROL’s benefits.

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*Clinical Studies*

Over the past few years,we have incurred significant expenditures related to conducting clinicalstudies to develop new pharmaceutical products and exploring the utility of ourexisting products in treating disorders beyond those currently approved intheir respective labels. For 2007, we expect to continue to incur significantlevels of research and development expenditures. We also expect to continue orbegin a number of significant clinical programs including, among others: ourPhase 3 program evaluating TREANDA for the treatment of non-Hodgkin’s lymphomaand other possible studies for the treatment of chronic lymphocytic leukemia,small cell lung cancer and mantle cell lymphoma; a Phase 3 program evaluatingCEP-701 for the treatment of acute myelogenous leukemia and otherpossible studies of CEP-701 in patients with myeloproliferative disorder;Phase 3 programs with FENTORA in non-cancer breakthrough pain; and clinicalprograms with NUVIGIL in bi-polardepression, cognition in schizophrenia and excessive sleepiness and fatigue inconditions such as Parkinson’s Disease and cancer. We may seek tomitigate the risk in our research and development programs by seeking sourcesof funding for a portion of these expenses through collaborative arrangementswith third parties. However, we intend to retain a portion of the commercialrights to these programs and, as a result, we still expect to spend significantfunds on our share of the cost of these programs, including the costs ofresearch, preclinical development, clinical research and manufacturing.

*Manufacturing, Selling and Marketing Efforts*

During 2007, we expect tocontinue to incur significant expenditures associated with manufacturing,selling and marketing our products. We expect to continue in-process capitalexpenditure projects at our research and development facilities in France andWest Chester. The aggregate amount of our sales and marketing expenses in 2007also will be significantly higher than that incurred in 2006, primarily as aresult of higher expenses associated with our promotional efforts related toPROVIGIL and FENTORA.

*Indebtedness*

We have significantindebtedness outstanding, consisting principally of indebtedness on convertiblesubordinated notes. The following table summarizes the principal terms of ourmost significant convertible subordinated notes outstanding as of December 31,2006:
| Security                                                                                                                      | ** ** | ** ** | ** ** | **Outstanding  (in millions)** | ** ** | **Conversion  Price** | ** ** | **Redemption  Rights and Obligations** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|--------------------------------|------------|-----------------------|------------|----------------------------------------|
| 2.0% Convertible  Senior Subordinated Notes due June 2015 (the “2.0% Notes”)                                   |       |       | $          | 820.0                          |       |                  |       | $                                      | 46.70* |   |   | Generally  not redeemable by the holder prior to December 2014. |
| Zero Coupon  Convertible Notes due June 2033, first putable June 15, 2008 (the  “2008 Zero Coupon Notes”) |       |       | $          | 213.2                          |       |                  |       | $                                      | 59.50* |   |   | Redeemable  on June 15, 2008 at either option of holder or us at a redemption price  of 100.25% of the principal amount redeemed. |
| Zero Coupon  Convertible Notes due June 2033, first putable June 15, 2010 (the  “2010 Zero Coupon Notes”) |       |       | $          | 199.5                          |       |                  |       | $                                      | 56.50* |   |   | Redeemable  on June 15, 2010 at either option of holder or us at a redemption price  of 100.25% of the principal amount redeemed. |

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*                    Statedconversion prices as per the terms of the notes. However, each convertible notecontains certain terms restricting a holder’s ability to convert the notes, includingthat a holder may only convert if the closing price of our stock on the dayprior to conversion is higher than $56.04, $71.40 or $67.80 with respect to the2.0% Notes, the 2008 Zero Coupon Notes or the 2010 Zero Coupon Notes,respectively. For a more complete description of these notes, including theassociated convertible note hedge, see Note 10 to our ConsolidatedFinancial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.

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In December 2006,certain holders of our Zero Coupon Notes and 2.0% Notes approached us and weagreed to exchange $436.9 million aggregate principal amount of our convertiblenotes for cash payments totaling $175.3 million and the issuance of 6.2 millionshares of our common stock. Concurrent with these exchanges, we amended ourconvertible note hedge agreements related to the Zero Coupon Notes and 2% Notesand amended the warrant agreements related to the Zero Coupon Notes. The effectof these amendments was to terminate the portion of the convertible note hedgeand, with respect to the Zero Coupon Notes, the warrants agreements related tothe $436.9 million principal amount of notes exchanged. In settlement of theseamendments, we received 1.8 million shares of our common stock from thecounterparties to these agreements. The warrants related to the 2% Notesexchanged in December 2006 remain outstanding.

Our 2.0% and 2010 ZeroCoupon Notes are convertible as of December 31, 2006 and, under the termsof the indentures governing the notes, we are obligated to repay in cash theaggregate principal balance of any such notes presented for conversion. As ofthe filing date of this Annual Report on Form 10-K, we do not haveavailable cash, cash equivalents and investments sufficient to repay all of theconvertible notes, if presented. In addition, there are no restrictions on ouruse of this cash and the cash available to repay indebtedness may decline overtime. If we do not have sufficient funds available to repay any principalbalance of notes presented for conversion, we will be required to raiseadditional funds. Because the financing markets may be unwilling to providefunding to us or may only be willing to provide funding on terms that we wouldconsider unacceptable, we may not have cash available or be able to obtainfunding to permit us to meet our repayment obligations, thus adverselyaffecting the market price for our securities.

As of December 31,2006, our 2.0% Notes and 2010 Zero Coupon Notes are convertible because theclosing price of our common stock on that date was higher than the restrictedconversion prices of these notes. As a result, the 2.0% Notes and 2010 ZeroCoupon Notes have been classified as current liabilities on our consolidatedbalance sheet as of December 31, 2006 (see Note 10 of ourConsolidated Financial Statements included in Part II, Item 8 of thisAnnual Report on Form 10-K for summary of our convertible debt, notehedge and call warrant). As of February 27, 2007, the fair value of boththe 2.0% Notes and 2010 Zero Coupon Notes is greater than the value of theshares into which such notes are convertible. We believe that the share priceof our common stock would have to significantly increase over the market priceas of the filing date of this report before the fair value of the convertiblenotes would be less than the value of the common stock shares underlying thenotes and, as such, we believe it is highly unlikely that holders of the 2.0%Notes or 2010 Zero Coupon Notes will present significant amounts of such notesfor conversion under the current terms. In the unlikely event that asignificant conversion did occur, we believe that we have the ability to raisesufficient cash to repay the principal amounts due through a combination ofutilizing our existing cash on hand, raising money in the capital markets orselling our note hedge instruments for cash.

The annual interestpayments on our convertible notes outstanding as of December 31, 2006 are$16.4 million, payable semi-annually on June 1 and December 1.In the future, we may agree to exchanges of the notes for shares of our commonstock or debt, or may determine to use a portion of our existing cash on handto purchase or retire all or a portion of the outstanding convertible notes.

Our 2.0% Notes and 2008 and 2010 Zero Coupon Noteseach are considered instrument C securities as defined by Emerging IssuesTask Force (“EITF”) Issue No. 90-19, “Convertible Bonds with IssuerOption to Settle for Cash upon Conversion” (“EITF 90-19”);therefore, these notes are included in the dilutive earnings per sharecalculation using the treasury stock method. Under the treasury stock method,we must calculate the number of shares issuable under the terms of these notesbased on the average market price of our common stock during the period, andinclude that number in the total diluted shares figure for the period. At thetime we sold our 2.0% Notes and Zero Coupon Notes we entered intoconvertible note hedge and warrant agreements that together are intended tohave the economic effect of reducing the net number of shares that will beissued upon conversion of the notes by increasing the 

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effective conversion pricefor these notes, from our perspective, to $67.92 and $72.08, respectively.However, from a U.S. GAAP perspective, SFAS No. 128, “Earnings PerShare” (“SFAS 128”) considers only the impact of the convertible notes and thewarrant agreements; since the impact of the convertible note hedge agreementsis always anti-dilutive, SFAS 128 requires that we exclude from thecalculation of fully diluted shares the number of shares of our common stockthat we would receive from the counterparties to these agreements uponsettlement.

Under the treasurystock method, changes in the share price of our common stock can have asignificant impact on the number of shares that we must include in the fullydiluted earnings per share calculation. The following table provides examplesof how changes in our stock price will require the inclusion of additionalshares in the denominator of the fully diluted earnings per share calculation (“TotalTreasury Stock Method Incremental Shares”). The table also reflects the impacton the number of shares we could expect to issue upon concurrent settlement ofthe convertible notes, the warrant and the convertible note hedge (“IncrementalShares Issued by Cephalon upon Conversion”):

| **Share Price** | ** ** | ** ** | ** ** | **Convertible  Notes Shares** | ** ** | **Warrant  Shares** | ** ** | **Total Treasury  Stock Method  Incremental  Shares(1)** | ** ** | ** ** | ** ** | **Shares Due to  Cephalon under  Note Hedge** | ** ** | **Incremental  Shares Issued by  Cephalon upon  Conversion(2)** | ** ** |
|----------------------|------------|------------|------------|------------------------------------|------------|---------------------|------------|--------------------------------------------------------------------|------------|------------|------------|-------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| $65.00               |       |       | 5,710      |                               |       |                | —     |                                                               |       |       | 5,710      |                                                              |       |                                                                           |       |   | (5,710 | ) |   |   | — |   |   |
| $75.00               |       |       | 8,239      |                               |       |                | 2,137      |                                                               |       |       | 10,376     |                                                              |       |                                                                           |       |   | (8,239 | ) |   |   | 2,137 |   |   |
| $85.00               |       |       | 10,173     |                               |       |                | 5,041      |                                                               |       |       | 15,214     |                                                              |       |                                                                           |       |   | (10,173 | ) |   |   | 5,041 |   |   |
| $95.00               |       |       | 11,699     |                               |       |                | 7,334      |                                                               |       |       | 19,033     |                                                              |       |                                                                           |       |   | (11,699 | ) |   |   | 7,334 |   |   |
| $105.00              |       |       | 12,935     |                               |       |                | 9,189      |                                                               |       |       | 22,124     |                                                              |       |                                                                           |       |   | (12,935 | ) |   |   | 9,189 |   |   |

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(1)          Represents the number ofincremental shares that must be included in the calculation of fully dilutedshares under U.S. GAAP

(2)          Represents the number ofincremental shares to be issued by us upon conversion of the convertible notes,assuming concurrent settlement of the convertible note hedges and warrants.

*Acquisition Strategy*

As part of our businessstrategy, we plan to consider and, as appropriate, make acquisitions of otherbusinesses, products, product rights or technologies. Our cash reserves andother liquid assets may be inadequate to consummate such acquisitions and itmay be necessary for us to issue stock or raise substantial additional funds inthe future to complete future transactions. In addition, as a result of ouracquisition efforts, we are likely to experience significant charges toearnings for merger and related expenses (whether or not our efforts aresuccessful) that may include transaction costs, closure costs or acquired in-processresearch and development charges.

*Other*

We mayexperience significant fluctuations in quarterly results based primarily on thelevel and timing of:

·       costof product sales;

·       achievementand timing of research and development milestones;

·       collaborationrevenues;

·       costand timing of clinical trials, regulatory approvals and product approvals;

·       marketingand other expenses;

·       manufacturingor supply disruptions; and

·       costsassociated with the operations of recently-acquired businesses and technologies.

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**CRITICAL ACCOUNTINGPOLICIES AND ESTIMATES**

Management’s Discussion and Analysis of FinancialCondition and Results of Operations discusses our consolidated financialstatements, which we have prepared in accordance with accounting principlesgenerally accepted in the United States. In preparing these financialstatements, we must make estimates and assumptions that affect the reportedamounts of assets and liabilities, the disclosure of contingent assets andliabilities at the date of the financial statements, and the reported amountsof revenues and expenses during the reporting period. We develop andperiodically change these estimates and assumptions based on historicalexperience and on various other factors that we believe are reasonable underthe circumstances. Actual results may differ from these estimates underdifferent assumptions or conditions.

Our significant accounting policies are described inNote 1 to our Consolidated Financial Statements for the year ended December 31,2006 included in Part II, Item 8 of this Annual Report on Form 10-K.The SEC defines critical accounting policies as those that are, in management’sview, most important to the portrayal of the company’s financial condition andresults of operations and most demanding of their judgment. Managementconsiders the following policies to be critical to an understanding of ourconsolidated financial statements and the uncertainties associated with thecomplex judgments made by us that could impact our results of operations,financial position and cash flows.

*Revenuerecognition—**In*the United States, we sell ourproducts to pharmaceutical wholesalers, the largest three of which account for71% of our total consolidated gross sales for the year ended December 31,2006. Decisions made by these wholesalers regarding the levels of inventorythey hold (and thus the amount of product they purchase from us) may havematerially affected the level of our sales in any particular period and thusour sales may not correlate to the number of prescriptions written for ourproducts as reported by IMS Health.

We have distribution service agreements with our majorwholesaler customers. These agreements obligate the wholesalers to provide uswith periodic retail demand information and current inventory levels for ourproducts held at their warehouse locations; additionally, the wholesalers haveagreed to manage the variability of their purchases and inventory levels withinspecified limits based on product demand.

Product sales are recognized upon the transfer ofownership and risk of loss for the product to the customer. In the UnitedStates, we sell all commercial products F.O.B. shipping point. Transfer ofownership and risk of loss for the product pass to the customer at the pointthat the product is picked up by a common carrier for shipment to the customer.In Europe, product sales are recognized predominantly upon customer receipt ofthe product, except in certain contractual arrangements where different termsmay be specified.

Payments under co-promotional or managed servicesagreements are recognized over the period when the products are sold or thepromotional activities are performed. The portion of the payments thatrepresent reimbursement of our expenses is recognized as an offset to thoseexpenses in our results of operations.

We recognize revenue on new product launches whensales returns can be reasonably estimated and all other revenue recognitionrequirements have been met. When determining if returns can be estimated, weconsider actual returns of similar products as well as sales returns withsimilar customers. In cases in which a new product is not an extension of anexisting line of product or where we have no history of experience withproducts in a similar therapeutic category such that we can not estimateexpected returns of the new product, we defer recognition of revenue until theright of return no longer exists or until we have developed sufficienthistorical experience to estimate sales returns. In developing estimates forsales returns, we consider inventory levels in the distribution channel, shelflife of the product and expected demand based on market data and prescriptions.

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As of December 31, 2006, we received informationfrom substantially all of our U.S. wholesaler customers about the levels ofinventory they held for our U.S. branded products. Based on this information,which we have not independently verified, we believe that total inventory heldat these wholesalers is approximately two weeks supply of our U.S. brandedproducts at our current sales levels. During the fourth quarter of 2006, weshipped launch quantities of our generic OTFC. At December 31, 2006, webelieve that generic OTFC inventory held at wholesalers and retailers isapproximately two to three months.

Sales of our generic OTFC product to wholesalers andretailers include both the right of return of expired product and retroactiveprice reductions under certain conditions, while sales of FENTORA also includethe right of return of expired product. Based on the sales levels and theprescription data during the fourth quarter of 2006, and based on the number ofunits on hand in the pipeline at December 31, 2006 relative to the overalldemand for the products, we have estimated and recorded all applicable productsales allowances related to generic OTFC and FENTORA as of December 31,2006. We have therefore recognized revenues for generic OTFC and FENTORA basedon a fixed and determinable sales price in 2006.

Sales of our generic OTFC product could be subject toretroactive price reductions for units that remain in the pipeline if the priceof generic OTFC is reduced, including as a result of another generic entrantinto the market, and as a result any estimated impact of such adjustments isrecorded at the time revenue is recognized. This estimate of both the potentialtiming of a generic entrant and the amount of the price reduction is highlysubjective. At December 31, 2006, we are not aware of any expectedadditional entrants into the generic OTFC market that would result in a pricereduction to customers for inventory already purchased from us, and do notbelieve that any revenue recognized as of December 31, 2006 would beeffected by a retroactive shelf stock adjustment. If an additional genericentrant had occurred at the beginning of the first quarter on January 1,2007, and generic OTFC prices were reduced by 15%, then a reduction of ourreported revenues of $5.4 million would result. We utilize Watson as our salesagent for the sales and distribution of our generic OTFC. We pay our salesagent a commission for these services and record this commission as SG&Aexpense.

*Product Sales Allowances—**We***record product sales net of the following significantcategories of product sales allowances: prompt payment discounts, wholesalerdiscounts, returns, coupons, Medicaid discounts and managed care andgovernmental contracts. In addition to these product sales allowances, in thefirst quarter of 2006 we also began recording an allowance to product sales forMedicare Part D discount reserves. Calculating each of these itemsinvolves significant estimates and judgments and requires us to use informationfrom external sources.

1)     *Prompt payment discounts*—We offer our U.S.wholesaler customers a 2% prompt-pay cash discount as an incentive to remitpayment within the first thirty-five days after the date of the invoice.Prompt-pay discount calculations are based on the gross amount of each invoice.We account for these discounts by reducing sales by the 2% discount amount whenproduct is sold, and apply earned cash discounts at the time of payment. Sincewe began selling our products commercially in 1999, our customers haveroutinely taken advantage of this discount. Based on common industry practicesand our customers’ overall payment performance, we accrue for cash discounts onall U.S. sales recorded during the period. We adjust the accrual to reflectactual experience as necessary and, as a result, the actual amount recognizedin any period may be slightly different from our accrual amount.

2)     *Wholesaler discounts*—During 2005, wefinalized distribution service agreements with a number of our wholesalercustomers that provide our wholesalers with the opportunity to earn up to 2% inadditional discounts in exchange for the performance of certain services. Theseagreements are effective from January 1, 2005. We have therefore recordeda provision equal to 2% of U.S. gross sales for the twelve months ended December 31,2006, less inventory appreciation adjustments for 2006 price increases. In 

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addition, at ourdiscretion, we may provide additional discounts to wholesalers such as thediscounts of $2.2 million that were provided and recorded during the firstquarter of 2005 and the additional discount offered to wholesalers on initial stockingorders of FENTORA. Actual discounts provided could therefore exceed historicalexperience and our estimates of expected discounts. If these discounts were toincrease by 1.0% of 2006 gross sales from our six products marketed in theU.S., then an additional provision of $14.8 million would result.

3)     *Returns*—Customers can return short-datedor expired product that meets the guidelines set forth in our return goodspolicy. Product shelf life from the date of manufacture for PROVIGIL is3 years, GABITRIL is 2 to 3 years, depending on product strength, andACTIQ and FENTORA are each 2 years. Returns are accepted from wholesalers andretail pharmacies. Wholesaler customers can return short dated product with sixmonths or less shelf life remaining and expired product within twelve monthsfollowing the expiration date. Retail pharmacies are not permitted to returnshort-dated product but can return full or partial quantities of expiredproduct only within twelve months following the expiration date. We base ourestimates of product returns for each of our products on the percentage ofreturns that we have experienced historically. Notwithstanding this, we mayadjust our estimate of product returns if we are aware of other factors that webelieve could meaningfully impact our expected return percentages. Thesefactors could include, among others, our estimates of inventory levels of ourproducts in the distribution channel, known sales trends and existing oranticipated competitive market forces such as product entrants and/or pricingchanges.

For the year ended December 31, 2006, we recordeda provision for returns at a weighted average rate of 1.3% of gross sales,which is consistent with our actual historical return percentages. The otherfactors described above did not have a significant impact for the year ended December 31,2006 on our estimate of product returns. Actual returns could exceed historicalexperience and our estimates of expected future returns activity because ofseveral factors, including, among other things, wholesaler and retailerstocking patterns and/or competition. If the returns provision percentage wereto increase by 0.5% of 2006 gross sales from our six products marketed in theU.S., then an additional provision of $7.4 million would result.

Based on fourthquarter sales, we believe a reasonable estimate of our maximum exposure forpotential returns related to product in our total supply pipeline as of December 31,2006 is approximately $53.6 million for PROVIGIL, $56.7 million for ACTIQ,$37.6 million for generic OTFC, $14.9 million for FENTORA and $4.7 millionfor GABITRIL.

4)     *Coupons*—We offer patients the opportunityto obtain free samples of our products through a program whereby physiciansprovide coupons to qualified patients for redemption at retail pharmacies. Wereimburse retail pharmacies for the cost of these products through a thirdparty administrator. We recognize the estimated cost of this reimbursement as areduction of gross sales when product is sold. In addition, we maintain anaccrual for unused coupons based on inventory in the distribution channel andhistorical coupon usage rates and adjust this accrual whenever changes in suchcoupon usage rates occur.

For the year ended December 31,2006, we recorded a provision for coupons at a weighted average rate of 1.4% ofgross sales. Actual coupon usage could exceed historical experience and ourestimates of expected future coupon activity. If the coupons provisionpercentage were to increase by 0.5% of 2006 gross sales from our six productsmarketed in the U.S., then an additional provision of $7.4 million wouldresult.

5)     *Medicaid discounts*—We record accruals forrebates to be provided through governmental rebate programs, such as theMedicaid Drug Rebate Program, as a reduction of sales when product is sold.These reductions are based on historical rebate amounts and trends of saleseligible for these governmental programs for a period, as well as any expectedchanges to the trends of our total product sales. In addition, we estimate theexpected unit rebate amounts to be used and adjust our rebate accruals based onthe expected changes in rebate pricing. Rebate amounts are generally invoicedand paid quarterly in arrears, 

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so that our accrualconsists of an estimate of the amount expected to be incurred for the currentquarter’s activity, plus an accrual for prior quarters’ unpaid rebates and anaccrual for inventory in the distribution channel.

For the year ended December 31,2006, we recorded a provision for Medicaid discounts at a weighted average rateof 2.4% of gross sales. Actual Medicaid discounts could exceed historicalexperience and our estimates of expected future Medicaid patient activity orunit rebate amounts. If the Medicaid discounts provision percentage were toincrease by 0.5% of 2006 gross sales from our six products marketed in theU.S., then an additional provision of $7.4 million would result.

6)     *Medicare Part D discounts*—Beginningin 2006, we have entered into agreements with certain customers covered under Part Dof the Medicare Prescription Drug Improvement and Modernization Act of 2003whereby we provide agreed-upon discounts to such entities based on formularypositioning. We record accruals for these discounts as a reduction of saleswhen product is sold based on the discount rates and expected levels of salesvolume of these customers during a period. We estimate eligible sales based onexpected amounts and trends of sales by these entities and on any expectedchanges to the trends of our product sales. Discounts are generally invoicedand paid quarterly in arrears, so that our accrual consists of an estimate ofthe amount expected to be incurred for the current quarter’s activity, plus anaccrual for prior quarters’ unpaid rebates and an accrual for inventory in thedistribution channel.

For the year ended December 31,2006, we recorded a provision for Medicare Part D discounts at a weightedaverage rate of 0.1% of gross sales. Actual Medicare Part D discountscould exceed our estimates of expected future Medicare patient activity or unitrebate amounts. If the Medicare Part D discounts provision percentage wereto increase by 0.5% of 2006 gross sales from our six products marketed in theU.S., then an additional provision of $7.4 million would result.

7)     *Managed care and governmental contracts*—Wehave entered into agreements with certain managed care customers whereby weprovide agreed-upon discounts to such entities based on market share. We recordaccruals for these discounts as a reduction of sales when product is sold basedon the discount rates and expected levels of market share of these managed carecustomers during a period. We estimate eligible sales based on historicalamounts and trends of sales by these entities and on any expected changes tothe trends of our product sales. Discounts are generally invoiced and paidquarterly in arrears, so that our accrual consists of an estimate of the amountexpected to be incurred for the current quarter’s activity, plus an accrual forprior quarters’ unpaid rebates and an accrual for inventory in the distributionchannel.

We have entered into agreements with certaingovernmental customers (other than Medicaid) whereby we provide legislativelymandated discounts and rebates to such entities. We record accruals for thesediscounts and rebates as a reduction of sales when product is sold based on thediscount amounts and expected levels of performance of these governmentalcustomers during a period. We estimate eligible sales based on historical salesamounts and trends of sales by these entities and on any expected changes tothe trends of our product sales. Generally, discounts are granted togovernmental customers by our wholesalers at time of purchase. In other cases,rebates are paid directly to governmental customers based on reported levels ofpatient usage. Wholesalers charge these discounts and rebates back to usgenerally within one to three months. We record accruals for our estimate ofunprocessed chargebacks related to sales made during the period based on anestimate of the amount expected to be incurred for the current quarter’s sales,plus an accrual based on the amount of inventory in the distribution channel.

We recognized a reduction in the managed care andgovernmental contracts allowance of $13.3 million in the third quarter of2006, representing amounts paid to the DoD under the Tricare program from October 2004through June 30, 2006. In October 2006, the DoD announced that itwould reimburse all companies that had voluntarily made such payments under theTricare program due to the U.S. Court of Appeals September 2006 ruling andwe received this reimbursement in December 2006.

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For the year ended December 31, 2006, we recordeda provision for managed care and governmental contracts at a weighted averagerate of 1.9% of gross sales. Actual chargebacks and rebates could exceedhistorical experience and our estimates of expected future participation inthese programs. If the chargebacks and rebates provision percentage were toincrease by 0.5% of 2006 gross sales from our six products marketed in theU.S., then an additional provision of $7.4 million would result.

Thefollowing table summarizes activity in each of the above categories for theyears ended December 31, 2005 and 2006:

| **(In thousands)**                | ** ** | ** ** | ** ** | **Prompt  Payment  Discounts** | ** ** | **Wholesaler  Discounts** | ** ** | **Returns*** | ** ** | **Coupons** | ** **  | **Medicaid  Discounts** | ** ** | **Medicare  Part D  Discounts** | ** ** | **Managed  Care &  Governmental  Contracts** | ** **  | **Total** | ** ** |
|----------------------------------------|------------|------------|------------|--------------------------------|------------|---------------------------|------------|--------------|------------|-------------|-------------|-------------------------|------------|--------------------------------------|------------|-------------------------------------------------------|-------------|-----------|------------|
| **Balance at January 1, 2005**    | ** ** | **$**      | **(2,899** | )                              |       | **$**                     | **—** | ** **   |       | **$**       | **(11,727** | **)**                   | **$**      | **(4,165**                           | **)**      | **$**                                                 | **(18,075** | )         |       | **$** | **—** | ** ** |   |   | **$** | **(4,409** | **)** |   | **$** | **(41,275** | **)** |
| Provision:                             |       |       |       |                           |       |                      |       |         |       |        |        |                    |       |                                 |       |                                                  |        |      |       |   |   |   |   |
| Current period                         |       | (22,284    | )          |                           | (24,373    | )                         |       | (13,132      | )          | (23,313     | )           | (66,653                 | )          |                                 | —     |                                                  |        |      | (26,072    | ) |   | (175,827 | ) |
| Prior periods                          |       | —     |       |                           | —     |                      |       | (2,721       | )          | —      |        | (592                    | )          |                                 | —     |                                                  |        |      | 56         |   |   | (3,257 | ) |
| Total                                  |       | (22,284    | )          |                           | (24,373    | )                         |       | (15,853      | )          | (23,313     | )           | (67,245                 | )          |                                 | —     |                                                  |        |      | (26,016    | ) |   | (179,084 | ) |
| Actual:                                |       |       |       |                           |       |                      |       |         |       |        |        |                    |       |                                 |       |                                                  |        |      |       |   |   |   |   |
| Current period**                       |       | 20,367     |       |                           | 21,645     |                      |       | (1,572       | )          | 18,633      |        | 33,199                  |       |                                 | —     |                                                  |        |      | 19,506     |   |   | 111,778 |   |
| Prior periods                          |       | 2,899      |       |                           | —     |                      |       | 6,554        |       | 4,150       |        | 18,667                  |       |                                 | —     |                                                  |        |      | 4,353      |   |   | 36,623 |   |
| Total                                  |       | 23,266     |       |                           | 21,645     |                      |       | 4,982        |       | 22,783      |        | 51,866                  |       |                                 | —     |                                                  |        |      | 23,859     |   |   | 148,401 |   |
| **Balance at December 31, 2005**  | ** ** | **$**      | **(1,917** | )                              |       | **$**                     | **(2,728** | **)**        |       | **$**       | **(22,598** | **)**                   | **$**      | **(4,695**                           | **)**      | **$**                                                 | **(33,454** | )         |       | **$** | **—** | ** ** |   |   | **$** | **(6,566** | **)** |   | **$** | **(71,958** | **)** |
| Provision***:                          |       |       |       |                           |       |                      |       |         |       |        |        |                    |       |                                 |       |                                                  |        |      |       |   |   |   |   |
| Current period                         |       | (32,384    | )          |                           | (2,939     | )                         |       | (24,735      | )          | (26,169     | )           | (45,990                 | )          |                                 | (2,217     | )                                                     |        |      | (43,712    | ) |   | (178,146 | ) |
| Prior periods                          |       | —     |       |                           | —     |                      |       | —       |       | (684        | )           | 723                     |       |                                 | —     |                                                  |        |      | 7,443      |   |   | 7,482 |   |
| Total                                  |       | (32,384    | )          |                           | (2,939     | )                         |       | (24,735      | )          | (26,853     | )           | (45,267                 | )          |                                 | (2,217     | )                                                     |        |      | (36,269    | ) |   | (170,664 | ) |
| Actual***:                             |       |       |       |                           |       |                      |       |         |       |        |        |                    |       |                                 |       |                                                  |        |      |       |   |   |   |   |
| Current period                         |       | 28,836     |       |                           | 2,629      |                      |       | —       |       | 21,508      |        | 19,588                  |       |                                 | 545        |                                                  |        |      | 25,889     |   |   | 98,995 |   |
| Prior periods                          |       | 1,917      |       |                           | 2,728      |                      |       | 18,490       |       | 5,378       |        | 32,731                  |       |                                 | —     |                                                  |        |      | (877       | ) |   | 60,367 |   |
| Total                                  |       | 30,753     |       |                           | 5,357      |                      |       | 18,490       |       | 26,886      |        | 52,319                  |       |                                 | 545        |                                                  |        |      | 25,012     |   |   | 159,362 |   |
| **Balance  at December 31, 2006** | ** ** | **$**      | **(3,548** | )                              |       | **$**                     | **(310**   | **)**        |       | **$**       | **(28,843** | **)**                   | **$**      | **(4,662**                           | **)**      | **$**                                                 | **(26,402** | )         |       | **$** | **(1,672** | **)** |   |   | **$** | **(17,823** | **)** |   | **$** | **(83,260** | **)** |

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*                    Given ourreturn goods policy, we assume that all returns in a current year relate toprior period sales.

**             Includes beginningreserve balances related to TRISENOX, which was acquired in the third quarterof 2005, of $0.1 million for prompt payment discounts and$1.6 million for returns.

***      Includes $13.3 millionrelated to the DoD Tricare program of which $5.5 million related to the currentperiod and $7.8 million related to prior periods.

*Inventories—**Our*inventories arevalued at the lower of cost or market, and include the cost of raw materials,labor, overhead and shipping and handling costs. Cost is computed on domesticinventories and certain of our foreign inventories using the last-in, first-out(“LIFO”) method. For the majority of our foreign inventories, the first-in,first-out (“FIFO”) method is utilized. The majority of our inventories aresubject to expiration dating. We regularly evaluate the carrying value of ourinventories and when, in our opinion, factors indicate that impairment hasoccurred, we establish a reserve against the inventories’ carrying value. Ourdetermination that a valuation reserve might be required, in addition to thequantification of such reserve, requires us to utilize significant judgment. Webase our analysis, in part, on the level of inventories on hand in relation toour estimated forecast of product demand, production 

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requirements forforecasted product demand and the expiration dates of inventories. Although wemake every effort to ensure the accuracy of forecasts of future product demand,any significant unanticipated decreases in demand could have a material impacton the carrying value of our inventories and our reported operating results. Todate, inventory adjustments have not been material.

We expense pre-launch inventory unless it is probablethat the inventory will be saleable. We have capitalized inventory costsassociated with marketed products and certain products prior to regulatoryapproval and product launch, based on management’s judgment of probable futurecommercial use and net realizable value. We could be required to expensepreviously capitalized costs related to pre-approval or pre-launch inventoryupon a change in such judgment, due to a denial or delay of approval byregulatory bodies, a delay in commercialization, or other potential factors. AtDecember 31, 2006, we had $89.1 million of capitalized inventory costsrelated to NUVIGIL, net of reserves of $8.9 million, as we do not expect thatcertain batches in inventory will be sold prior to their expiration date. At December 31,2006, we had an $8.6 million inventory reserve related to the FDA’sdetermination that the SPARLON sNDA was not approvable (see Note 6 of theConsolidated Financial Statements included in Part II, Item 8 of thisAnnual Report on Form 10-K). At December 31, 2005, we had$44.6 million, $5.9 million and $0.6 million of capitalized inventorycosts related to NUVIGIL, SPARLON and other pre-launch products, respectively.

We have committed to make future minimum payments tothird parties for certain raw material inventories. The minimum purchasecommitments total $86.6 million as of December 31, 2006, the majorityof which relate to modafinil and armodafinil. We expect to fully utilize thesecontracts.

*Valuationof Property and Equipment, Intangible Assets, Goodwill and Investments—**Our***property and equipment have been recorded at cost and arebeing depreciated on a straight-line basis over the estimated useful life ofthose assets.

We regularly assess our property and equipment,intangible assets, goodwill and other long lived assets to determine whetherany impairment in these assets may exist and, if so, the extent of suchimpairment. To do this, in the case of goodwill we estimate the fair value ofeach of our reporting units and compare it to the book value of their netassets. In the case of intangibles and other long lived assets, we assesswhether triggering events have occurred and if so, we compare the estimatedcash flows of the related asset group and compare it to the book value of theasset group. Calculating fair value as well as future cash flows requires thatwe make a number of critical legal, economic, market and business assumptionsthat reflect our best estimates as of the testing date. We believe the methodswe use to determine these underlying assumptions and estimates are reasonableand reflective of common practice. Notwithstanding this, our assumptions andestimates may differ significantly from actual results, or circumstances couldchange that would cause us to conclude that an impairment now exists or that wepreviously understated the extent of impairment. For additional informationregarding our significant accounting policies with respect to goodwill,intangibles and other long-lived assets, see Note 1 of our ConsolidatedFinancial Statements included in Part II, Item 8 of this Annual Report on Form 10-K.

*Incometaxes—**We* provide for income taxes inaccordance with SFAS No. 109, “Accounting for Income Taxes,” whichrequires the recognition of deferred tax assets and liabilities for theexpected tax consequences of temporary differences between the tax andfinancial reporting bases of assets and liabilities.

We provide for income taxes at a rate equal to ourestimated annual combined federal, state and foreign statutory effective rates.Subsequent adjustments to our estimates of our ability to recover the deferredtax assets or other changes in circumstances or estimates could cause ourprovision for income taxes to vary from period to period, as it has for thecurrent year ended December 31, 2006.

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Based on our profitability for the year ended December 31,2005, projected future results, and resolution of several generic challenges,during the fourth quarter of 2005 we concluded that it was likely that asignificant portion of the deferred tax assets would be realized. Therefore, weagain reversed a significant portion of the valuation allowance. At December 31,2006, we retained a valuation allowance of $78.0 million, against a totaldeferred tax asset balance of $460.0 million, composed entirely of stateand foreign net operating losses, and state tax credits. We will continue toreview and analyze the likelihood of realizing tax benefits related to deferredtax assets as there is more certainty surrounding our future levels ofprofitability related to specific company operations and the related taxingjurisdictions.

*Stock-based compensation—**Effective* January 1,2006, we adopted SFAS 123(R) using the modified prospective method, inwhich compensation cost was recognized based on the requirements of SFAS 123(R) for(a) all share-based payments granted after the effective date and (b) forall awards granted to employees prior to the effective date of SFAS 123(R)that remain unvested on the effective date. SFAS 123(R) requires theuse of judgment and estimates in performing multiple calculations. We estimatethe fair value using the Black-Scholes option-pricing model whenassessing the fair value of stock options granted. The Black-Scholesoption-pricing model requires several inputs, one of which is volatility. Thefair value of stock options is most sensitive to the volatility input. Ourestimate of volatility is based upon the historical volatility experienced inour stock price as well as the implied volatility from publicly traded stockoptions on our stock. To the extent volatility of our stock price or the optionmarket on our stock increases in the future, our estimates of the fair value ofstock options granted in the future could increase, thereby increasingstock-based compensation expense in future periods. For instance, an increase in estimated volatility of ten percentagepoints would have resulted in additional annual pre-tax stock-basedcompensation expense of approximately $3.4 million for the year ended December 31,2006. In addition, we apply anexpected forfeiture rate when amortizing stock-based compensation expense. Ourestimate of the forfeiture rate is based primarily upon historical experienceof employee turnover. To the extent we revise this estimate in the future oractual experience differs from this estimate, our stock-based compensationexpense could be materially impacted. Anestimated forfeiture rate of one percentage point lower would have resulted inan insignificant increase in stock-based compensation expense for theyear ended December 31, 2006. Ourexpected term of stock options granted was derived from the average midpointbetween vesting and the contractual term, as described in SEC’s StaffAccounting Bulletin No. 107, “*Share-BasedPayment.*” In the future, as information regarding post vestingtermination becomes more accessible, we may change our method of deriving theexpected term. This change could impact our fair value of stock options grantedin the future. We expect to refine our method of deriving expected term nolater than January 1, 2008.

**RECENT ACCOUNTINGPRONOUNCEMENTS**

In July 2006, the FASB issued FASB InterpretationNo. 48, *Accounting for Uncertainty inIncome Taxes—an interpretation of FASB Statement No. 109* (“FIN 48”). FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements. FIN 48 prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in the tax return. FIN 48 is effectivefor fiscal years beginning after December 15, 2006. We are currentlyevaluating the effect the adoption of FIN 48 will have on our 2007 consolidatedfinancial statements, but we do not expect it to be significant.

In September 2006, the FASB issued FASB StatementNo. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 clarifies the definitionof fair value, establishes a framework for measuring fair value and expands thedisclosures on fair value measurements. SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007. We are currently evaluating the impactof SFAS 157 adoption on our consolidated financial statements.

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In September 2006, the FASB issued FASB StatementNo. 158, “Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and132(R)” (“SFAS 158”). SFAS 158requires the recognition of the overfunded or underfunded status of a definedbenefit postretirement plan (other than a multiemployer plan) as an asset orliability in its statement of financial position, the measurement of a plan’sassets and its obligations that determine its funded status as of the end ofthe employer’s fiscal year and the recognition of changes in that funded statusin the year in which the changes occur through comprehensive income. We adoptedSFAS 158 effective December 31, 2006. Our retirement plans are unfundedand our unrecognized gains or losses, prior service costs or credits, andtransition assets or obligations at December 31, 2006 were notsignificant.

In September 2006, the SEC Staff issued StaffAccounting Bulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements* (“SAB 108”). SAB 108 was issued in order toeliminate the diversity of practice surrounding how public companies quantifyfinancial statement misstatements. Traditionally, there have been twowidely-recognized methods for quantifying the effects of financial statementmisstatements: the “rollover” method and the “iron curtain” method. Therollover method focuses primarily on the impact of a misstatement on the incomestatement—including the reversing effect of prior year misstatements—but itsuse can lead to the accumulation of misstatements in the balance sheet. Theiron curtain method, on the other hand, focuses primarily on the effect ofcorrecting the period-end balance sheet with less emphasis on the reversingeffects of prior year errors on the income statement.

SAB 108 is effective for any report for an interimperiod of the first fiscal year ending after November 15, 2006. We believethe adoption of this bulletin effective January 1, 2007 will have noimpact on our 2007 consolidated financial statements.

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**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to foreign currency exchange riskrelated to our operations in European subsidiaries that have transactions,assets, and liabilities denominated in foreign currencies that are translatedinto U.S. dollars for consolidated financial reporting purposes. Historically,we have not hedged any of these foreign currency exchange risks. For the yearended December 31, 2006, an average 10% weakening of the U.S. dollarrelative to the currencies in which our European subsidiaries operate wouldhave resulted in an increase of $29.1 million in reported total revenuesand a corresponding increase in reported expenses. This sensitivity analysis ofthe effects of changes in foreign currency exchange rates does not assume anychanges in the level of operations of our European subsidiaries.

Our exposure to marketrisk for a change in interest rates relates to our investment portfolio, sinceall of our outstanding debt is fixed rate. Our investments are classified asshort-term and as “available for sale.” We do not believe that short-termfluctuations in interest rates would materially affect the value of oursecurities.

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**ITEM 8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

**REPORT OFMANAGEMENT**

**Management’s Reporton Financial Statements**

Our management isresponsible for the preparation, integrity and fair presentation of informationin our consolidated financial statements, including estimates and judgments.The consolidated financial statements presented in this Annual Report on Form 10-Khave been prepared in accordance with accounting principles generally acceptedin the United States of America. Our management believes the consolidatedfinancial statements and other financial information included in this AnnualReport on Form 10-K fairly present, in all material respects, ourfinancial condition, results of operations and cash flows as of and for theperiods presented in this Annual Report on Form 10-K. Theconsolidated financial statements have been audited by PricewaterhouseCoopersLLP, an independent registered public accounting firm, as stated in theirreport, which is included herein.

**Management’s Reporton Internal Control Over Financial Reporting**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting. Our internalcontrol over financial reporting is designed to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with accountingprinciples generally accepted in the United States of America.

Our internal control over financial reporting includesthose policies and procedures that:

·       pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect our transactions and dispositions of our assets;

·       providereasonable assurance that our transactions are recorded as necessary to permitpreparation of our financial statements in accordance with accounting principlesgenerally accepted in the United States of America, and that our receipts andexpenditures are being made only in accordance with authorization of ourmanagement and our directors; and

·       providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of our assets that could have a materialeffect on the consolidated financial statements.

Because of its inherent limitations, internal controlover financial reporting can provide only reasonable assurance and may notprevent or detect misstatements. Also, projections of any evaluation of theeffectiveness of such controls in future periods are subject to the risk thatthe controls may become inadequate because of changes in conditions or that thedegree of compliance with the policies and procedures may deteriorate.

Our management conducted an assessment of theeffectiveness of internal control over financial reporting based on theframework in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission. Based on this assessment,our management concluded that, as of December 31, 2006, our internalcontrols over financial reporting were effective to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with accountingprinciples generally accepted in the United States of America.

Our management’sassessment of the effectiveness of our internal control over financialreporting has been audited by PricewaterhouseCoopers LLP, an independentregistered public accounting firm, as stated in their report which is includedherein.

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Stockholders of Cephalon, Inc.:

We have completedintegrated audits of Cephalon, Inc.’s consolidated financial statementsand of its internal control over financial reporting as of December 31,2006 in accordance with the standards of the Public Company AccountingOversight Board (United States). Our opinions, based on our audits, arepresented below.

*Consolidated financial statementsand financial statement schedule*

In our opinion, the consolidated financial statementslisted in the index appearing under Item 15(a)(1), present fairly, in allmaterial respects, the financial position of Cephalon, Inc. and itssubsidiaries at December 31, 2006 and 2005, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2006 in conformity with accounting principles generallyaccepted in the United States of America. In addition, in our opinion, thefinancial statement schedule listed in the index appearing under Item 15(a)(2),presents fairly, in all material respects, the information set forth thereinwhen read in conjunction with the related consolidated financial statements.These financial statements and the financial statement schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and the financial statement schedulebased on our audits. We conducted our audits of these statements in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit of financial statements includes examining, ona test basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

As discussed  in Note 3 to the consolidated financialsstatements, effective January 1, 2006, the Company adopted Statement ofFinancial Accounting Standards 123(R) “Share-Based Payment (revised 2004).”

*Internal control over financialreporting*

Also, in our opinion, management’s assessment,included in “Management’s Report on Internal Control Over Financial Reporting”appearing under Item 8, that the Company maintained effective internal controlover financial reporting as of December 31, 2006 based on criteriaestablished in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), is fairly stated, in all material respects, basedon those criteria. Furthermore, in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2006, based on criteria established in *InternalControl—Integrated Framework* issued by the COSO. The Company’s managementis responsible for maintaining effective internal control over financialreporting and for its assessment of the effectiveness of internal control overfinancial reporting. Our responsibility is to express opinions on management’sassessment and on the effectiveness of the Company’s internal control overfinancial reporting based on our audit. We conducted our audit of internalcontrol over financial reporting in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. An audit of internal control over financial reportingincludes obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother 

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procedures as we considernecessary in the circumstances. We believe that our audit provides a reasonablebasis for our opinions.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

/s/ PricewaterhouseCoopersLLP

Philadelphia, PAFebruary 28, 2007

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**CEPHALON, INC. ANDSUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

**(In thousands, except share data)**

| ** **                                                                                                                                               | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                               | ** ** | **2006**              | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                                               | ** ** |                  | ** ** | ** **            |       |   | ** ** | ** ** |   |
| CURRENT ASSETS:                                                                                                                                          |       |                  |       |                  |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                |       |                  | $          | 496,512               |       |   |   | $ | 205,060 |   |   |
| Investments                                                                                                                                              |       |                  | 25,212     |                  |       |   | 279,030 |   |   |
| Receivables, net                                                                                                                                         |       |                  | 270,045    |                  |       |   | 199,086 |   |   |
| Inventory, net                                                                                                                                           |       |                  | 174,300    |                  |       |   | 137,886 |   |   |
| Deferred tax assets, net                                                                                                                                 |       |                  | 184,518    |                  |       |   | 187,436 |   |   |
| Other current assets                                                                                                                                     |       |                  | 47,278     |                  |       |   | 40,339 |   |   |
| Total current assets                                                                                                                                     |       |                  | 1,197,865  |                  |       |   | 1,048,837 |   |   |
| PROPERTY AND EQUIPMENT, net                                                                                                                              |       |                  | 453,010    |                  |       |   | 323,830 |   |   |
| GOODWILL                                                                                                                                                 |       |                  | 467,167    |                  |       |   | 471,051 |   |   |
| INTANGIBLE  ASSETS, net                                                                                                                                  |       |                  | 793,037    |                  |       |   | 742,874 |   |   |
| DEFERRED TAX  ASSETS, net                                                                                                                                |       |                  | 118,192    |                  |       |   | 200,629 |   |   |
| OTHER ASSETS                                                                                                                                             |       |                  | 16,226     |                  |       |   | 31,985 |   |   |
|                                                                                                                                                     |       |                  | $          | 3,045,497             |       |   |   | $ | 2,819,206 |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                            | ** ** |                  | ** ** | ** **            |       |   | ** ** | ** ** |   |
| CURRENT LIABILITIES:                                                                                                                                     |       |                  |       |                  |       |   |   |   |   |
| Current portion of long-term debt                                                                                                                        |       |                  | $          | 1,023,312             |       |   |   | $ | 933,160 |   |   |
| Accounts payable                                                                                                                                         |       |                  | 90,586     |                  |       |   | 53,699 |   |   |
| Accrued expenses                                                                                                                                         |       |                  | 263,478    |                  |       |   | 291,744 |   |   |
| Total current liabilities                                                                                                                                |       |                  | 1,377,376  |                  |       |   | 1,278,603 |   |   |
| LONG-TERM DEBT                                                                                                                                           |       |                  | 224,992    |                  |       |   | 763,097 |   |   |
| DEFERRED TAX  LIABILITIES, net                                                                                                                           |       |                  | 72,491     |                  |       |   | 110,703 |   |   |
| OTHER LIABILITIES                                                                                                                                        |       |                  | 61,178     |                  |       |   | 54,632 |   |   |
| Total liabilities                                                                                                                                        |       |                  | 1,736,037  |                  |       |   | 2,207,035 |   |   |
| COMMITMENTS AND CONTINGENCIES (Note 13)                                                                                                                  |       |                  | —     |                  |       |   | — |   |   |
| STOCKHOLDERS’  EQUITY:                                                                                                                              |       |                  |       |                  |       |   |   |   |   |
| Preferred stock, $.01 par value, 5,000,000 shares  authorized, 2,500,000 shares issued, and none outstanding                                             |       |                  | —     |                  |       |   | — |   |   |
| Common stock, $.01 par value, 200,000,000 shares  authorized, 67,853,389 and 58,445,405 shares issued, and 65,596,227 and  58,072,562 shares outstanding |       |                  | 678        |                  |       |   | 584 |   |   |
| Additional paid-in capital                                                                                                                               |       |                  | 1,780,749  |                  |       |   | 1,166,166 |   |   |
| Treasury stock, at cost, 2,257,162 and 372,843  shares outstanding                                                                                       |       |                  | (151,068   | )                     |       |   | (17,125 | ) |   |
| Accumulated deficit                                                                                                                                      |       |                  | (425,256   | )                     |       |   | (570,072 | ) |   |
| Accumulated other comprehensive income                                                                                                                   |       |                  | 104,357    |                  |       |   | 32,618 |   |   |
| Total stockholders’ equity                                                                                                                          |       |                  | 1,309,460  |                  |       |   | 612,171 |   |   |
|                                                                                                                                                     |       |                  | $          | 3,045,497             |       |   |   | $ | 2,819,206 |   |   |

 

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

75

----

**CEPHALON, INC. ANDSUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS**

**(In thousands, except per share data)**

| ** **                                                              | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                              | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| REVENUES:                                                               |       |                                       |       |   |   |   |   |
| Sales                                                                   |       | $                                          | 1,720,172  |   | $ | 1,156,518 |   | $ | 980,375 |   |
| Other revenues                                                          |       | 43,897                                     |       | 55,374 |   | 35,050 |   |
|                                                                    |       | 1,764,069                                  |       | 1,211,892 |   | 1,015,425 |   |
| COSTS AND  EXPENSES:                                                    |       |                                       |       |   |   |   |   |
| Cost of sales                                                           |       | 257,061                                    |       | 164,223 |   | 119,973 |   |
| Research and development                                                |       | 403,367                                    |       | 354,826 |   | 273,972 |   |
| Selling, general and administrative                                     |       | 675,576                                    |       | 443,861 |   | 339,477 |   |
| Depreciation and amortization                                           |       | 116,511                                    |       | 84,305 |   | 52,798 |   |
| Impairment charges                                                      |       | 12,417                                     |       | 20,820 |   | 30,071 |   |
| Acquired in-process research and development                            |       | 5,000                                      |       | 366,815 |   | 185,700 |   |
|                                                                    |       | 1,469,932                                  |       | 1,434,850 |   | 1,001,991 |   |
| INCOME (LOSS)  FROM OPERATIONS                                          |       | 294,137                                    |       | (222,958 | ) | 13,434 |   |
| OTHER INCOME  (EXPENSE):                                                |       |                                       |       |   |   |   |   |
| Interest income                                                         |       | 25,438                                     |       | 26,171 |   | 16,486 |   |
| Interest expense                                                        |       | (18,922                                    | )          | (25,235 | ) | (22,186 | ) |
| Debt exchange expense                                                   |       | (48,122                                    | )          | — |   | (28,230 | ) |
| Write-off of deferred debt issuance costs                               |       | (13,105                                    | )          | (27,109 | ) | — |   |
| Gain (charge) on early extinguishment of debt                           |       | —                                     |       | 2,085 |   | (2,313 | ) |
| Other income (expense), net                                             |       | (1,172                                     | )          | 1,928 |   | (5,375 | ) |
|                                                                    |       | (55,883                                    | )          | (22,160 | ) | (41,618 | ) |
| INCOME (LOSS)  BEFORE INCOME TAXES                                      |       | 238,254                                    |       | (245,118 | ) | (28,184 | ) |
| INCOME TAX EXPENSE (BENEFIT)                                            |       | 93,438                                     |       | (70,164 | ) | 45,629 |   |
| NET INCOME (LOSS)                                                       |       | $                                          | 144,816    |   | $ | (174,954 | ) | $ | (73,813 | ) |
| BASIC INCOME (LOSS) PER COMMON SHARE                                    |       | $                                          | 2.39       |   | $ | (3.01 | ) | $ | (1.31 | ) |
| DILUTED INCOME (LOSS) PER COMMON SHARE                                  |       | $                                          | 2.08       |   | $ | (3.01 | ) | $ | (1.31 | ) |
| WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING                    |       | 60,507                                     |       | 58,051 |   | 56,489 |   |
| WEIGHTED AVERAGE  NUMBER OF COMMON SHARES OUTSTANDING-ASSUMING DILUTION |       | 69,672                                     |       | 58,051 |   | 56,489 |   |

 

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

76

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**CEPHALON, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands, except share data)**

| ** **                                                                              | ** ** | ** **             | ** ** | ** ** | ** ** | ** **            | ** ** | ** **  | ** ** | ** **              | ** ** | ** **      | ** ** | ** **        | ** ** | ** **  | ** ** | **Accumulated** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------|------------|------------|------------|-----------------------|------------|-------------|------------|-------------------------|------------|-----------------|------------|-------------------|------------|-------------|------------|-----------------|------------|
| ** **                                                                              | ** ** | ** **             | ** ** | ** ** | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**          | ** ** | ** **      | ** ** | ** **        | ** ** | ** **  | ** ** | **Other**       | ** ** |
| ** **                                                                              | ** ** | **Comprehensive**      | ** ** | ** ** | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Treasury Stock** | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** |
| ** **                                                                              | ** ** | **Income (Loss)** | ** ** | **Total**  | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**             | ** ** | **Shares**      | ** ** | **Amount**        | ** ** | **Deficit** | ** ** | **Income**      | ** ** |
| BALANCE, JANUARY  1, 2004                                                               |       |                   |       |       |       | $                     | 770,370    |        | 55,842,510 |                    |       | $               | 558        |              |       |        | $          | 1,052,059       |       |   | 308,828 |   | $ | (13,692 | ) |   | $ | (321,305 | ) |   |   | $ | 52,750 |   |   |
| Net loss                                                                                |       |                   | $          | (73,813    | )          |                  | (73,813    | )           |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   | (73,813 | ) |   |   |   |   |   |
| Foreign currency  translation gain                                                      |       |                   | 16,071     |       |       |                  |       |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized  investment losses                                                           |       |                   | (1,878     | )          |       |                  |       |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Other  comprehensive gain                                                               |       |                   | 14,193     |       |       | 14,193                |       |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   |   |   |   | 14,193 |   |   |
| Comprehensive loss                                                                      |       |                   | $          | (59,620    | )          |                  |       |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of common  stock upon conversion of convertible notes                          |       |                   |       |       |       | 105,122               |       | 1,518,169   |       |                    | 15         |            |       |              | 105,107    |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Tax effect upon  conversion of convertible notes                                        |       |                   |       |       |       | (10,100               | )          |        |       |                    |       |            |       |              | (10,100    | )           |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Stock options  exercised                                                                |       |                   |       |       |       | 12,051                |       | 535,446     |       |                    | 6          |            |       |              | 12,045     |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Tax benefit from  the exercise of stock options                                         |       |                   |       |       |       | 8,017                 |       |        |       |                    |       |            |       |              | 8,017      |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Restricted stock  unit awards                                                           |       |                   |       |       |       | 5,372                 |       | 76,925      |       |                    | 1          |            |       |              | 5,371      |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Treasury stock  acquired                                                                |       |                   |       |       |       | (1,168                | )          |        |       |                    |       |            |       |              |       |        |       | 23,956          |       | (1,168 | ) |   |   |   |   |   |   |   |   |
| BALANCE, DECEMBER  31, 2004                                                             |       |                   |       |       |       | 830,044               |       | 57,973,050  |       |                    | 580        |            |       |              | 1,172,499  |        |       | 332,784         |       | (14,860 | ) |   | (395,118 | ) |   |   | 66,943 |   |   |
| Net loss                                                                                |       |                   | $          | (174,954   | )          |                  | (174,954   | )           |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   | (174,954 | ) |   |   |   |   |   |
| Foreign currency  translation loss                                                      |       |                   | (33,317    | )          |       |                  |       |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized  investment losses                                                           |       |                   | (1,008     | )          |       |                  |       |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Other  comprehensive loss                                                               |       |                   | (34,325    | )          |       | (34,325               | )          |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   |   |   |   | (34,325 | ) |   |
| Comprehensive loss                                                                      |       |                   | $          | (209,279   | )          |                  |       |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   |   |   |   |   |   |   |   |
| Sale of warrants  associated with convertible subordinated notes                        |       |                   |       |       |       | 217,071               |       |        |       |                    |       |            |       |              | 217,071    |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Purchase of  convertible note hedge associated with convertible subordinated notes      |       |                   |       |       |       | (382,261              | )          |        |       |                    |       |            |       |              | (382,261   | )           |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Tax benefit from  the purchase of convertible note hedge                                |       |                   |       |       |       | 133,791               |       |        |       |                    |       |            |       |              | 133,791    |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Stock options  exercised                                                                |       |                   |       |       |       | 11,460                |       | 346,730     |       |                    | 3          |            |       |              | 11,457     |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Tax benefit from  the exercise of stock options, net of adjustment                      |       |                   |       |       |       | 2,826                 |       |        |       |                    |       |            |       |              | 2,826      |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Restricted stock  unit awards                                                           |       |                   |       |       |       | 10,784                |       | 125,625     |       |                    | 1          |            |       |              | 10,783     |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Treasury stock  acquired                                                                |       |                   |       |       |       | (2,265                | )          |        |       |                    |       |            |       |              |       |        |       | 40,059          |       | (2,265 | ) |   |   |   |   |   |   |   |   |
| BALANCE, DECEMBER  31, 2005                                                             |       |                   |       |       |       | 612,171               |       | 58,445,405  |       |                    | 584        |            |       |              | 1,166,166  |        |       | 372,843         |       | (17,125 | ) |   | (570,072 | ) |   |   | 32,618 |   |   |
| Net income                                                                              |       |                   | $          | 144,816    |       |                  | 144,816    |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   | 144,816 |   |   |   |   |   |   |
| Foreign currency  translation gain                                                      |       |                   | 70,743     |       |       |                  |       |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized  investment gains                                                            |       |                   | 996        |       |       |                  |       |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Other comprehensive  gain                                                               |       |                   | 71,739     |       |       | 71,739                |       |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   |   |   |   | 71,739 |   |   |
| Comprehensive  income                                                                   |       |                   | $          | 216,555    |       |                  |       |        |       |                    |       |            |       |              |       |        |       |            |       |   |   |   |   |   |   |   |   |   |   |   |
| Issuance of common  stock upon conversions and exchanges of convertible notes           |       |                   |       |       |       | 310,155               |       | 6,169,429   |       |                    | 62         |            |       |              | 310,093    |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Termination of  warrants and convertible note hedge upon exchanges of convertible notes |       |                   |       |       |       | —                |       |        |       |                    |       |            |       |              | 129,525    |        |       | 1,823,847       |       | (129,525 | ) |   |   |   |   |   |   |   |   |
| Tax effect of  conversions and exchanges of convertible notes                           |       |                   |       |       |       | (38,490               | )          |        |       |                    |       |            |       |              | (38,490    | )           |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Stock options  exercised                                                                |       |                   |       |       |       | 143,491               |       | 3,058,430   |       |                    | 30         |            |       |              | 143,461    |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Tax benefit from  equity compensation                                                   |       |                   |       |       |       | 27,189                |       |        |       |                    |       |            |       |              | 27,189     |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Stock-based  compensation expense                                                       |       |                   |       |       |       | 42,807                |       | 180,125     |       |                    | 2          |            |       |              | 42,805     |        |       |            |       |   |   |   |   |   |   |   |   |   |   |
| Treasury stock acquired                                                                 |       |                   |       |       |       | (4,418                | )          |        |       |                    |       |            |       |              |       |        |       | 60,472          |       | (4,418 | ) |   |   |   |   |   |   |   |   |
| BALANCE, DECEMBER  31, 2006                                                             |       |                   |       |       |       | $                     | 1,309,460  |        | 67,853,389 |                    |       | $               | 678        |              |       |        | $          | 1,780,749       |       |   | 2,257,162 |   | $ | (151,068 | ) |   | $ | (425,256 | ) |   |   | $ | 104,357 |   |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

77

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**CEPHALON, INC. ANDSUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

| ** **                                                                                                   | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                   | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                                        |       |                                       |       |   |   |   |   |
| Net income (loss)                                                                                            |       | $                                          | 144,816    |   | $ | (174,954 | ) | $ | (73,813 | ) |
| Adjustments to reconcile  net income (loss) to net cash provided by operating activities:                    |       |                                       |       |   |   |   |   |
| Deferred income  tax expense (benefit)                                                                       |       | 28,064                                     |       | (77,341 | ) | 32,997 |   |
| Tax benefit from  stock-based compensation                                                                   |       | —                                     |       | 5,826 |   | 8,017 |   |
| Debt exchange  expense                                                                                       |       | 48,122                                     |       | — |   | 28,230 |   |
| Tax effect on  conversion of convertible notes                                                               |       | —                                     |       | — |   | (10,100 | ) |
| Depreciation and  amortization                                                                               |       | 126,531                                    |       | 89,967 |   | 59,016 |   |
| Amortization of  debt issuance costs                                                                         |       | 493                                        |       | 7,301 |   | 8,275 |   |
| Write-off of debt  issuance costs associated with convertible subordinated notes                             |       | 13,105                                     |       | 27,109 |   | — |   |
| Stock-based  compensation expense                                                                            |       | 42,807                                     |       | 10,784 |   | 5,372 |   |
| Non-cash (gain)  charge on early extinguishment of debt                                                      |       | —                                     |       | (4,549 | ) | 2,313 |   |
| Pension  curtailment                                                                                         |       | —                                     |       | — |   | (4,214 | ) |
| Loss on disposals  of property and equipment                                                                 |       | 3,292                                      |       | 1,107 |   | 1,423 |   |
| Impairment charges                                                                                           |       | 12,417                                     |       | 20,820 |   | 30,071 |   |
| Acquired  in-process research and development                                                                |       | —                                     |       | 201,815 |   | 185,700 |   |
| Changes in operating  assets and liabilities, net of effect from acquisitions:                               |       |                                       |       |   |   |   |   |
| Receivables                                                                                                  |       | (63,932                                    | )          | 35,070 |   | (105,523 | ) |
| Inventory                                                                                                    |       | (21,796                                    | )          | (44,167 | ) | (16,699 | ) |
| Other assets                                                                                                 |       | 37,403                                     |       | 9,424 |   | (19,958 | ) |
| Accounts payable,  accrued expenses and deferred revenues                                                    |       | (19,764                                    | )          | 94,523 |   | 47,864 |   |
| Other liabilities                                                                                            |       | (31,641                                    | )          | (17,004 | ) | (367 | ) |
| Net cash provided  by operating activities                                                                   |       | 319,917                                    |       | 185,731 |   | 178,604 |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                        |       |                                       |       |   |   |   |   |
| Purchases of  property and equipment                                                                         |       | (159,917                                   | )          | (118,050 | ) | (50,244 | ) |
| Acquisition of  CIMA LABS, net of cash acquired                                                              |       | —                                     |       | — |   | (482,521 | ) |
| Acquisition of  Salmedix, net of cash acquired                                                               |       | —                                     |       | (130,733 | ) | — |   |
| Acquisition of  TRISENOX                                                                                     |       | —                                     |       | (69,722 | ) | — |   |
| Acquisition of  Zeneus, net of cash acquired                                                                 |       | —                                     |       | (365,786 | ) | — |   |
| Acquisition of  intangible assets                                                                            |       | (115,850                                   | )          | (33,459 | ) | (45,771 | ) |
| Sales and  maturities of investments                                                                         |       | 260,082                                    |       | 149,072 |   | 90,973 |   |
| Purchases of  investments                                                                                    |       | (4,691                                     | )          | (211,802 | ) | (197,651 | ) |
| Net cash used for  investing activities                                                                      |       | (20,376                                    | )          | (780,480 | ) | (685,214 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                        |       |                                       |       |   |   |   |   |
| Proceeds from  exercises of common stock options                                                             |       | 143,491                                    |       | 11,460 |   | 12,051 |   |
| Windfall tax  benefits from stock-based compensation                                                         |       | 27,189                                     |       | — |   | — |   |
| Acquisition of  treasury stock                                                                               |       | (4,418                                     | )          | (2,265 | ) | (1,168 | ) |
| Payments on and  retirements of long-term debt                                                               |       | (188,886                                   | )          | (504,113 | ) | (51,905 | ) |
| Net proceeds from  issuance of convertible subordinated notes                                                |       | —                                     |       | 891,949 |   | — |   |
| Proceeds from sale  of warrants                                                                              |       | —                                     |       | 217,071 |   | — |   |
| Purchase of  convertible note hedge                                                                          |       | —                                     |       | (382,261 | ) | — |   |
| Net cash provided  by (used for) financing activities                                                        |       | (22,624                                    | )          | 231,841 |   | (41,022 | ) |
| EFFECT OF EXCHANGE  RATE CHANGES ON CASH AND CASH EQUIVALENTS                                                |       | 14,535                                     |       | (6,276 | ) | 6,177 |   |
| NET INCREASE  (DECREASE) IN CASH AND CASH EQUIVALENTS                                                        |       | 291,452                                    |       | (369,184 | ) | (541,455 | ) |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF YEAR                                                                |       | 205,060                                    |       | 574,244 |   | 1,115,699 |   |
| CASH AND CASH  EQUIVALENTS, END OF YEAR                                                                      |       | $                                          | 496,512    |   | $ | 205,060 |   | $ | 574,244 |   |
| Supplemental disclosures of cash flow information:                                                           |       |                                       |       |   |   |   |   |
| Cash payments for  interest, net of capitalized interest                                                     |       | $                                          | 20,272     |   | $ | 16,595 |   | $ | 16,588 |   |
| Cash payments for  income taxes                                                                              |       | 36,954                                     |       | 15,963 |   | 24,182 |   |
| Non-cash investing and financing activities:                                                                 |       |                                       |       |   |   |   |   |
| Capital lease  additions                                                                                     |       | 2,134                                      |       | 2,303 |   | 2,337 |   |
| Tax benefit from  the purchase of convertible note hedge                                                     |       | —                                     |       | 133,791 |   | — |   |
| Acquisition of  treasury stock associated with termination of convertible note hedge and  warrant agreements |       | 129,525                                    |       | — |   | — |   |
| Exchange/conversion  of convertible notes into common stock, net of debt exchange expense                    |       | 262,033                                    |       | — |   | 78,250 |   |

 

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

78

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**1.   NATUREOF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

**Business**

Cephalon is aninternational biopharmaceutical company dedicated to the discovery, developmentand marketing of innovative products in four core therapeutic areas: centralnervous system (“CNS”) disorders, pain, cancer and addiction. In addition toconducting an active research and development program, we market six productsin the United States and numerous products in various countries throughoutEurope.

**Use of Estimates**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires us to make estimates and assumptionsthat affect the reported amounts of assets, liabilities, revenues, andexpenses, and related disclosure of assets and liabilities. Actual results maydiffer from those estimates.

**Principles ofConsolidation**

The consolidated financialstatements include the results of our operations and our wholly-ownedsubsidiaries. All significant intercompany accounts and transactions have beeneliminated. We completed the acquisitions of issued share capital of ZeneusHoldings Limited and its wholly-owned subsidiaries on December 22,2005, substantially all assets related to the TRISENOX injection business fromCell Therapeutics, Inc. and CTI Technologies, Inc., a wholly-ownedsubsidiary of CTI on July 18, 2005, outstanding capital stock of Salmedix, Inc.on June 14, 2005 and the outstanding shares of capital stock of CIMALABS INC. on August 12, 2004. These acquisitions have been accountedfor either as business combinations or asset purchases.

**Foreign Currency**

For foreign operating entities with currencies otherthan the U.S. Dollar, the local currency is the functional currency. Wetranslate asset and liability balances at exchange rates in effect at the endof the period and income and expense transactions at the average exchange ratesin effect during the period. Resulting translation adjustments are reported asa separate component of accumulated other comprehensive income included instockholders’ equity. Gains and losses from foreign currency transactions areincluded in the consolidated statements of operations.

Statement of FinancialAccounting Standards (“SFAS”) No. 95, “Statement of Cash Flows” requiresthat the effect of exchange rate changes on cash held in foreign currencies bereported as a separate item in the reconciliation of beginning and ending cashand cash equivalents. All other foreign currency cash flows are reported in theapplicable line of the consolidated statement of cash flows using anapproximation of the exchange rate in effect at the time of the cash flows.

**Cash Equivalentsand Investments**

Cash equivalents includeinvestments in liquid securities with original maturities of three months orless from the date of purchase. In accordance with SFAS No. 115, “Accountingfor Certain Investments in Debt and Equity Securities,” we consider ourinvestments to be “available for sale.” We classify these 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**1.**   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

investmentsas short-term and carry them at fair market value. Unrealized gains and losseshave been recorded as a separate component of accumulated other comprehensiveincome included in stockholders’ equity. All realized gains and losses on ouravailable for sale securities are recognized in results of operations.

**Major U.S.Customers and Concentration of Credit Risk**

Ourtwo most significant products, PROVIGIL® (modafinil) Tablets [C-IV] and ACTIQ®(oral transmucosal fentanyl citrate) [C-II], comprised the following: 

| ** **     | ** ** | **% of total consolidated  net sales** | ** ** | **% of net sales in  U.S. market** | ** ** |
|----------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **     | ** ** | **Year Ended  December 31,**                     | ** ** | **Year Ended  December 31,**                      | ** ** |
| ** **     | ** ** | **2006**                                                   | ** ** | **2005**                                                    | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| PROVIGIL sales |       |                                                       | 43         | %                                                           |       |   | 44 | % |   |   | 45 | % |   |   | 94 | % |   |   | 93 | % |   |   | 92 | % |   |
| ACTIQ sales    |       |                                                       | 34         | %                                                           |       |   | 36 | % |   |   | 35 | % |   |   | 95 | % |   |   | 96 | % |   |   | 98 | % |   |

 

In theUnited States, we sell our products primarily to a limited number ofpharmaceutical wholesalers without requiring collateral. We periodically assessthe financial strength of these customers and establish allowances foranticipated losses, if necessary.

| ** **                    | ** ** | **% of total trade  accounts receivable** | ** ** | **% of total consolidated  gross sales** | ** ** |
|-------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                    | ** ** | **At December 31,**                                 | ** ** | **Year Ended  December 31,**                       | ** ** |
| ** **                    | ** ** | **2006**                                                      | ** ** | **2005**                                                     | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Major U.S. customers:         |       |                                                          |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| AmerisourceBergen Corporation |       |                                                          | 8          | %                                                            |       |   | 10 | % |   |   | 14 | % |   |   | 15 | % |   |   | 17 | % |   |   | 18 | % |   |
| Cardinal Health, Inc.    |       |                                                          | 17         | %                                                            |       |   | 33 | % |   |   | 31 | % |   |   | 30 | % |   |   | 32 | % |   |   | 33 | % |   |
| McKesson Corporation          |       |                                                          | 15         | %                                                            |       |   | 12 | % |   |   | 35 | % |   |   | 26 | % |   |   | 26 | % |   |   | 28 | % |   |
| Total                         |       |                                                          | 40         | %                                                            |       |   | 55 | % |   |   | 80 | % |   |   | 71 | % |   |   | 75 | % |   |   | 79 | % |   |

 

At December 31, 2006,trade accounts receivable of our major U.S. customers as a percentage of totaltrade accounts receivable of 40% decreased as compared to 55% at December 31,2005. This decrease is primarily attributable to growth of our Europeanbusiness and Watson trade accounts receivable related to our generic version ofACTIQ (“generic OTFC”) sales. For a summary of accounts receivable, seeNote 5 herein.

**Inventory**

Inventory is stated at the lower of cost or marketvalue. Our domestic inventories and certain of our foreign inventories arevalued using the last-in, first-out (“LIFO”) method. The majority of ourforeign inventories are valued using the first-in, first-out (“FIFO”) method.See Note 6 herein.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**1.**   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued)

We expense pre-launchinventory unless it is probable that the inventory will be saleable. Wecapitalize inventory costs associated with marketed products and certainproducts prior to regulatory approval and product launch, based on management’sjudgment of probable future commercial use and net realizable value. We couldbe required to expense previously capitalized costs related to pre-approval orpre-launch inventory upon a change in such judgment, due to a denial or delayof approval by regulatory bodies, a delay in commercialization, or otherpotential factors. See Note 6 herein.

**Property andEquipment**

Property and equipment are recorded at cost anddepreciated using the straight-line method over the estimated useful lives ofthe assets, which range from three to 40 years. Property and equipment undercapital leases are depreciated or amortized over the shorter of the lease termor the expected useful life of the assets. Expenditures for maintenance andrepairs are charged to expense as incurred, while major renewals andbetterments are capitalized.

We capitalize interest inconnection with the construction of plant and equipment.

**Fair Value ofFinancial Instruments**

The carrying values ofcash, cash equivalents, short-term investments, accounts receivable, accountspayable and accrued expenses approximate the respective fair values. The marketvalue of our 2.0% convertible senior subordinated notes was $1.4 billionas compared to a carrying value of $820.0 million and the market value ofour Zero Coupon convertible subordinated notes was $529.1 million ascompared to a carrying value of $413.5 million, at December 31, 2006,based on quoted market values. The majority of our other debt instruments thatwere outstanding as of December 31, 2006 do not have readily ascertainablemarket values; however, management believes that the carrying valuesapproximate the respective fair values.

**Goodwill,Intangible Assets and Other Long-Lived Assets**

Goodwill represents the excess of purchase price overnet assets acquired. In accordance with SFAS No. 142, “Goodwill and OtherIntangible Assets,” (“SFAS 142”) goodwill is not amortized; rather, it issubject to a periodic assessment for impairment by applying a fair-value-basedtest. We perform our annual test of impairment of goodwill as of July 1.At December 31, 2006, we had $267.9 million of goodwill in our UnitedStates segment and $199.3 million in our Europe segment. We completed ourannual test of impairment of goodwill in each segment at July 1, 2006 andconcluded that goodwill was not impaired.

In accordance with SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets,” we reviewamortizable assets for impairment on a quarterly basis or whenever changes incircumstances indicate the carrying value of the asset may not be recoverable.If impairment is indicated, we measure the amount of such impairment bycomparing the carrying value of the assets to the present value of the expectedfuture cash flows associated with the use of the asset.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**1.**   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued)

**Revenue Recognition**

In the United States, we sell our products topharmaceutical wholesalers, the largest three of which account for 71% of ourtotal consolidated gross sales for the year ended December 31, 2006.Decisions made by these wholesalers regarding the levels of inventory they hold(and thus the amount of product they purchase from us) can materially affectthe level of our sales in any particular period and thus may not correlate tothe number of prescriptions written for our products as reported by IMS HealthIncorporated. We believe that speculative buying of product, particularly inanticipation of possible price increases, has been the historic practice ofmany pharmaceutical wholesalers. In past years, we attempted to minimize thesefluctuations both by providing, from time to time, discounts to our customersto stock normal amounts of inventory (which we had historically defined asapproximately one month’s supply at our current sales level) and by cancelingorders if we believe a particular customer is speculatively buying inventory inanticipation of possible price increases.

Over the past two years, our wholesaler customers, aswell as others in the industry, began modifying their business models fromarrangements where they derive profits from the management of various discountsand rebates, to arrangements where they charge a fee for their services. Inconnection with this new wholesaler business model, we finalized distributionservice agreements in the third quarter of 2005 with our major wholesalercustomers. These agreements obligate the wholesalers to provide us withperiodic retail demand information and current inventory levels for ourproducts held at their warehouse locations; additionally, the wholesalers haveagreed to manage the variability of their purchases and inventory levels withinspecified limits based on product demand.

As of December 31, 2006, we received informationfrom substantially all of our U.S. wholesaler customers about the levels ofinventory they held for our U.S. branded products. Based on this information,which we have not independently verified, we believe that total inventory heldat these wholesalers is approximately two weeks supply of our U.S. brandedproducts at our current sales levels. During the fourth quarter of 2006, weshipped launch quantities of our generic OTFC. At December 31, 2006, webelieve that generic OTFC inventory held at wholesalers and retailers isapproximately two to three months.

Product sales are recognized upon the transfer ofownership and risk of loss for the product to the customer. In the UnitedStates, we sell all commercial products F.O.B. shipping point. Transfer ofownership and risk of loss for the product pass to the customer at the pointthat the product is picked up by a common carrier for shipment to the customer.In Europe, product sales are recognized predominantly upon customer receipt ofthe product except in certain contractual arrangements where different termsmay be specified. We record product sales net of estimated reserves forcontractual allowances, discounts and returns. Contractual allowances resultfrom sales under contracts with managed care organizations and governmentagencies.

Other revenue, which includes revenues fromcollaborative agreements, consists primarily of up-front fees, ongoing researchand development funding, milestone payments and payments under co-promotionalor managed services agreements. Non-refundable up-front fees are deferred andamortized to revenue over the related performance period. We estimate ourperformance period based on the specific terms of 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**1.**   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued)

each collaborativeagreement. We adjust the performance periods, if appropriate, based uponavailable facts and circumstances. We recognize periodic payments over theperiod that we perform the related activities under the terms of theagreements. Revenue resulting from the achievement of milestone eventsstipulated in the agreements is recognized when the milestone is achieved.Milestones are based upon the occurrence of a substantive element specified inthe contract or as a measure of substantive progress towards completion underthe contract. In connection with these collaborations, we also incur costs thatare reflected in our operating expenses. For the years ended December 31,2006, 2005 and 2004, the amounts approximated $14.0 million,$33.6 million and $27.9 million, respectively.

Payments under co-promotional or managed servicesagreements are recognized when the products are sold or the promotionalactivities are performed. The portion of the payments that representsreimbursement of our expenses is recognized as an offset to those expenses inour statement of income.

We recognize revenue on new product launches whensales returns can be reasonably estimated and all other revenue recognitionrequirements have been met. When determining if returns can be estimated, weconsider actual returns of similar products as well as sales returns withsimilar customers. In cases in which a new product is not an extension of anexisting line of product or where we have no history of experience withproducts in a similar therapeutic category such that we can not estimateexpected returns of the new product, we defer recognition of revenue until theright of return no longer exists or until we have developed sufficienthistorical experience to estimate sales returns. In developing estimates forsales returns, we consider inventory levels in the distribution channel, shelflife of the product and expected demand based on market data and prescriptions.

On September 27, 2006, welaunched generic OTFC, utilizing WatsonPharmaceuticals, Inc. as our salesagent in this effort. We pay our sales agent a commission for theseservices and record this commission as SG&A expense. In October 2006, we launched FENTORA. Salesof our generic OTFC product to wholesalers and retailers include both the rightof return of expired product and retroactive price reductions under certainconditions, while sales of FENTORA also include the right of return of expiredproduct. Based on the sales levels and the prescription data during the fourthquarter of 2006, and based on the number of units on hand in the pipeline at December 31,2006 relative to the overall demand for the products, we have estimated andrecorded all applicable product sales allowances related to generic OTFC andFENTORA as of December 31, 2006. We have therefore recognized revenues forgeneric OTFC and FENTORA based on a fixed and determinable sales price in 2006.

Sales of our generic OTFCproduct could be subject to retroactive price reductions for units that remainin the pipeline if the price of generic OTFC is reduced, including as a resultof another generic entrant into the market, and as a result any estimatedimpact of such adjustments is recorded at the time revenue is recognized. Thisestimate of both the potential timing of a generic entrant and the amount ofthe price reduction are highly subjective. At December 31, 2006, we arenot aware of any expected additional entrants into the generic OTFC market thatwould result in a price reduction to customers for inventory already purchasedfrom us, and do not believe that any revenue recognized as of December 31,2006 would be effected by a retroactive shelf stock adjustment.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**1.**   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued)

**Research andDevelopment**

All research anddevelopment costs are charged to expense as incurred.

**Acquired In-ProcessResearch and Development**

Acquired in-process research and development (“IPR&D”)represents the estimated fair value assigned to research and developmentprojects acquired in a purchase business combination that have not beencompleted at the date of acquisition and which have no future alternative use.Accordingly, these costs are charged to expense as of the acquisition date.

The value assigned to IPR&D is determined byestimating the costs to develop the acquired technology into commerciallyviable products, estimating the resulting net cash flows from the projects anddiscounting the net cash flows to their present value. The revenue projectionsused to value IPR&D were, in some cases, reduced based on the probabilityof developing a new drug, and considered the relevant market sizes and growthfactors, expected trends in technology, and the nature and expected timing ofnew product introductions by us and our competitors. The resulting net cashflows from such projects are based on management’s estimates of cost of sales,operating expenses and income taxes from such projects. The rates utilized todiscount the net cash flows to their present value were based on estimated costof capital calculations.

If these projects are notsuccessfully developed, the sales and profitability of the combined company maybe adversely affected in future periods. Additionally, the value of otheracquired intangible assets may become impaired. We believed that the foregoingassumptions used in the IPR&D analysis were reasonable at the time of theacquisition. No assurance can be given, however, that the underlyingassumptions used to estimate expected project sales, development costs orprofitability or the events associated with such projects, will transpire asestimated.

**Other ComprehensiveIncome**

We follow SFAS No. 130, “Reporting ComprehensiveIncome.” This statement requires the classification of items of othercomprehensive income by their nature and disclosure of the accumulated balanceof other comprehensive income, separately within the equity section of thebalance sheet. Comprehensive income is comprised of net earnings and othercomprehensive income, which includes certain changes in equity that areexcluded from net earnings, such as translation adjustments and unrealizedholding gains and losses on available for sale securities.

Thecomponents of accumulated other comprehensive income, net of taxes, at December 31,2006 and 2005 were as follows:

|                                                                 | ** ** | **Year Ended  December 31,** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Foreign currency  translation gain                              |       | $                                      | 104,369    |   | $ | 33,626 |   |
| Unrealized  investment losses on available for sale  securities |       | (12                                    | )          | (1,008 | ) |
| Other comprehensive gain                                        |       | $                                      | 104,357    |   | $ | 32,618 |   |

 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**1.**   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued)

**Stock-BasedCompensation**

Prior to the January 1,2006 adoption of Financial Accounting Standards Board (“FASB”) Statement No. 123(R),“Share Based Payment” (“SFAS 123(R)”), we accounted for stock option plans andrestricted stock unit plans in accordance with Accounting Principles BoardOpinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” (“APB25”). Accordingly, no compensation expense has been recognized for stockoptions since all stock options granted had an exercise price equal to themarket value of the underlying stock on the grant date. Restricted stock unitshave been recorded as compensation cost over the requisite vesting periodsbased on the market value on the date of grant. As permitted by SFAS No. 123,“Accounting for Stock-Based Compensation (“SFAS 123”), stock-based compensationwas presented as a pro forma disclosure in the notes to the consolidatedfinancial statements. See also Note 3of the Consolidated Financial Statements included in Part II, Item 8 ofthis Annual Report on Form 10-K.

**Income Taxes**

We account for income taxesusing the liability method under SFAS No. 109, “Accounting for IncomeTaxes” (“SFAS 109”). This method generally provides that deferred tax assetsand liabilities be recognized for temporary differences between the financialreporting basis and the tax basis of the assets and liabilities and expectedbenefits of utilizing net operating loss and tax credit carryforwards. Werecord a valuation allowance for certain temporary differences for which it ismore likely than not that we will not generate future tax benefits. The impacton deferred taxes of changes in tax rates and laws, if any, are applied to theyears during which temporary differences are expected to be settled andreflected in the consolidated financial statements in the period of enactment.

**Reclassifications**

Certain reclassificationsof prior year amounts have been made to conform to the current yearpresentation.

**Recent AccountingPronouncements**

In July 2006, the FASB issued FASB InterpretationNo. 48, *Accounting for Uncertainty inIncome Taxes—an interpretation of FASB Statement No. 109* (“FIN 48”). FIN 48 clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements. FIN 48 prescribes a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in the tax return. FIN 48 is effectivefor fiscal years beginning after December 15, 2006. We are currentlyevaluating the effect the adoption of FIN 48 will have on our 2007 consolidatedfinancial statements, but we do not expect it to be significant.

In September 2006, the FASB issued FASB StatementNo. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 clarifies the definition of fair value, establishes aframework for measuring fair value and expands the disclosures on fair valuemeasurements. SFAS 157 is effective for fiscal years beginning after November 15,2007. We are currently evaluating the impact of SFAS 157 adoption on ourconsolidated financial statements.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**1.**   NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(Continued)

In September 2006,the FASB issued FASB Statement No. 158, “Employers’ Accounting for DefinedBenefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87,88, 106, and 132(R)” (“SFAS 158”). SFAS158 requires the recognition of the overfunded or underfunded status of adefined benefit postretirement plan (other than a multiemployer plan) as anasset or liability in its statement of financial position, the measurement of aplan’s assets and its obligations that determine its funded status as of theend of the employer’s fiscal year and the recognition of changes in that fundedstatus in the year in which the changes occur through comprehensive income. Weadopted SFAS 158 effective December 31, 2006. Our retirement plans areunfunded and our unrecognized gains or losses, prior service costs or credits,and transition assets or obligations at December 31, 2006 were notsignificant.

In September 2006, theSecurities and Exchange Commission (the “SEC”) Staff issued Staff AccountingBulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements* (“SAB 108”). SAB 108 was issued in order toeliminate the diversity of practice surrounding how public companies quantifyfinancial statement misstatements. Traditionally, there have been twowidely-recognized methods for quantifying the effects of financial statementmisstatements: the “rollover” method and the “iron curtain” method. Therollover method focuses primarily on the impact of a misstatement on the incomestatement—including the reversing effect of prior year misstatements—but itsuse can lead to the accumulation of misstatements in the balance sheet. Theiron curtain method, on the other hand, focuses primarily on the effect ofcorrecting the period-end balance sheet with less emphasis on the reversingeffects of prior year errors on the income statement.

SAB 108 is effective forany report for an interim period of the first fiscal year ending afterNovember 15, 2006. We believe the adoption of this bulletin effectiveJanuary 1, 2007 will have no impact on our 2007 consolidated financialstatements.

**2.   ACQUISITIONS AND TRANSACTIONS**

**CIMA LABS INC.**

On August 12, 2004,we completed our acquisition of CIMA LABS. Under the Agreement and Plan ofMerger dated November 3, 2003, we acquired each outstanding share of CIMALABS common stock for $34.00 per share in cash. The total cash paid to CIMALABS stockholders in the transaction was approximately $482.5 million, netof CIMA LABS’ existing cash on hand, or $409.4 million, net of its cash,cash equivalents and investments. As a result of the acquisition, we obtainedthe rights to CIMA LABS’ fentanyl buccal tablet product candidate. In lateSeptember 2006, we received FDA approval of this proprietary pain product,FENTORATM (fentanyl buccal tablet) [C-II], and launched the product in theUnited States in early October. FENTORA is indicated for the management ofbreakthrough pain in patients with cancer who are already receiving and aretolerant to opioid therapy for their underlying persistent cancer pain.

The total purchase priceof $514.1 million consists of $500.1 million for all outstandingshares of CIMA LABS at $34.00 per share and $14.0 million in directtransaction costs. The acquisition was funded from Cephalon’s existing cash andshort-term investments. In connection with the acquisition, CIMA LABS used $18.8 millionof their own funds to purchase all outstanding employee stock options, whetheror not vested or exercisable, for an amount equal to $34.00 less the exerciseprice for such option.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**2.**   ACQUISITIONSAND TRANSACTIONS (Continued)

Thefollowing table summarizes the estimated fair values of assets acquired andliabilities assumed at the date of acquisition:

| ** **                                   | ** ** | **At August 12,  2004** | ** ** |
|----------------------------------------------|------------|-----------------------------------|------------|
| Cash and cash equivalents                    |       |                              | $          | 31,604 |   |   |
| Available-for-sale investments               |       |                              | 73,169     |   |   |
| Receivables                                  |       |                              | 8,821      |   |   |
| Inventory                                    |       |                              | 6,224      |   |   |
| Deferred tax asset, net                      |       |                              | 20,985     |   |   |
| Other current assets                         |       |                              | 555        |   |   |
| Property, plant and equipment                |       |                              | 82,474     |   |   |
| Intangible assets                            |       |                              | 113,100    |   |   |
| Acquired in-process research and development |       |                              | 185,700    |   |   |
| Goodwill                                     |       |                              | 68,843     |   |   |
| Total assets acquired                        |       |                              | 591,475    |   |   |
| Current liabilities                          |       |                              | (32,783    | ) |   |
| Deferred tax liability                       |       |                              | (44,567    | ) |   |
| Total liabilities assumed                    |       |                              | (77,350    | ) |   |
| Net assets acquired                          |       |                              | $          | 514,125 |   |   |

 

Of the $113.1 million of acquired intangibleassets, $70.0 million was assigned to the DURASOLV® technology with anestimated useful life of 14 years, $32.7 million was assigned to theORASOLV® technology with a weighted average estimated useful life ofapproximately 6 years, and $10.4 million was assigned to thedeveloped OraVescent® technology with an estimated useful life of15 years. During the fourth quarter of 2005, goodwill was reduced by$9.0 million as a result of a reassessment of the realizability of certaindeferred tax assets.

Our purchase price allocation was finalized during2005. We allocated $185.7 million of the purchase price to IPR&Dprojects. At the acquisition date, CIMA LABS’ ongoing research and developmentinitiatives were primarily involved with the development and commencement ofPhase 3 clinical trials of FEBT (at a total cost of approximately$5.6 million), and several other minor ongoing research and developmentprojects. As of the year ended December 31, 2005, we spent an additional$17.3 million on the FEBT project and do not expect to incur significantadditional charges to complete this project. The estimated revenues for thein-process projects, including FEBT, are expected to be recognized from 2006through 2019. A discount rate of 28 percent was used to value the project.We believe that this discount rate was commensurate with the project stage ofdevelopment and the uncertainties in the economic estimates described above. Atthe date of acquisition, the development of these projects had not yet reachedtechnological feasibility, and the research and development in progress had noalternative future uses. Accordingly, these costs in the amount of$185.7 million were charged to expense in the third quarter of 2004.

The results of operationsfor CIMA LABS have been included in our consolidated statements since theacquisition date of August 12, 2004.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**2.**   ACQUISITIONS AND TRANSACTIONS (Continued)

**SALMEDIX, INC.**

On June 14, 2005, wecompleted our acquisition of Salmedix. Under the Agreement and Plan of Mergerdated May 12, 2005, we acquired all of the outstanding capital stock ofSalmedix for $160.9 million in cash and future payments totaling up to$40 million upon achievement of certain regulatory milestones. Theacquisition was funded from our existing cash on hand and was accounted for asan asset acquisition, as Salmedix is a development stage company. As a resultof the acquisition, we obtained the rights to market TREANDAÔ(bendamustine hydrochloride) for which we are conducting a Phase 3clinical trials in the United States and Canada for the treatment of indolent(slowly progressing) non-Hodgkin’s lymphoma (“NHL”), a type of hematologicmalignancy. Of the purchase price, $30.8 million has been allocated to thefair value of the tangible net assets and liabilities as of the acquisitiondate, with the remaining purchase price of $130.1 million allocated toIPR&D relating primarily to TREANDA. Upon acquisition, we recognized a netdeferred tax asset of $4.3 million relating to the U.S. federal and statenet operating losses and tax credits acquired from Salmedix. In the fourthquarter of 2005, we reversed a portion of the previously recorded valuationallowance as we believe it is more likely than not that the related deferredtax assets will be recovered. The results of operations for Salmedix have beenincluded in our consolidated financial statements as of the acquisition date.

**VIVITROL LICENSEAND COLLABORATION**

In June 2005, we entered into a license andcollaboration agreement with Alkermes, Inc. to develop and commercializeVIVITROL® (naltrexone for extended-release injectable suspension) in theUnited States. In April 2006, the FDA approved VIVITROL for the treatmentof alcohol dependent patients who are able to abstain from drinking in anoutpatient setting and are not actively drinking when initiating treatment and,in June 2006, we launched the product.

Concurrent with the execution of this agreement, weentered into a supply agreement under which Alkermes provides to us finishedcommercial supplies of VIVITROL. We made an initial payment of$160 million cash to Alkermes upon execution of this agreement, all ofwhich was recorded as IPR&D as the product had not yet received FDAapproval. In April 2006, we made an additional cash payment of$110 million to Alkermes upon FDA approval of the product. This paymenthas been capitalized and is being amortized over the life of the agreement.Alkermes also could receive up to an additional $220 million in milestonepayments that are contingent on attainmentof certain agreed-upon sales levels of VIVITROL.

We have formed a joint commercialization team with Alkermes,and the parties share responsibility for developing the commercial strategy forVIVITROL. We have primary responsibility for all marketing and sale efforts andcurrently have approximately 135 persons focused on the marketing and sale ofVIVITROL; Alkermes is augmenting this effort with a team of 28 managers ofmarket development. Alkermes also is responsible for manufacturing the supplyof VIVITROL. Until December 31, 2007, Alkermes is responsible for anycumulative losses up to $120 million and we are responsible for anycumulative losses in excess of $120 million. Pre-tax profit, as adjustedfor certain items, and losses incurred after December 31, 2007 will besplit equally between the parties. We began recognizing revenue for VIVITROLeffective in the third quarter of 2006.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**2.**   ACQUISITIONS AND TRANSACTIONS (Continued)

In October 2006, weamended the existing license and collaboration agreement with Alkermes toprovide that we would be responsible for our own VIVITROL-related costs duringthe period August 1, 2006 through December 31, 2006 and, for thatperiod, such costs will not be chargeable to the collaboration and against the$120 million cumulative loss cap. The parties also agreed to amend the existingsupply agreement to provide that we will purchase from Alkermes two VIVITROLmanufacturing lines (and related equipment). At December 31, 2006, weincurred approximately $25.4 million related to the construction of these twomanufacturing lines. We expect to incur up to an additional $45.6 million forcertain future capital improvements related to these two manufacturing lines. Wealso have granted Alkermes an option, exercisable after two years, to purchasethese manufacturing lines at the then-current net book value of the assets.

**TRISENOX**

On July 18, 2005, we completed the acquisition ofsubstantially all assets related to the TRISENOX® (arsenic trioxide) injectionbusiness from CTI for $69.7 million in cash, funded from our existing cashon hand. The acquisition agreement provides for contingent future cash paymentsto CTI, totaling up to $100.0 million, upon the achievement of certainlabel expansion and sales milestones. TRISENOX is indicated as a single agentfor the treatment of patients with relapsed or refractory acute promyelocyticleukemia (“APL”), a life-threatening hematologic cancer. The results ofoperations of TRISENOX have been included in the consolidated statements ofoperations since the acquisition date.

The acquisition of the assets related to the TRISENOXbusiness has been accounted for as a business combination. At the date ofacquisition, the fair value of assets and liabilities acquired equaled$114.0 million, consisting of $0.7 million of net working capital,$113.0 million of intangible assets, $0.5 million of IPR&D (whichwas expensed in the third quarter of 2005), net deferred tax assets of$15.6 million and deferred tax liabilities of $15.8 million. Wefinalized our purchase price allocation during the fourth quarter of 2005.

The fair value of acquired net assets exceeded thecost by $42.4 million. Because the acquisition agreement provides forcontingent consideration up to $100 million, the $42.4 million excessof fair value of acquired net assets over cost has been recognized as aliability at the date of acquisition in accordance with SFAS No. 141,“Business Combinations.” When the contingencies are resolved, any contingentconsideration amounts paid will reduce this liability. Any excess of thecontingent payments over this liability will be recognized as an additionalcost of the TRISENOX acquisition. Any excess of this liability over thecontingent payments will reduce the recognized value of the acquired net assetson a pro rata basis.

All of the intangibleassets acquired relate to the developed TRISENOX technology with estimateduseful lives between eight and 13 years.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**2.**   ACQUISITIONSAND TRANSACTIONS (Continued)

**ZENEUS HOLDINGSLIMITED**

On December 22, 2005, we completed ouracquisition of all of the issued share capital of Zeneus. Total considerationpaid in connection with the acquisition was $365.8 million. Total purchaseprice after transaction costs and other working capital adjustments was$385.6 million, which included payment for $19.8 million of cashacquired. Zeneus has three key products that are currently marketed in majorEuropean countries: MYOCET® (liposomal doxorubicin), a cardio-protectivechemotherapy agent used to treat late-stage breast cancer; ABELCET®(amphotericin B lipid complex), an anti-fungal product used bycancer patients; and TARGRETIN® (bexarotene), a treatment for cutaneous T-celllymphoma. Key customer targets are oncologists, hematologists anddermatologists.

The total purchase price of $385.6 millionconsists of $375.5 million for all the outstanding shares of Zeneus and$10.1 million paid for transaction costs and the settlement of other sellerrelated liabilities. The acquisition was funded from our existing cash andshort-term investments.

Thefollowing table summarizes the estimated fair values of assets acquired andliabilities assumed at the date of acquisition:

| ** **                                   | ** ** | **At December 22,** | ** ** |
|----------------------------------------------|------------|-------------------------------|------------|
| ** **                                   | ** ** | **2005**                      | ** ** |
| Cash and cash equivalents                    |       |                          | $          | 19,792 |   |   |
| Receivables                                  |       |                          | 29,577     |   |   |
| Inventory                                    |       |                          | 12,085     |   |   |
| Other current assets                         |       |                          | 6,316      |   |   |
| Property, plant and equipment                |       |                          | 1,319      |   |   |
| Intangible assets                            |       |                          | 224,100    |   |   |
| Acquired in-process research and development |       |                          | 71,200     |   |   |
| Goodwill                                     |       |                          | 91,003     |   |   |
| Total assets acquired                        |       |                          | 455,392    |   |   |
| Other liabilities                            |       |                          | (27,588    | ) |   |
| Deferred tax liability                       |       |                          | (42,226    | ) |   |
| Total liabilities assumed                    |       |                          | (69,814    | ) |   |
| Net assets acquired                          |       |                          | $          | 385,578 |   |   |

 

Of the $236.3 million of acquired intangibleassets, $182.5 million was assigned to the MYOCET-related technologywith an estimated useful life of 20 years, $26.1 million was assignedto ABELCET-related technology with an estimated useful life ofapproximately 20 years, $8.6 million was assigned to the TARGRETINtechnology with an estimated useful life of 9 years and $19.1 was assignedto non core products with an average estimated useful life of 20 years.All of the $114.6 million of goodwill was assigned to our Europe segmentand none of this goodwill is expected to be deductible for income tax purposes.

We allocated $71.2 million of the purchase priceto an IPR&D project related to MYOCET for use in the U.S. market. MYOCEThas not been approved by the FDA in the U.S., thus the estimated value of $71.2 millionrelating to the U.S. MYOCET technology is considered IPR&D. At theacquisition date, 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**2.**   ACQUISITIONS AND TRANSACTIONS (Continued)

Zeneus had several earlystage projects that were not assigned any value based on Management’s view ofthe likelihood of positive outcomes. The estimated revenue for the in-processproject is expected to be recognized from 2008 through 2025. A discount rate of16 percent was used to value the project. We believe that this discountrate was commensurate with the project stage of development and theuncertainties in the economic estimates described above. See Note 1 hereinfor a description of our policy as it relates to IPR&D.

At the date of acquisition, the project had not yetreached commercialization and the development in progress had no alternativefuture uses. Accordingly, these costs in the amount of $71.2 million werecharged to expense in the fourth quarter of 2005. Our remaining costs tocomplete this project are expected to be minimal.

The purchase price allocation was finalized during thethird quarter of 2006. During the second quarter of 2006, we finalized theZeneus integration plan as it relates to employee severance costs and recordeda reserve for employee termination benefits of $3.4 million. This reserve isfor employee severance costs related to 31 employees throughout theorganization including finance, legal, clinical and regulatory, sales andmarketing and general administration. The termination of these employees issubstantially complete as of December 31, 2006. Severance payments areexpected to be completed by the end of 2007.

During the second quarterof 2006, we finalized our valuation of the Zeneus intellectual property and, asa result of this review, we have reduced the net book value of the MYOCET intellectual property by $12.2million. Also during the second quarter of 2006, we reduced the net deferredtax liability by $19.7 million. This adjustment was to record the deferred taxeffect on deferred revenue and intellectual property adjustments describedabove as well as the finalization of our assessment of the deductibility ofpreviously acquired intangible assets.

**UNAUDITED PRO FORMAINFORMATION**

Thefollowing unaudited pro forma information shows the results of our operationsfor the years ended December 31, 2005 and 2004 as though the acquisitionsof CIMA LABS, included in 2004, and Zeneus, included in 2005 and 2004, hadoccurred as of the beginning of the periods presented:

| ** **                                    | ** ** | **Year Ended  December 31,** | ** ** |
|-----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                    | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Total revenues                                |       | $                                      | 1,305,404  |   | $ | 1,124,920 |   |
| Net loss                                      |       | $                                      | (195,601   | ) | $ | (103,927 | ) |
| Basic and diluted net  loss per common share: |       |                                   |       |   |   |
| Basic loss per common share                   |       | $                                      | (3.37      | ) | $ | (1.84 | ) |
| Diluted loss per  common share                |       | $                                      | (3.37      | ) | $ | (1.84 | ) |

 

The pro forma results havebeen prepared for comparative purposes only and are not necessarily indicativeof the actual results of operations had the acquisition taken place as of thebeginning of the periods presented, or the results that may occur in thefuture. Furthermore, the pro forma results do not 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**2.**   ACQUISITIONS AND TRANSACTIONS (Continued)

giveeffect to all cost savings or incremental costs that may occur as a result ofthe integration and consolidation of the acquisition.

**CO-PROMOTIONAGREEMENT WITH TAKEDA**

On June 12, 2006, we entered into a co-promotionagreement with a three-year term effective July 1, 2006 with TakedaPharmaceuticals North America, Inc. with respect to PROVIGIL in the UnitedStates.

Under our co-promotion agreement with Takeda, 500Takeda sales representatives began promoting PROVIGIL in the second position toprimary care physicians and other appropriate health care professionals in theUnited States beginning July 1, 2006. Effective January 1, 2007, anadditional 250 Takeda sales representatives were added, all of whom aredetailing PROVIGIL in the first position. Together with our CNS field sales andsales management teams, we now have nearly 1,200 persons focused on detailingPROVIGIL in the United States. We also have an option to utilize the Takedasales force for the promotion of NUVIGIL, assuming FDA approval of this productcandidate. The parties have formed a joint commercialization committee tomanage the promotion of PROVIGIL. We have retained all responsibility for thedevelopment, manufacture, distribution and sale of the product.

We pay Takeda a royaltybased on certain sales criteria for PROVIGIL and NUVIGIL during the three-yearterm and, if specified sales levels are reached, during the three calendaryears following the expiration of the co-promotion agreement.

**3.   STOCKHOLDERS’EQUITY**

**Equity CompensationPlans**

We have established equity compensation plans for ouremployees, directors and certain other individuals. The Stock Option andCompensation Committee of our Board of Directors approves all grants and theterms of such grants, subject to ratification by the Board of Directors. We maygrant non-qualified stock options under the Cephalon, Inc. 2004 EquityCompensation Plan (the “2004 Plan”) and the Cephalon, Inc. 2000 EquityCompensation Plan (the “2000 Plan”), and also may grant incentive stock optionsand restricted stock units under the 2004 Plan. Stock options and restrictedstock units generally become exercisable or vest ratably over four years fromthe grant date, and stock options must be exercised within ten years of thegrant date. There are currently 11.5 million and 4.3 million sharesauthorized for issuance under the 2004 Plan and the 2000 Plan, respectively. AtDecember 31, 2006, the shares available for future grants of stock optionsor restricted stock units were 1,081,494, of which up to 286,209 may be issuedas restricted stock units.

Prior to the January 1, 2006 adoption of SFAS123(R), we accounted for stock option plans and restricted stock unit plans inaccordance with APB 25. Accordingly, no compensation expense has beenrecognized for stock options since all stock options granted had an exerciseprice equal to the market value of the underlying stock on the grant date.Restricted stock units have been recorded as compensation cost over the requisitevesting periods based on the market value on the date of grant. As permitted bySFAS 123, stock-based compensation was presented as a pro forma disclosure inthe notes to the consolidated financial statements.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**3.**   STOCKHOLDERS’ EQUITY (Continued)

Effective January 1, 2006, we adopted the fairvalue recognition provisions of SFAS 123(R), using the modified-prospectivetransition method. Under this transition method, stock-based compensation isrecognized in the consolidated financial statements for stock granted.Compensation expense recognized in the financial statements includes estimatedexpense for stock options granted after December 31, 2005, based on thegrant date fair value estimated in accordance with the provisions of SFAS123(R), and the estimated expense for the stock options granted prior to, butnot vested as of January 1, 2006, based on the grant date fair valueestimated in accordance with the original provisions of SFAS 123. SFAS 123(R) alsorequires us to estimate forfeitures in calculating the expense relating tostock-based compensation as opposed to only recognizing forfeitures and thecorresponding reduction in expense as they occur. We recorded an adjustment forthis cumulative effect for restricted stock units and recognized a reduction instock-based compensation in the first quarter of 2006 consolidated statementsof operations allocated evenly between research and development and selling,general and administrative expenses based on the employees’ compensationallocation between these line items. The adjustment was not significant to theconsolidated statement of operations.

Total stock-based compensation expense recognized inthe consolidated statement of operations for the year ended December 31,2006 was $42.8 million before income taxes or $27.1 million after-tax. Theimpact of the adoption of SFAS 123(R) on basic income per common share anddiluted income per common share was $0.32 and $0.28, respectively. Stock-basedcompensation expense consisted of stock option and restricted stock unitexpense of $31.4 million and $11.4 million, respectively. This expense wasrecognized evenly between research and development and selling, general andadministrative expenses based on the employees’ compensation allocation betweenthese line items. Compensation expense is recognized in the period the employeeperforms the service in accordance with FASB Interpretation *Accounting for Stock Appreciation Rights and OtherVariable Stock Option or Award Plans* (“FIN 28”). The impact ofcapitalizing stock-based compensation was not significant at December 31,2006.

During the second quarter of 2006, we elected to adoptthe short-cut method of FASB Staff Position (“FSP”) No. SFAS 123(R)-3“The Transition Election Related to Accounting for the Tax Effects of ShareBased Payment Awards” (“FSP SFAS 123(R)-3”) to determine our pool ofwindfall tax benefits under SFAS 123(R). Under the short-cut method, ourhistorical pool of windfall tax benefits was calculated as cumulative netincreases to additional paid-in capital related to tax benefits fromstock-based compensation after the election date of SFAS 123 less the productof cumulative SFAS 123 compensation cost, as adjusted, multiplied by theblended statutory tax rate at adoption of SFAS 123(R). Using this calculation,we determined our historical windfall tax pool was zero as of January 1,2006. Following the guidance within FSP SFAS 123(R)-3, we retrospectivelyapplied the short-cut method to our consolidated financial statements for thethree months ended March 31, 2006. Under the transition provisions of theshort-cut method, for awards fully vested at the adoption date of SFAS 123(R) andsubsequently settled, the pool of windfall tax benefits is equal to the total taxbenefit recognized in additional paid-in capital upon settlement. Prior to theelection of the short-cut method, we accounted for the on-going income taxeffects for partially or fully vested awards as of the date of SFAS 123(R) adoptionusing the “as if” method of accounting required by the long-form method underSFAS 123(R). The retrospective application adjustments to our consolidatedfinancial statements for the three months ended March 31, 2006 had noimpact on our financial position or results of operations. For the three monthsended March 31, 2006, there was no change to our total net cash flows;however, our net cash used for operating activities 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**3.**   STOCKHOLDERS’ EQUITY (Continued)

increased by $21.5 millionto $33.6 million and our net cash provided by financing activities increased by$21.5 million to $127.9 million. Upon adoption during the second quarter of2006, the impact of the election was not significant to our consolidatedfinancial statements. The cumulative pool of windfall tax benefits was $27.2million as of December 31, 2006

Based on our historical experience of stock option andrestricted stock unit pre-vesting forfeitures, we have assumed an expectedforfeiture rate of 12% over the four year life of the stock option andrestricted stock unit for all new stock options and restricted stock unitsgranted. Under the provisions of SFAS 123(R), we will record additional expenseif the actual pre-vesting forfeiture rate is lower than we estimated and willrecord a recovery of prior expense if the actual forfeitures are higher thanour estimate. As of January 1, 2006, the memo cumulative after-tax effectof this change in accounting for forfeitures for restricted stock units, ifthis adjustment were recorded, would have been to increase stock-basedcompensation by $0.6 million.

Our expected term of options granted was derived fromthe average midpoint between vesting and the contractual term, as described inSEC’s Staff Accounting Bulletin No. 107, “*Share-BasedPayment*.”  For 2006, expectedvolatilities are based on a combination of implied volatilities from tradedoptions on our stock and the historical volatility of our stock for the relatedvesting period. The risk-free interest rate is based on the implied yieldavailable on U.S. Treasury zero-coupon issues with an equivalent remainingterm. We have not paid dividends in the past and do not plan to pay anydividends in the foreseeable future.

Thefollowing table illustrates the effect on pro forma net loss and earnings pershare if we had applied the fair value recognition provisions of SFAS 123:

| ** **                                                                                                                                    | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Net loss, as  reported                                                                                                                        |       | $                                          | (174,954   | ) | $ | (73,813 | ) |
| Add: Stock-based  compensation expense included in net loss, net of related tax effects                                                       |       | 6,826                                      |       | 3,187 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (30,163                                    | )          | (40,035 | ) |
| Pro forma net  loss                                                                                                                           |       | $                                          | (198,291   | ) | $ | (110,661 | ) |
| Earnings per share:                                                                                                                           |       |                                       |       |   |   |
| Basic loss per share, as reported                                                                                                             |       | $                                          | (3.01      | ) | $ | (1.31 | ) |
| Basic loss per share, pro forma                                                                                                               |       | $                                          | (3.42      | ) | $ | (1.96 | ) |
| Diluted loss per share, as reported                                                                                                           |       | $                                          | (3.01      | ) | $ | (1.31 | ) |
| Diluted loss per  share, pro forma                                                                                                            |       | $                                          | (3.42      | ) | $ | (1.96 | ) |

 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**3.**   STOCKHOLDERS’ EQUITY (Continued)

Thefair value of each option grant at the grant date is calculated using theBlack-Scholes option-pricing model with the following weighted averageassumptions:

| ** **                               | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|
| ** **                               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Risk free interest  rate                 |       | 4.62                                       | %          | 4.41 | % | 3.87 | % |
| Expected term  (years)                   |       | 6.18                                       |       | 6.50 |   | 6.50 |   |
| Expected  volatility                     |       | 41.0                                       | %          | 50.0 | % | 66.0 | % |
| Expected dividend  yield                 |       | —                                     | %          | — | % | — | % |
| Estimated fair  value per option granted |       | $                                          | 33.20      |   | $ | 27.52 |   | $ | 31.81 |   |
|                                          |            |                                            |            |  |  |  |  |  |  |  |

 

**Stock Options**

Thefollowing tables summarize the aggregate option activity under the plans forthe years ended December 31:

| ** **                       | ** ** | **2006**   | ** ** |
|----------------------------------|------------|------------|------------|
| ** **                       | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life (years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
| Outstanding,  January 1,    |       | 9,955,904  |       |   | $ | 50.84 |   |   |   |   |   |   |   |   |   |   |
| Granted                          |       | 1,116,800  |       |   | 69.85 |   |   |   |   |   |   |   |   |   |   |
| Exercised                        |       | (3,058,430 | )          |   | 47.46 |   |   |   |   |   |   |   |   |   |   |
| Forfeited                        |       | (305,475   | )          |   | 50.54 |   |   |   |   |   |   |   |   |   |   |
| Expired                          |       | (14,501    | )          |   | 50.62 |   |   |   |   |   |   |   |   |   |   |
| Outstanding,  December 31,  |       | 7,694,298  |       |   | $ | 54.90 |   |   |   | 6.7 |   |   |   | $ | 121,836 |   |   |
| Vested options at end of  period |       | 5,143,900  |       |   | $ | 53.39 |   |   |   | 5.6 |   |   |   | $ | 89,430 |   |   |

 

| ** **                       | ** ** | **2005**   | ** ** | **2004**                                   | ** ** |
|----------------------------------|------------|------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Outstanding,  January 1,    |       | 9,664,084  |       |                                       | $          | 50.34 |   |   | 9,881,100 |   |   | $ | 49.04 |   |   |
| Granted                          |       | 1,022,100  |       |                                       | 50.24      |   |   | 768,950 |   |   | 49.43 |   |   |
| Exercised                        |       | (346,730   | )          |                                       | 32.89      |   |   | (535,446 | ) |   | 22.51 |   |   |
| Cancelled                        |       | (383,550   | )          |                                       | 53.05      |   |   | (450,520 | ) |   | 53.29 |   |   |
| Outstanding,  December 31,  |       | 9,955,904  |       |                                       | $          | 50.84 |   |   | 9,664,084 |   |   | $ | 50.34 |   |   |
| Vested options at end of  period |       | 6,733,471  |       |                                       | $          | 51.49 |   |   | 5,485,360 |   |   | $ | 49.56 |   |   |

 

 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**3.**   STOCKHOLDERS’EQUITY (Continued)

| ** **                                 | ** ** | **Options Outstanding** | ** ** | **Vested Options** | ** ** |
|--------------------------------------------|------------|------------------------------|------------|-------------------------|------------|
| **Range of Exercise Price** | ** ** | ** **                   | ** ** | **Shares**              | ** ** | **Weighted  Average  Remaining  Contractual  Life (years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $6.00-$14.99                               |       | 240,200                      |       |                    | 1.5        |   |   |   | $ | 9.62 |   |   | 240,200 |   |   | $ | 9.62 |   |   |
| $15.00-$29.99                              |       | 134,938                      |       |                    | 2.7        |   |   |   | 27.07 |   |   | 134,938 |   |   | 27.07 |   |   |
| $30.00-$50.99                              |       | 2,215,185                    |       |                    | 7.2        |   |   |   | 47.67 |   |   | 1,353,111 |   |   | 47.62 |   |   |
| $51.00-$59.99                              |       | 2,589,550                    |       |                    | 6.5        |   |   |   | 51.67 |   |   | 1,952,626 |   |   | 51.81 |   |   |
| $60.00-$71.96                              |       | 2,514,425                    |       |                    | 7.1        |   |   |   | 70.42 |   |   | 1,463,025 |   |   | 70.44 |   |   |
|                                       |       | 7,694,298                    |       |                    | 6.7        |   |   |   | 54.90 |   |   | 5,143,900 |   |   | 53.39 |   |   |
|                                            |            |                              |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As of December 31,2006, there was approximately $49.0 million of total unrecognized compensationcost related to outstanding options that is expected to be recognized over aweighted-average period of 1.6 years. For the years ended December 31,2006, 2005 and 2004, we received net proceeds of $143.5 million, $11.5 millionand $12.1 million, respectively, from the exercise of stock options.

The intrinsic value ofstock options exercised for the years ended December 31, 2006 and 2005 was$79.8 million and $7.7 million, respectively. The estimated fair value ofshares that vested for the years ended December 31, 2006 and 2005 was$40.8 million and $35.1 million, respectively.

**Restricted Stock Units**

Thefollowing table summarizes restricted stock units activity for the years endedDecember 31:

| ** **                               | ** ** | **2006**   | ** ** |
|------------------------------------------|------------|------------|------------|
| ** **                               | ** ** | **Shares** | ** ** | **Weighted Average  Fair Value** | ** ** |
| Nonvested,  January 1,              |       | 624,575    |       |   | $ | 49.52 |   |   |
| Granted                                  |       | 325,900    |       |   | 71.06 |   |   |
| Vested                                   |       | (180,125   | )          |   | 72.61 |   |   |
| Forfeited                                |       | (60,450    | )          |   | 49.48 |   |   |
| Nonvested,  December 31,            |       | 709,900    |       |   | $ | 59.49 |   |   |
| Intrinsic Value as of  December 31, |       | $          | 49,984     |   |   |   |   |   |
|                                          |            |            |            |  |  |  |  |  |  |

 

| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Nonvested, January 1, |       | 455,650  |       |     | 223,175    |   |   |
| Granted                         |       | 298,500  |       |     | 309,400    |   |   |
| Vested                          |       | (125,625 | )          |     | (76,925    | ) |   |
| Forfeited                       |       | (3,950   | )          |     | —     |   |   |
| Nonvested,  December 31,   |       | 624,575  |       |     | 455,650    |   |   |

 

As of December 31,2006, there was approximately $30.2 million of total unrecognized compensationcost related to nonvested restricted stock units that is expected to berecognized over a weighted-average period of 1.6 years. For the years endedDecember 31, 2006, 2005 and 2004, total compensation expense recognizedfor restricted stock units was $11.4 million, $10.8 million and $5.4 million,respectively.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**3.**   STOCKHOLDERS’EQUITY (Continued)

**Qualified Savingsand Investment Plan**

We have a profit sharingplan pursuant to section 401(k) of the Internal Revenue Code wherebyeligible employees may contribute up to 20% of their annual salary to the plan,subject to statutory maximums. Our matching contribution is made solely in cashon 100% on the first 6% of employee salaries. We contributed $11.8 million,$8.8 million and $6.3 million to the plan for the years ended December 31,2006, 2005, and 2004, respectively.

**Pro forma AggregateConversions or Exercises**

At December 31, 2006,the conversion or exercise of all outstanding stock options and restrictedstock units would increase the outstanding number of shares of common stock byapproximately 8.4 million shares, or 13%. The conversion of our convertiblesubordinated notes and warrants into shares of Cephalon common stock inaccordance with their terms is dependent upon actual stock price at the time ofconversion.

**Preferred SharePurchase Rights**

In November 1993, ourBoard of Directors declared a dividend distribution of one right for eachoutstanding share of common stock. In addition, a right attaches to and tradeswith each new issue of our common stock. Each right entitles each registeredholder, upon the occurrence of certain events, to purchase from us a unitconsisting of one one-hundredth of a share of our Series A JuniorParticipating Preferred Stock, or a combination of securities and assets ofequivalent value, at a purchase price of $200.00 per unit, subject toadjustment.

**4.   CASH, CASHEQUIVALENTS AND INVESTMENTS**

At December 31,cash, cash equivalents and investments consisted of the following:

| ** **                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Cash and cash  equivalents:                |       |     |       |     |       |
| Demand deposits                            |       | $        | 158,821    |     | $          | 116,931 |   |
| Repurchase agreements                      |       | 111,309  |       | 44,660   |       |
| Commercial paper                           |       | 226,382  |       | 31,489   |       |
| Asset-backed securities                    |       | —   |       | 11,980   |       |
|                                       |       | 496,512  |       | 205,060  |       |
| Short-term  investments (at market value): |       |     |       |     |       |
| U.S. government agency obligations         |       | 417      |       | 84,469   |       |
| Asset-backed securities                    |       | 11,282   |       | 48,158   |       |
| Bonds                                      |       | 8,751    |       | 127,602  |       |
| Commercial paper                           |       | 4,762    |       | 18,801   |       |
|                                       |       | 25,212   |       | 279,030  |       |
|                                       |       | $        | 521,724    |     | $          | 484,090 |   |

 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**4.**   CASH, CASHEQUIVALENTS AND INVESTMENTS (Continued)

The contractual maturitiesof our investments in cash, cash equivalents, and investments at December 31,2006 are as follows:

| Less than one  year                            |   | $     | 519,019 |   |
|------------------------------------------------|--------|-------|---------|--------|
| Greater than one  year but less than two years |   | 1,574 |    |
| Greater than two  years                        |   | 1,131 |    |
|                                           |   | $     | 521,724 |   |

 

**5.   RECEIVABLES,NET**

At December 31,receivables consisted of the following:

| ** **                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|
| Trade receivables                                |       | $        | 258,298    |     | $          | 177,897 |   |
| Receivables from  collaborations                 |       | 1,562    |       | 4,877    |       |
| Other receivables                                |       | 15,764   |       | 21,934   |       |
|                                             |       | 275,624  |       | 204,708  |       |
| Less reserve for  sales discounts and allowances |       | (5,579   | )          | (5,622   | )          |
|                                             |       | $        | 270,045    |     | $          | 199,086 |   |

 

Trade receivables are recorded at the invoiced amountand do not bear interest. Our allowance for doubtful accounts is our bestestimate of probable credit losses in our existing accounts receivable. Wedetermine the allowance based on a percentage of trade receivables past due,specific customer issues, and a reserve related to our specific historicalwrite-off experience and general industry experience. We review and adjust ourallowance for doubtful accounts quarterly. Receivable balances or specificcustomer issues are written off against the allowance when we feel that it isprobable that the receivable amount will not be recovered. Certain Europeanreceivable balances with government operated hospitals are over 90 dayspast due but we believe are collectible and are therefore, not reserved. In thepast, our historical write-off experience has not been significant. We do nothave any off-balance sheet credit exposure related to our customers.

**6.**   INVENTORY,NET

AtDecember 31, inventory consisted of the following:

| ** **      | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------|------------|----------|------------|----------|------------|
| Raw materials   |       | $        | 112,822    |     | $          | 67,164 |   |
| Work-in-process |       | 15,915   |       | 28,430   |       |
| Finished goods  |       | 45,563   |       | 42,292   |       |
|            |       | $        | 174,300    |     | $          | 137,886 |   |

 

Our domestic inventories and certain of our foreigninventories are valued using the last-in, first-out (“LIFO”) method.Inventories valued using the LIFO method were $125.1 million and$91.9 million at December 31, 2006 and 2005, respectively. The excessof current or replacement cost over LIFO inventory value was $3.6 millionand $2.0 million at December 31, 2006 and 2005, respectively.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**6.**   INVENTORY,NET (Continued)

The majority of our foreign inventories are valuedusing the first-in, first-out (“FIFO”) method. Inventories valued using theFIFO method were $49.2 million and $46.0 million at December 31,2006 and 2005, respectively.

We capitalize inventory costs associated with marketedproducts and certain products prior to regulatory approval and product launch,based on management’s judgment of probable future commercial use and netrealizable value. We could be required to expense previously capitalized costsrelated to pre-approval or pre-launch inventory upon a change in such judgment,due to a denial or delay of approval by regulatory bodies, a delay incommercialization, or other potential factors. At December 31, 2006, wehad $89.1 million of capitalized inventory costs related to NUVIGIL, net ofreserves of $8.9 million, as we do not expect that certain batches in inventorywill be sold prior to their expiration date.

In August 2006, we announced that we received aletter from the FDA stating that our supplemental new drug application (“sNDA”)for SPARLONTM (modafinil) Tablets [C-IV], a proprietary dosage form of modafinilfor the treatment of attention-deficit/hyperactivity disorder (“ADHD”) inchildren and adolescents, was not approvable. In light of the FDA’s decision,we currently are not pursuing development of SPARLON. Prior to the FDA’sdecision that the sNDA for SPARLON was not approvable, we had net capitalizedinventory costs related to SPARLON of $8.6 million. In consideration ofthe FDA’s decision, we have fully reserved all of these capitalized inventorycosts related to SPARLON at December 31, 2006.

We received FDA approval of FENTORA in late September 2006and launched the product in the United States in early October. FENTORA isindicated for the management of breakthrough pain in patients with cancer whoare already receiving and are tolerant to opioid therapy for their underlyingpersistent cancer pain.

At December 31, 2005,we had $44.6 million, $5.9 million and $0.6 million of capitalizedinventory costs related to NUVIGIL, SPARLON and other pre-launch products,respectively.

**7.   PROPERTY ANDEQUIPMENT, NET**

At December 31,property and equipment consisted of the following:

| ** **                                      | ** ** | **Estimated  Useful Lives** | ** **     | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------|------------|----------------------------------|----------------|----------|------------|----------|------------|
| Land and  improvements                          |       |                             | —         |     |       | $        | 8,741      |   | $ | 9,019 |   |
| Buildings and  improvements                     |       |                             | 3-40 year | s        |       | 227,408  |       | 162,808 |   |
| Laboratory,  machinery and other equipment      |       |                             | 3-30 year | s        |       | 211,666  |       | 145,916 |   |
| Construction in  progress                       |       |                             | —         |     |       | 108,816  |       | 97,527 |   |
|                                            |       |                             |           |     |       | 556,631  |       | 415,270 |   |
| Less accumulated  depreciation and amortization |       |                             |           |     |       | (103,621 | )          | (91,440 | ) |
|                                            |       |                             |           |     |       | $        | 453,010    |   | $ | 323,830 |   |

 

Depreciation andamortization expense related to property and equipment, excluding depreciationrelated to assets used in the production of inventory, was $34.8 million,$26.7 million and $15.0 million for 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**7.**   PROPERTY AND EQUIPMENT, NET (Continued)

theyears ended December 31, 2006, 2005 and 2004, respectively. We had $32.9million and $22.6 million of capitalized computer software costs included inproperty and equipment, net, at December 31, 2006 and 2005, respectively. Depreciationand amortization expense related to capitalized software costs was $11.2million, $6.9 million and $2.5 million for the years ended December 31,2006, 2005 and 2004, respectively. We had $15.1 million and$14.9 million of capitalized software costs included in construction inprogress at December 31, 2006 and 2005, respectively.

**8.   INTANGIBLEASSETS, NET AND OTHER ASSETS**

At December 31,intangible assets consisted of the following:

| ** **                      | ** ** | ** **                   | ** ** | **2006**                    | ** ** | **2005**                      | ** ** |
|---------------------------------|------------|------------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **                      | ** ** | **Estimated  Useful  Lives** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** |
| Modafinil  developed technology |       | 15 years                |       | $                           | 99,000     |                          |       | $ | 33,000 |   |   | $ | 66,000 |   | $ | 99,000 |   |   | $ | 26,400 |   |   | $ | 72,600 |   |
| DURASOLV  technology            |       | 14 years                |       | 70,000                      |       |                          | 11,565     |   |   | 58,435 |   | 70,000 |   |   | 6,696 |   |   | 63,304 |   |
| ACTIQ marketing  rights         |       | 10 years                |       | 75,465                      |       |                          | 39,010     |   |   | 36,455 |   | 75,465 |   |   | 31,359 |   |   | 44,106 |   |
| GABITRIL product  rights        |       | 9-15 year               | s          | 106,232                     |       |                          | 46,826     |   |   | 59,406 |   | 115,371 |   |   | 38,053 |   |   | 77,318 |   |
| TRISENOX product  rights        |       | 8-13 year               | s          | 113,752                     |       |                          | 13,634     |   |   | 100,118 |   | 112,942 |   |   | 4,494 |   |   | 108,448 |   |
| VIVITROL product  rights        |       | 15 years                     |       | 110,000                     |       |                          | 5,500      |   |   | 104,500 |   | — |   |   | — |   |   | — |   |
| MYOCET trademark                |       | 20 years                |       | 192,367                     |       |                          | 9,618      |   |   | 182,749 |   | 182,500 |   |   | — |   |   | 182,500 |   |
| Other product  rights           |       | 5-20 year               | s          | 259,054                     |       |                          | 73,680     |   |   | 185,374 |   | 243,465 |   |   | 48,867 |   |   | 194,598 |   |
|                            |       |                         |       | $                           | 1,025,870  |                          |       | $ | 232,833 |   |   | $ | 793,037 |   | $ | 898,743 |   |   | $ | 155,869 |   |   | $ | 742,874 |   |

 

Intangible assets areamortized over their estimated useful economic life using the straight linemethod. Amortization expense was $81.7 million, $57.7 million and$37.8 million for the years ended December 31, 2006, 2005 and 2004,respectively. Estimated amortization expense of intangible assets for each ofthe next five years is approximately $85.1 million in 2007 and 2008,$85.0 million in 2009, $73.9 million in 2010 and $67.1 millionin 2011.

**Impairment Charges**

In June 2006, we announced that data from ourPhase 3 clinical program evaluating GABITRIL for the treatment of generalizedanxiety disorder (“GAD”) did not reach statistical significance on the primarystudy endpoints. We have no further plans to continue studying GABITRIL for thetreatment of GAD. As a result, we performed a test of impairment on thecarrying value of our investment in GABITRIL product rights and recorded animpairment charge of $12.4 million in the second quarter of 2006 related to ourEuropean rights.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**8.**   INTANGIBLE ASSETS, NET AND OTHER ASSETS (Continued)

During the second quarter of 2006, we finalized ourvaluation of the Zeneus intellectual property and, as a result of this review,we reduced the net book value of the MYOCET intellectual property by $12.2million.

As a result of the negotiations with Novartis PharmaAG in the fourth quarter of 2005 and the termination of the PROVIGILdistribution agreement in the United Kingdom in March 2006, we determinedthat the carrying value of our investment in Novartis CNS product rights wasfully impaired and we recorded an impairment charge of $20.8 million inour fourth quarter of 2005 results of operations.

In January 2003, we purchased from MDSProteomics Inc. (“MDSP”), a privately-held Canadian company and a subsidiaryof MDS Inc., a $30.0 million convertible note due 2010 and enteredinto a five-year research agreement focused on accelerating the clinicaldevelopment of our pipeline of small chemical compounds. In 2004, MDSP decidedto change its business model to focus upon the provision of services to thepharmaceutical and biotechnology industries.

On July 29, 2004,MDSP completed its reorganization under Canada’s Companies Creditors’Arrangement Act and changed its name to Protana Inc. As part of the reorganization,we agreed to terminate our research agreement with Protana and cancelled the$30.0 million convertible note we held in return for shares of Class APreferred Stock and Common Stock of Protana. In light of the restructuring ofProtana and the uncertain business prospects for the company, we determinedthat the carrying value of our investment was fully impaired and we recorded animpairment charge of $30.1 million, which included transaction costs, inour second quarter of 2004 results of operations.

**9.**   ACCRUEDEXPENSES

AtDecember 31, accrued expenses consisted of the following:

| ** **                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Accrued  contractual sales allowances     |       | $        | 50,559     |     | $          | 44,738 |   |
| Accrued  compensation and benefits        |       | 49,046   |       | 37,707   |       |
| Accrued sales and  marketing costs        |       | 32,619   |       | 22,655   |       |
| Accrued product  sales returns allowances |       | 28,843   |       | 22,598   |       |
| Accrued product  related costs            |       | 19,482   |       | 47,787   |       |
| Accrued research  and development         |       | 14,442   |       | 15,794   |       |
| Accrued license  fees and royalties       |       | 15,099   |       | 7,070    |       |
| Accrued income  taxes                     |       | 8,924    |       | 15,898   |       |
| Accrued clinical  trial fees              |       | 5,380    |       | 19,499   |       |
| Other accrued  expenses                   |       | 39,084   |       | 57,998   |       |
|                                      |       | $        | 263,478    |     | $          | 291,744 |   |

 

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**CEPHALON, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(In thousands, except per share data)**

**10.   LONG-TERM DEBT**

At December 31,long-term debt consisted of the following:

| ** **                                                                     | ** ** | **2006**   | ** ** | **2005**  | ** ** |
|--------------------------------------------------------------------------------|------------|------------|------------|-----------|------------|
| 2.0% convertible  senior subordinated notes due June 1, 2015              |       | $          | 820,000    |      | $          | 920,000 |   |
| 2.5% convertible  subordinated notes due December 2006                    |       | —     |       | 10,007    |       |
| Zero Coupon  convertible subordinated notes first putable June 2008 (Old) |       | 263        |       | 313       |       |
| Zero Coupon  convertible subordinated notes first putable June 2010 (Old) |       | 94         |       | 99        |       |
| Zero Coupon  convertible subordinated notes first putable June 2008 (New) |       | 213,417    |       | 374,958   |       |
| Zero Coupon  convertible subordinated notes first putable June 2010 (New) |       | 199,716    |       | 375,070   |       |
| Mortgage and  building improvement loans                                       |       | 8,291      |       | 8,975     |       |
| Capital lease  obligations                                                     |       | 3,787      |       | 3,658     |       |
| Other                                                                          |       | 2,736      |       | 3,177     |       |
| Total debt                                                                     |       | 1,248,304  |       | 1,696,257 |       |
| Less current  portion                                                          |       | (1,023,312 | )          | (933,160  | )          |
| Total long-term  debt                                                          |       | $          | 224,992    |      | $          | 763,097 |   |

 

Aggregatematurities of long-term debt at December 31, 2006 are as follows:

| 2007                 |   | $       | 1,023,312 |   |
|----------------------|--------|---------|-----------|--------|
| 2008                 |   | 217,342 |      |
| 2009                 |   | 2,744   |      |
| 2010                 |   | 1,488   |      |
| 2011                 |   | 869     |      |
| 2012 and  thereafter |   | 2,549   |      |
|                 |   | $       | 1,248,304 |   |

 

In 2005, our 2.0% convertible senior subordinatednotes due June 1, 2015 (the “2.0% Notes”) became convertible. As a result,the 2.0% Notes have been classified as a current liability on our consolidatedbalance sheet. In 2006, our 2008 and 2010 Zero Coupon Notes (collectively, the “ZeroCoupon Notes”) became convertible and the related deferred debt issuance costsof $13.1 million were written off. Our convertible notes will beclassified as current liabilities and presented in current portion of long-termdebt on our consolidated balance sheet if our stock price is above therestricted conversion prices of $56.04, $71.40 or $67.80 with respect to the2.0% Notes, the 2008 Zero Coupon Notes or the 2010 Zero Coupon Notes,respectively at the balance sheet date. At December 31, 2006, our 2.0%Notes and Zero Coupon Notes first putable June 15, 2010 are considered tobe current liabilities are presented in current portion of long-term debton our consolidated balance sheet.

In the event that a significant conversion did occur,we believe that we have the ability to fund the payment of principal amountsdue through a combination of utilizing our existing cash on hand, raising moneyin the capital markets or selling our note hedge instruments for cash.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**10.**   LONG-TERMDEBT (Continued)

**Gain (Charge) onEarly Extinguishment of Debt**

In December 2006, certain holders of our ZeroCoupon Notes and 2.0% Notes approached us and we agreed to exchange $436.9million aggregate principal amount of our convertible notes for cash paymentstotaling $175.3 million and the issuance of 6.2 million shares of our commonstock. We recorded $310.1 million in additional paid-in capital related to theshares issued. Concurrent with these exchanges, we amended our convertible notehedge agreements (described below) related to the Zero Coupon Notes and 2%Notes and amended the warrant agreements related to the Zero Coupon Notes. Theeffect of these amendments was to terminate the portion of the convertible notehedge and, with respect to the Zero Coupon Notes, the warrants agreementsrelated to the $436.9 million principal amount of notes exchanged. Insettlement of these amendments, we received 1.8 million shares of our commonstock from the counterparties to these agreements. We recorded $129.5 millionin additional paid-in capital and treasury stock related to the shares received.The warrants related to the 2% Notes exchanged in December 2006 remainoutstanding.

Forthe year ended December 31, 2006, we recognized $48.1 million of debtexchange expense in accordance with SFAS No. 84, “Induced Conversion ofConvertible Debt” (“SFAS 84”) as follows:

| ** **        | ** ** | **Fair value of cash  and securities  transferred** | ** ** | **Fair value issuable  under original  conversion** | ** ** | **Total debt  exchange expense** | ** ** |
|-------------------|------------|-------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------|------------|
| Zero Coupon Notes |       |                                                                    | $          | 445,617                                                            |       |                                       |       | $ | 412,646 |   |   |   | $ | 32,971 |   |   |
| 2% Notes          |       |                                                                    | 167,335    |                                                               |       |                                       | 152,184    |   |   |   | 15,151 |   |   |
| Total for 2006    |       |                                                                    | $          | 612,952                                                            |       |                                       |       | $ | 564,830 |   |   |   | $ | 48,122 |   |   |

 

Forthe year ended December 31, 2005, we recognized a $2.1 million gainon early extinguishment of debt as follows:

| ** **                                                          | ** ** | **Principal  Amount** | ** ** | **Discount** | ** ** | **Write-off of  unamortized  debt issuance  costs** | ** ** | **Professional  Fees** | ** ** | **Loss on  termination  of interest  rate swap** | ** ** | **Total gain  on early  extinguishment  of debt** | ** ** |
|---------------------------------------------------------------------|------------|-----------------------|------------|--------------|------------|---------------------------------------------------------------|------------|------------------------|------------|-----------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| 2.5% convertible  subordinated notes  repurchased in July 2005 |       | $                     | 512,000    |         | $          | 12,794                                                        |       |                   | $          | (5,326                                                          | )          |                                                             |       | $ | (65 | ) |   |   | $ | (5,318 | ) |   |   | $ | 2,085 |   |   |
|                                                                     |            |                       |            |              |            |                                                               |            |                        |            |                                                                 |            |                                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**10.**   LONG-TERM DEBT (Continued)

For the year ended December 31,2004, we recognized a $2.3 million charge on early extinguishment of debtas follows:

| ** **                                                             | ** ** | **Principal  Amount** | ** ** | **Premium** | ** ** | **Write-off of  unamortized  debt issuance  costs** | ** ** | **Total (charge)  on early  extinguishment  of debt** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|---------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| 3.875%  convertible subordinated notes repurchased in March 2004  |       | $                     | 10,000     |        |       | $                                                             | (950       | )                                                                    |       |   | $ | (11 | ) |   |   | $ | (961 | ) |   |
| 3.875%  convertible subordinated notes repurchased in August 2004 |       | 33,000                |       |        | (1,320     | )                                                             |       |                                                                 | (32        | ) |   |   | (1,352 | ) |   |
| Total for 2004                                                         |       | $                     | 43,000     |        |       | $                                                             | (2,270     | )                                                                    |       |   | $ | (43 | ) |   |   | $ | (2,313 | ) |   |

 

**2.0% ConvertibleSenior Subordinated Notes**

In June and July 2005, we issued through apublic offering $920 million of 2.0% Notes, of which $820 millionremains outstanding as of December 31, 2006. Interest on the 2.0% Notes ispayable semi-annually in arrears on June 1 and December 1 of eachyear, commencing December 1, 2005.

The 2.0% Notes are subordinated to our existing andfuture senior indebtedness and senior to our existing and future subordinatedindebtedness. The 2.0% Notes are convertible prior to maturity, subject tocertain conditions described below, into cash and shares of our common stock atan initial conversion price of $46.70 per share, subject to adjustment(equivalent to a conversion rate of approximately 21.4133 shares per$1,000 principal amount of 2.0% Notes).

The 2.0% Notes alsocontain a restricted convertibility feature that does not affect the conversionprice of the 2.0% Notes but, instead, places restrictions on a holder’s abilityto convert their 2.0% Notes into shares of our common stock (the “conversionshares”). A holder may convert the 2.0% Notes prior to December 1, 2014only if one or more of the following conditions are satisfied:

·       if,on the trading day prior to the date of surrender, the closing sale price ofour common stock is more than 120% of the applicable conversion price per share(the “conversion price premium”);

·       ifthe average of the trading prices of the 2.0% Notes for any five consecutivetrading day period is less than 100% of the average of the conversion values ofthe 2.0% Notes during that period; or

·       ifwe make certain significant distributions to our holders of common stock; weenter into specified corporate transactions; or our common stock ceases to beapproved for listing on the NASDAQ Stock Market and is not listed for tradingon a U.S. national securities exchange or any similar U.S. system of automatedsecurities price dissemination.

Holders also may surrender their 2.0% Notes forconversion anytime after December 1, 2014 and on or prior to the close ofbusiness on the business day immediately preceding the maturity date,regardless if any of the foregoing conditions have been satisfied. Upon thesatisfaction of any of the foregoing conditions as of the last day of thereporting period, or during the twelve months prior to December 1, 2014,we would classify the then-aggregate principal balance of the 2.0% Notes as acurrent liability on our consolidated balance sheet.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**10.**   LONG-TERM DEBT (Continued)

Each $1,000 principal amount of the 2.0% Notes isconvertible into cash and shares of our common stock, if any, based on anamount (the “Daily Conversion Value”), calculated for each of the twentytrading days immediately following the conversion date (the “Conversion Period”).The Daily Conversion Value for each trading day during the Conversion Periodfor each $1,000 aggregate principal amount of the 2.0% Notes is equal toone-twentieth of the product of the then applicable conversion rate multipliedby the volume weighted average price of our common stock on that day.

For each $1,000aggregate principal amount of the 2.0% Notes surrendered for conversion, wewill deliver the aggregate of the following for each trading day during theConversion Period:

(1)         if the Daily ConversionValue for each trading day for each $1,000 aggregate principal amount of the2.0% Notes exceeds $50.00, (a) a cash payment of $50.00 and (b) theremaining Daily Conversion Value in shares of our common stock; or

(2)         if the Daily ConversionValue for each trading day for each $1,000 aggregate principal amount of the2.0% Notes is less than or equal to $50.00, a cash payment equal to the DailyConversion Value.

If the 2.0% Notes areconverted in connection with certain fundamental changes that occur prior to June 2015,we may be obligated to pay an additional (or “make whole”) premium with respectto the 2.0% Notes so converted.

*Convertible NoteHedge and Warrant Agreements*

Concurrent with the sale of the 2.0% Notes, wepurchased convertible note hedges from Deutsche Bank AG (“DB”) at a cost of$382.3 million. We also sold to DB warrants to purchase an aggregate of19,700,214 shares of our common stock and received net proceeds from the saleof these warrants of $217.1 million. At issuance, the convertible notehedge and warrant agreements, taken together, have the effect of increasing theeffective conversion price of the 2.0% Notes from our perspective to $67.92 pershare if held to maturity. At our option, the warrants may be settled in eithernet cash or net shares. The convertible note hedge must be settled using netshares. Under the convertible note hedge, DB will deliver to us the aggregatenumber of shares we are required to deliver to a holder of 2.0% Notes thatpresents such notes for conversion. If the market price per share of our commonstock is above $67.92 per share, we will be required to deliver either sharesof our common stock or cash to DB representing the value of the warrants inexcess of the strike price of the warrants. In accordance with Emerging IssuesTask Force (“EITF”) Issue No. 00-19, “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled In, a Company’s OwnStock” (“EITF No. 00-19”) and SFAS No. 150, “Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity” (“SFAS 150”), we recorded the convertible note hedges and warrants inadditional paid-in capital, and will not recognize subsequent changes in fairvalue. We also recognized a deferred tax asset of $133.8 million for theeffect of the future tax benefits related to the convertible note hedge.

The warrants have a strikeprice of $67.92. The warrants are exercisable only on the respective expirationdates (European style). We issued and sold the warrants to DB in a transactionexempt from the registration requirements of the Securities Act of 1933, asamended, because the offer and sale did not 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**10.**   LONG-TERM DEBT (Continued)

involvea public offering. There were no underwriting commissions or discounts inconnection with the sale of the warrants.

**2.5% Convertible Subordinated Notes**

In December 2001, wecompleted a private placement of $600.0 million of 2.5% convertiblesubordinated notes due December 2006 (the “2.5% Notes”). Debt issuancecosts of $21.3 million were originally capitalized in other assets;$7.6 million were written off in 2005 in conjunction with the debtexchange and the cash tender offer described below.

In July 2004, aholder of the 2.5% Notes approached us, and we agreed, to exchange$78.3 million of these outstanding notes for 1,518,169 shares of ourcommon stock. We recognized debt exchange expense of $28.2 million in thethird quarter of 2004 relating to these early exchanges in accordance with SFAS84. We also recognized the tax effect of this exchange of $10.1 million asa reduction of additional paid-in capital in our statement of stockholders’equity and as a tax benefit in our statement of operations for the year ended December 31,2004.

In July 2005, wecompleted a cash tender offer for our outstanding 2.5% Notes. As a result ofthe tender, we purchased approximately $512 million of the 2.5% Notes at aprice of $975 for each $1,000 of principal amount of 2.5% Notes tendered, plusaccrued and unpaid interest to the date of payment of $1.94 for each $1,000 ofprincipal amount of 2.5% Notes tendered. After completion of the tender offer,there remained outstanding approximately $10 million of the 2.5% Notes,which we retired at maturity in December 2006. In July 2005, we alsoterminated the interest rate swap agreement associated with $200 millionnotional amount of the 2.5% Notes.          Inthe third quarter of 2005, we recognized a net gain of $2.1 millionconsisting of a gain on extinguishment of the 2.5% Notes of $7.4 millionand a loss on the termination of the interest rate swap of $5.3 million.

**Zero Coupon Convertible Subordinated Notes**

In June 2003, weissued and sold in a private placement $750.0 million of Zero CouponConvertible Notes. The interest rate on the notes is zero and the notes do notaccrete interest. The notes were issued in two tranches: $375.0 million ofZero Coupon Convertible Subordinated Notes Due 2033, First Putable June 15,2008 (the “Old 2008 Notes”) and $375.0 million of Zero Coupon ConvertibleSubordinated Notes Due 2033, First Putable June 15, 2010 (the “Old 2010Notes” and, together with the Old 2008 Notes, the “Old Notes”).

In November 2004, wecommenced an offer to exchange our Zero Coupon Convertible Subordinated NotesDue 2033, First Putable June 15, 2008 (the “New 2008 Notes”), and our ZeroCoupon Convertible Subordinated Notes Due 2033, First Putable June 15,2010 (the “New 2010 Notes” and, together with the New 2008 Notes, the “NewNotes”), for any and all of our outstanding Old 2008 Notes and Old 2010 Notes.Upon expiration of the exchange offer, we issued $374.7 million principalamount at maturity of New 2008 Notes in exchange for a like principal amount atmaturity of our outstanding Old 2008 Notes and $374.9 million principalamount at maturity of New 2010 Notes in exchange for a like principal amount atmaturity of our outstanding Old 2010 Notes. Following our exchange ofconvertible debt for cash and stock in December 2006, there remainsoutstanding as of December 31, 2006, $213.2 million and 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**10.**   LONG-TERM DEBT(Continued)

$199.5 millionaggregate principal amount of the New 2008 Notes and New 2010 Notes,respectively. There also remains outstanding $0.3 million and$0.1 million of the Old 2008 Notes and Old 2010 Notes, respectively, as ofDecember 31, 2006.

The New Notes were issued solely to our existingsecurity holders pursuant to our offer to exchange, which was made in relianceupon the exemption from the registration requirement of the Securities Actafforded by Section 3(a)(9) thereof. We did not pay or give, directlyor indirectly, any commission or other remuneration for solicitation of theexchange of the Old Notes for the New Notes.

The New Notescontain the following terms:

·       theNew 2008 Notes are first putable on June 15, 2008 at a price of 100.25% ofthe face amount of the New 2008 Notes. The holders of the New 2008 Notes mayalso require us to repurchase all or a portion of the New 2008 Notes for cashon June 15, 2013, June 15, 2018, June 15, 2023 and June 15,2028, in each case at a price equal to the face amount of the New 2008 Notes.The New 2008 Notes are convertible prior to maturity, subject to certainconditions described below, into cash and shares of our common stock at aconversion price of $59.50 per share (an equivalent conversion rate ofapproximately 16.8067 shares per $1,000 principal amount of notes). We mayredeem any outstanding New 2008 Notes for cash on June 15, 2008 at a priceequal to 100.25% of the principal amount of such notes redeemed and after June 15,2008 at a price equal to 100% of the principal amount of such notes redeemed;and

·       theNew 2010 Notes are first putable for cash on June 15, 2010 at a price of100.25% of the face amount of the New 2010 Notes. The holders of the New 2010Notes may also require us to repurchase all or a portion of the New 2010 Notesfor cash on June 15, 2015, June 15, 2020, June 15, 2025 and June 15,2030, in each case at a price equal to the face amount of the New 2010 Notes.The New 2010 Notes are convertible prior to maturity, subject to certainconditions described below, into cash and shares of our common stock at aconversion price of $56.50 per share (an equivalent conversion rate ofapproximately 17.6991 shares per $1,000 principal amount of notes). We mayredeem any outstanding New 2010 Notes for cash on June 15, 2010 at a priceequal to 100.25% of the principal amount of such notes redeemed and after June 15,2010 at a price equal to 100% of the principal amount of such notes redeemed.

The New Notes alsocontain restricted convertibility terms that do not affect the conversion priceof the notes, but instead place restrictions on a holder’s ability to converttheir notes into a combination of cash and shares of our common stock, asdescribed below. A holder may convert the New Notes only if one or more of thefollowing conditions are satisfied:

·       if,on the trading day prior to the date of surrender, the closing sale price ofour common stock is more than 120% of the applicable conversion price pershare;

·       ifwe have called the New Notes for redemption;

·       ifthe average of the trading prices of the applicable New Notes for a specifiedperiod is less than 100% of the average of the conversion values of the NewNotes during that period; provided, however, that no New Notes may be convertedbased on the satisfaction of this condition during the six-month periodimmediately preceding each specified date on which the holders may require usto 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**10.**   LONG-TERM DEBT (Continued)

repurchase their notes(for example, with respect to the June 15, 2008 put date for the New 2008Notes, the New 2008 Notes may not be converted from December 15, 2007 to June 15,2008); or

·       ifwe make certain significant distributions to holders of our common stock, if weenter into specified corporate transactions or if our common stock is neitherlisted for trading on a U.S. national securities exchange or any similar U.S.system of automated securities price dissemination (a “Fundamental Change”).

Upon the satisfaction of any one of these conditions,we would classify the then-aggregate outstanding principal balance of New Notesas a current liability on our consolidated balance sheet.

Each $1,000 principal amount of New Notes isconvertible into cash and shares of our common stock, if any, based on anamount (the “Daily Conversion Value”), calculated for each of the ten tradingdays immediately following the conversion date (the “Conversion Period”). TheDaily Conversion Value for each trading day during the Conversion Period foreach $1,000 aggregate principal amount of New Notes is equal to one-tenth ofthe product of the then applicable conversion rate multiplied by the volumeweighted average price of our common stock on that day.

For each $1,000aggregate principal amount of New Notes surrendered for conversion, we willdeliver the aggregate of the following for each trading day during theConversion Period:

(1)         if the Daily ConversionValue for each trading day for each $1,000 aggregate principal amount of NewNotes exceeds $100.00, (a) a cash payment of $100.00 and (b) theremaining Daily Conversion Value in shares of our common stock; or

(2)         if the Daily ConversionValue for each trading day for each $1,000 aggregate principal amount of NewNotes is less than or equal to $100.00, a cash payment equal to the DailyConversion Value.

If the New Notes areconverted in connection with a Fundamental Change that occurs prior to June 15,2008, we may also be obligated to pay an additional premium with respect to theNew Notes so converted.

*Convertible NoteHedge*

Concurrent with the private placement of the OldNotes, we purchased a convertible note hedge from Credit Suisse First BostonInternational (“CSFBI”) at a cost of $258.6 million. We also sold to CSFBIwarrants to purchase an aggregate of 12,939,689 shares of our common stock andreceived net proceeds from the sale of $178.3 million. Following the December 2006amendment of the warrant agreements described above, there remain outstandingwarrants to purchase 7,120,396 shares of our common stock. In connection withour exchange of Old Notes for New Notes, we amended the convertible note hedgeto reflect the mandatory net share settlement feature of the New Notes. Takentogether, the convertible note hedge and warrants have the effect of increasingthe effective conversion price of the New Notes from our perspective to $72.08if held to maturity, a 50% premium to the last reported NASDAQ composite bidfor our common stock on the day preceding the date of the original agreements.At our option, the warrants may be settled in either net cash or net shares;the convertible note hedge must be settled using net shares. Under theconvertible note hedge, CSFBI will deliver to us the aggregate number of shareswe are required to deliver to a holder of New Notes that presents such NewNotes for conversion, provided, 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**10.**   LONG-TERM DEBT (Continued)

however, that if themarket price per share of our common stock is above $72.08, we will be requiredto deliver either shares of our common stock or cash to CSFBI representing thevalue of the warrants in excess of the strike price of the warrants. Inaccordance with EITF No. 00-19 and SFAS 150, we recorded theconvertible note hedge and warrants in additional paid-in capital as of June 30,2003, and do not recognize subsequent changes in fair value. We also recognizeda deferred tax asset of $90.5 million in the second quarter of 2003 forthe effect of the future tax benefits related to the convertible note hedge.

The warrants have a strikeprice of $72.08. Of the total warrants outstanding as of December 31,2006, 3,586,995 warrants expire on June 15, 2008, with the remaining3,533,401 warrants expiring on June 15, 2010. The warrants are exercisableonly on the respective expiration dates (European style) or upon the conversionof the notes, if earlier.

**Mortgage andBuilding Improvement Loans**

In March 1995, we purchased the buildings housingour administrative offices and research facilities in West Chester,Pennsylvania for $11.0 million. We financed the purchase through theassumption of an existing $6.9 million first mortgage and from$11.6 million in state funding provided by the Commonwealth ofPennsylvania. The first mortgage has a 15-year term with an annualinterest rate of 9.625%. The state funding has a 15-year term with anannual interest rate of 2%. The loans require annual aggregate principal andinterest payments of $1.8 million. The loans are secured by the buildingsand by all our equipment located in Pennsylvania that is otherwise unsecured.

In November 2002, thePennsylvania Industrial Development Board (“PIDA”) authorized the write-off ofthe outstanding principal balance of $5.3 million due on a loan granted byPIDA in 1995, contingent upon the commencement of construction of a newheadquarters facility in the Commonwealth of Pennsylvania no later than June 30,2004 and our creation of a specified number of new jobs in the Commonwealth. Atits meeting held June 8, 2004, the PIDA Board approved the extension ofthe construction deadline until December 31, 2005, subject to therequirement that, effective July 1, 2004, we must commence payment ofinterest only on the original loan. In January 2006, the PIDA board votedto extend the deadline to December 31, 2007 for the job creationobligations, and eliminated the requirement to commence construction of a newheadquarters facility by December 31, 2005. If the PIDA Board determinesnot to grant an extension to the December 31, 2007 job-creation deadlineor we do not meet these job-creation obligations, we will be required to resumepayment of principal on the original loan in addition to the payment ofinterest.

**11.   EARNINGS PERSHARE (“EPS”)**

We compute income per common share in accordance withSFAS No. 128, “Earnings Per Share” (“SFAS 128”). Basic income per commonshare is computed based on the weighted average number of common sharesoutstanding during the period. Diluted income per common share is computedbased on the weighted average number of common shares outstanding and thedilutive impact of common stock equivalents outstanding during the period. Thedilutive effect of employee stock options, restricted stock units, the ZeroCoupon Convertible Notes issued in December 2004 (the “New Zero CouponNotes”), the 2.0% Notes and the warrants are measured using the treasury stockmethod. The dilutive effect of our other convertible notes, including theremaining outstanding portions of the 2.5% Notes and the Zero 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**11.**   EARNINGS PER SHARE (“EPS”) (Continued)

Coupon Convertible Notesissued in June 2003 (the “Old Zero Coupon Notes”), are measured using the “if-converted”method. Common stock equivalents are not included in periods where there is anet loss, as they are anti-dilutive.

The 2.0% Notes and New Zero Coupon Notes each areconsidered to be instrument C securities as defined by EITF 90-19, “ConvertibleBonds with Issuer Option to Settle for Cash upon Conversion” (“EITF 90-19”);therefore, these notes are included in the dilutive earnings per sharecalculation using the treasury stock method. Under the treasury stock method,we must calculate the number of shares issuable under the terms of these notesbased on the average market price of the stock during the period, and includethat number in the total diluted shares figure for the period. Since there wasa net loss for the fourth quarter of 2006, there was no impact of these noteson diluted shares or diluted EPS during the period. Since the average shareprice of our stock during the year ended December 31, 2006 exceeded theconversion price of $46.70 for the 2.0% Notes and $56.50 and $59.50 for the NewZero Coupon Notes, the impact of these notes during the period was anadditional 7.3 million of incremental shares included to calculate dilutedEPS.

We have entered into convertible note hedge andwarrant agreements that, in combination, have the economic effect of reducingthe dilutive impact of the 2.0% Notes and the New Zero Coupon Notes. SFAS 128,however, requires us to analyze separately the impact of the convertible notehedge and warrant agreements on diluted EPS. As a result, the purchases of theconvertible note hedges are excluded because their impact will always beanti-dilutive. SFAS 128 further requires that the impact of the sale of thewarrants be computed using the treasury stock method. For example, using thetreasury stock method, if the average price of our stock during the periodended December 31, 2006 had been $75.00, $85.00 or $95.00, the shares fromthe warrants to be included in diluted EPS would have been 2.1 million,5.0 million and 7.3 million shares, respectively. The total number of sharesthat could potentially be included under the warrants is 26.8 million. Sincethere was a net loss for the fourth quarter of 2006, there was no impact of thewarrants on diluted shares or diluted EPS during the period. Since the averageshare price of our stock during the year ended December 31, 2006 did notexceed the effected conversion prices of either the 2.0% Notes or New ZeroCoupon Notes, there was no impact of the warrants on diluted shares or dilutedEPS during the period.

As of the filing date of this report, if our stockprice continues to exceed the 2.0% Notes and New Zero Coupon Notes effectiveconversion prices at March 31, 2007, the impact of the convertible notesand warrants will be included in the fully diluted EPS calculation.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**11.**   EARNINGS PER SHARE (“EPS”) (Continued)

The following is areconciliation of net income (loss) and weighted average common sharesoutstanding for purposes of calculating basic and diluted income (loss) percommon share:

| ** **                                                               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Basic  income (loss) per common share computation:**                   | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator:                                                               |       |                                       |       |   |   |   |   |
| Net income (loss)  used for basic income (loss) per common share         |       | $                                          | 144,816    |   | $ | (174,954 | ) | $ | (73,813 | ) |
| Denominator:                                                             |       |                                       |       |   |   |   |   |
| Weighted average  shares used for basic income (loss) per common share   |       | 60,507                                     |       | 58,051 |   | 56,489 |   |
| Weighted average  shares of participating securities                     |       | —                                     |       | — |   | 316 |   |
| **Basic income (loss) per common share**                                 | ** ** | **$**                                      | **2.39**   | ** ** | **$** | **(3.01** | **)** | **$** | **(1.31** | **)** |
| **Diluted income (loss) per common share  computation:**                 | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerator:                                                               |       |                                       |       |   |   |   |   |
| Net income (loss)  used for basic income (loss) per common share         |       | $                                          | 144,816    |   | $ | (174,954 | ) | $ | (73,813 | ) |
| Interest on  convertible notes (net of tax) per common share             |       | 154                                        |       | — |   | — |   |
| Net income (loss)  used for diluted income (loss) per common share       |       | $                                          | 144,970    |   | $ | (174,954 | ) | $ | (73,813 | ) |
| Denominator:                                                             |       |                                       |       |   |   |   |   |
| Weighted average  shares used for basic income (loss) per common share   |       | 60,507                                     |       | 58,051 |   | 56,489 |   |
| Effect of  dilutive securities:                                          |       |                                       |       |   |   |   |   |
| Convertible  subordinated notes and warrants                             |       | 7,432                                      |       | — |   | — |   |
| Employee stock  options and restricted stock units                       |       | 1,733                                      |       | — |   | — |   |
| Weighted average  shares used for diluted income (loss) per common share |       | 69,672                                     |       | 58,051 |   | 56,489 |   |
| **Diluted  income (loss) per common share**                              | ** ** | **$**                                      | **2.08**   | ** ** | **$** | **(3.01** | **)** | **$** | **(1.31** | **)** |

 

The following reconciliationshows the shares excluded from the calculation of diluted income per commonshare as the inclusion of such shares would be anti-dilutive:

| ** **                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted average  shares excluded:                 |       |                                       |       |   |   |   |   |
| Employee stock options and  restricted stock units |       | 2,693                                      |       | 8,827 |   | 4,041 |   |
| Convertible subordinated notes and warrants        |       | 26,821                                     |       | 3,454 |   | 7,284 |   |
|                                               |       | 29,514                                     |       | 12,281 |   | 11,325 |   |

 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**12.   PENSIONS ANDOTHER POSTRETIREMENT BENEFITS**

At Cephalon France,we have a defined benefit pension plan for current employees and apostretirement benefit plan for employees who retired prior to 2003. Theseplans are noncontributory and are not funded; benefit payments are funded fromoperations.

Weaccount for these plans using actuarial models required by SFAS No. 87,“Employers’ Accounting for Pensions,” and SFAS No. 106, “Employers’Accounting for Postretirement Benefits Other Than Pensions.” A summary of ourchange in benefit obligation as of the end of the last three fiscal years, andthe components of net periodic benefit costs for each of the last three fiscalyears, is as follows:

| ** **                              | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|-----------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                              | ** ** | **2006**                  | ** ** | **2005**                | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Change in benefit  obligation:          |       |                      |       |                    |       |   |   |   |   |   |   |   |   |
| Benefit obligation at beginning of year |       | $                         | 7,211      |                    | $          | 7,421 |   | $ | 6,627 |   | $ | 1,560 |   | $ | 1,839 |   | $ | 6,000 |   |
| Service cost                            |       | 556                       |       | 515                     |       | 486 |   | 41 |   | 34 |   | 33 |   |
| Interest cost                           |       | 282                       |       | 321                     |       | 351 |   | 52 |   | 56 |   | 89 |   |
| Actuarial (gain) loss                   |       | (6                        | )          | (264                    | )          | (277 | ) | 14 |   | (6 | ) | (41 | ) |
| Amortization of prior improvements      |       | —                    |       | —                  |       | — |   | (25 | ) | (25 | ) | — |   |
| Recognized gain due to plan curtailment |       | —                    |       | —                  |       | — |   | — |   | — |   | (4,214 | ) |
| Benefits paid                           |       | (164                      | )          | (68                     | )          | (359 | ) | (82 | ) | (99 | ) | (113 | ) |
| Foreign currency translation            |       | (15                       | )          | (714                    | )          | 593 |   | 4 |   | (239 | ) | 85 |   |
| Benefit  obligation at end of year      |       | $                         | 7,864      |                    | $          | 7,211 |   | $ | 7,421 |   | $ | 1,564 |   | $ | 1,560 |   | $ | 1,839 |   |

 

| ** **                                | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|-------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **2006**                  | ** ** | **2005**                | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Components of net  periodic benefit cost: |       |                      |       |                    |       |   |   |   |   |   |   |   |   |
| Service cost                              |       | $                         | 556        |                    | $          | 515 |   | $ | 486 |   | $ | 41 |   | $ | 34 |   | $ | 33 |   |
| Interest cost                             |       | 282                       |       | 321                     |       | 351 |   | 52 |   | 56 |   | 89 |   |
| Actuarial (gain) loss                     |       | (6                        | )          | (264                    | )          | (277 | ) | 14 |   | (6 | ) | (41 | ) |
| Amortization of prior improvements        |       | —                    |       | —                  |       | — |   | (25 | ) | (25 | ) | — |   |
| Recognized gain due to plan curtailment   |       | —                    |       | —                  |       | — |   | — |   | — |   | (4,214 | ) |
| Net periodic  benefit cost                |       | $                         | 832        |                    | $          | 572 |   | $ | 560 |   | $ | 82 |   | $ | 59 |   | $ | (4,133 | ) |

 

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**CEPHALON, INC. ANDSUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS(In thousands, except per share data)**

**12.**   PENSIONSAND OTHER POSTRETIREMENT BENEFITS (Continued)

In the first quarter of 2004, we cancelledpostretirement health care benefits at Cephalon France for employees not yetretired. This resulted in a gain of $4.2 million, which has beenrecognized as an offset to net periodic benefits costs for the year ended December 31,2004.

Thefollowing table presents the significant assumptions used in the abovecalculations:
|                                                | ** ** | **Pension Benefits** | ** ** | **Other Benefits** | ** ** |
|------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **2006**                  | ** ** | **2005**                | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Discount rate                                  |       |                      | 4.5        | %                       |       |   | 4.0 | % |   |   | 4.5 | % |   |   | 4.5 | % |   |   | 4.0 | % |   |   | 4.5 | % |   |
| Rate of  compensation increase                 |       |                      | 3.0        | %                       |       |   | 3.0 | % |   |   | 3.0 | % |   |   | 3.0 | % |   |   | 3.0 | % |   |   | 3.0 | % |   |
| Rate of health care cost  increase   |       |                      | —     | %                       |       |   | — | % |   |   | — | % |   |   | 2.0 | % |   |   | 2.0 | % |   |   | 2.0 | % |   |

 

Contributions made by Cephalon France forpostretirement health care benefits have been frozen at 2004 levels for allfuture periods. Participants are required to pay for any changes to the cost ofthis plan. Therefore, the disclosure of the effects of a 1% change in theassumed health care cost trend is not applicable as it would not impact ourcosts.

The accumulated benefit obligation for the definedbenefit pension plan was $5.0 million, $4.6 million and$5.2 million at December 31, 2006, 2005 and 2004, respectively.

Thefollowing benefits payments, which reflect expected future service, asappropriate, are expected to be paid as follows:

| **Year**  | ** ** | ** ** | ** ** | **Pension  Benefits** | ** ** | **Other  Benefits** | ** ** |
|-----------|------------|------------|------------|-----------------------|------------|---------------------|------------|
| 2007      |       |       | $          | 88                    |       |                |       | $ | 109 |   |   |
| 2008      |       |       | 84         |                  |       |                | 105        |   |   |
| 2009      |       |       | 47         |                  |       |                | 114        |   |   |
| 2010      |       |       | 229        |                  |       |                | 105        |   |   |
| 2011      |       |       | 465        |                  |       |                | 101        |   |   |
| 2012-2016 |       |       | 5,641      |                  |       |                | 603        |   |   |

 

We adopted SFAS 158effective December 31, 2006. Our retirement plans are unfunded and our unrecognizedgains or losses, prior service costs or credits, and transition assets orobligations at December 31, 2006 were not significant.

**13.   COMMITMENTS ANDCONTINGENCIES**

**Leases**

We lease certain of our offices and automobiles underoperating leases in the United States and Europe that expire at various timesthrough 2019. Lease expense under all operating leases totaled$20.0 million, $16.0 million and $12.4 million in 2006, 2005,and 2004, respectively.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENT (In thousands, except per share data)**

**13.**   COMMITMENTSAND CONTINGENCIES (Continued)

Estimatedlease expense for each of the next five years as of December 31, 2006 isas follows:

| 2007                 |   | $      | 18,596 |   |
|----------------------|--------|--------|--------|--------|
| 2008                 |   | 17,466 |   |
| 2009                 |   | 12,694 |   |
| 2010                 |   | 8,824  |   |
| 2011                 |   | 7,078  |   |
| 2012 and  thereafter |   | 24,926 |   |
|                 |   | $      | 89,584 |   |

 

**Cephalon ClinicalPartners, L.P.**

In August 1992, we exclusively licensed ourrights to MYOTROPHIN for human therapeutic use within the United States, Canadaand Europe to Cephalon Clinical Partners, L.P. (“CCP”). Development andclinical testing of MYOTROPHIN is performed on behalf of CCP under a researchand development agreement with CCP.

CCP has granted us an exclusive license to manufactureand market MYOTROPHIN for human therapeutic use within the United States,Canada and Europe in return for royalty payments equal to a percentage ofproduct sales and a milestone payment of approximately $12.4 million thatwill be made if MYOTROPHIN receives regulatory approval.

We have a contractualoption, but not an obligation, to purchase all of the limited partnershipinterests of CCP, which is exercisable upon the occurrence of certain eventsfollowing the first commercial sale of MYOTROPHIN. If, and only if, we decideto exercise this purchase option, we would make an advance payment ofapproximately $30.9 million in cash or, at our election, approximately$32.5 million in shares of common stock or a combination thereof. Shouldwe discontinue development of MYOTROPHIN, or if we do not exercise thispurchase option, our license will terminate and all rights to manufacture ormarket MYOTROPHIN in the United States, Canada and Europe will revert to CCP,which may then commercialize MYOTROPHIN itself or license or assign its rightsto a third party. In that event, we would not receive any benefits from such commercialization,license or assignment of rights.

**Legal Proceedings**

*PROVIGIL PatentLitigation and Settlements*

In March 2003, we filed a patent infringementlawsuit in the U.S. District Court in New Jersey against four companies—TevaPharmaceuticals USA, Inc., Mylan Pharmaceuticals, Inc., RanbaxyLaboratories Limited and Barr Laboratories, Inc.—based upon theabbreviated new drug applications (“ANDA”) filed by each of these firms withthe FDA seeking approval to market a generic form of modafinil. The lawsuitclaimed infringement of our U.S. Patent No. RE37,516 (the “‘516 Patent”)which covers the pharmaceutical compositions and methods of treatment with theform of modafinil contained in PROVIGIL and which expires on April 6,2015. We believe that these four companies were the first to file ANDAs withParagraph IV certifications and thus are eligible for the 180-dayexclusivity provided by the provisions of the Federal Food, Drug and CosmeticAct.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENT (In thousands, except per share data)**

**13.**   COMMITMENTS ANDCONTINGENCIES (Continued)

In late 2005 and early 2006, we entered intosettlement agreements with each of Teva, Mylan, Ranbaxy and Barr. As part ofthese separate settlements, we agreed to grant to each of these parties anon-exclusive royalty-bearing right to market and sell a generic version ofPROVIGIL in the United States. These licenses will become effective in April 2012.An earlier entry may occur based upon the entry of another generic version ofPROVIGIL. Each of these settlements has been filed with both the United StatesFederal Trade Commission (the “FTC”) and the Antitrust Division of theDepartment of Justice (the “DOJ”) as required by the Medicare PrescriptionDrug, Improvement and Modernization Act of 2003 (the “Medicare ModernizationAct”). The FTC has requested from us, and we have provided, certain informationin connection with its review of the PROVIGIL settlements. In July 2006,the FTC requested that we voluntarily submit additional information anddocuments in connection with its investigation of this matter. We arecooperating fully with this request. The FTC could challenge in anadministrative or judicial proceeding any or all of the settlements if theybelieve that the agreements violate the antitrust laws, although we believethat such a challenge would take years to resolve.

The impact on 2005 consolidated statements ofoperations was a $10.6 million selling, general and administrative chargefor agreements executed with Teva and Ranbaxy. We received licenses to certainmodafinil-related intellectual property developed by each party and inexchange for these licenses, we agreed to make payments to Barr, Ranbaxy andTeva collectively totaling up to $136.0 million, consisting of upfrontpayments, milestones and royalties on net sales of our modafinil products. Inorder to maintain an adequate supply of the active drug substance modafinil, weentered into agreements with three modafinil suppliers whereby we will purchasean annual minimum amount of modafinil over a six year period beginning in 2006,with the aggregate payments over that period totaling approximately$82.6 million.

We also are aware of a number of civil antitrustcomplaints, purportedly filed as class actions, filed by private parties inU.S. District Court for the Eastern District of Pennsylvania, each namingCephalon, Barr, Mylan, Teva and Ranbaxy as co-defendants and claiming, amongother things, that the patent litigation settlements concerning PROVIGILviolate the antitrust laws of the United States and certain state laws. Theproposed consolidated class action complaints have been designated byplaintiffs, each of which seeks to certify separate, purported classes ofplaintiffs: direct purchasers of PROVIGIL, and consumers and other indirectpurchasers of PROVIGIL. The plaintiffs in both cases are seeking monetarydamages and/or equitable relief. Separately, in June 2006, Apotex, Inc.,a subsequent ANDA filer seeking FDA approval of a generic form of modafinil,filed suit against us also in the U.S. District Court for the Eastern Districtof Pennsylvania alleging similar violations of antitrust laws and state law.Apotex asserts that the PROVIGIL settlement agreements improperly prevent itfrom obtaining FDA approval of its ANDA, and seeks monetary and equitableremedies, including a declaratory judgment that the ‘516 Patent is invalid andunenforceable. We filed a motion to dismiss the Apotex case in late September 2006.We believe that both the purported class action cases and the Apotex case arewithout merit. While we intend to vigorously defend ourselves and the proprietyof the settlement agreements, these efforts will be both expensive and timeconsuming and, ultimately, due to the nature of litigation, there can be noassurance that these efforts will be successful.

In early 2005, we also filed a patent infringementlawsuit in the U.S. District Court in New Jersey against Carlsbad Technology, Inc.based upon the Paragraph IV ANDA filed related to modafinil that 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENT (In thousands, except per share data)**

**13.**   COMMITMENTS AND CONTINGENCIES (Continued)

Carlsbad filed with theFDA. Carlsbad has asserted counterclaims for non-infringement of the ‘516Patent and invalidity of the ‘516 Patent. In early August 2006, we enteredinto a settlement agreement with Carlsbad and its development partner, WatsonPharmaceuticals, Inc., which we understand has the right to commercializethe Carlsbad product if approved by FDA. As part of this settlement, we agreedto grant to Watson a non-exclusive royalty-bearing right to market and sell ageneric version of PROVIGIL in the United States. This license will becomeeffective on or after April 6, 2012, subject to applicable regulatoryconsiderations. An earlier entry may occur based upon the entry of anothergeneric version of PROVIGIL. This agreement has been filed with both the FTCand DOJ, as required by the Medicare Modernization Act.

In November 2005 and March 2006,we received notice that Caraco Pharmaceutical Laboratories, Ltd. and Apotex, Inc.,respectively, also filed Paragraph IV ANDAs with the FDA in which each firm isseeking to market a generic form of PROVIGIL. We have not filed a patentinfringement lawsuit against either Caraco or Apotex as of the filing date ofthis report, although Apotex has filed suit against us, as described above.

*ACTIQ Patent Litigationand Settlement*

In February 2006, wealso announced that we had agreed to settle with Barr our pending patentinfringement dispute in the United States related to Barr’s ANDA filed with theFDA seeking to sell generic OTFC. Under the settlement, we granted to Barr anexclusive royalty bearing right to market and sell generic OTFC in the UnitedStates. The settlement with Barr related to ACTIQ has been filed with both theFTC and the Antitrust Division of the DOJ as required by the Medicare ModernizationAct. The FTC has requested from us, and we have provided, certain informationin connection with its review of this settlement. The FTC, the DOJ, or aprivate party could challenge in an administrative or judicial proceeding thesettlement with Barr if they believe that the agreement violates the antitrustlaws. If the settlement is challenged, there is no assurance that we couldsuccessfully defend against such challenge and, in that case, we could besubject to, among other things, damages, fines and possible invalidation of thesettlement agreement.

*U.S. Attorney’sOffice and Connecticut Attorney General Investigations*

Over the past few years, a significant number ofpharmaceutical and biotechnology companies have been the target of inquiriesand investigations by various federal and state regulatory, investigative,prosecutorial and administrative entities, including the DOJ and various U.S.Attorney’s Offices, the Office of Inspector General of the Department of Healthand Human Services, the FDA, the FTC and various state Attorneys Generaloffices. These investigations have alleged violations of various federal andstate laws and regulations, including claims asserting antitrust violations,violations of the Food, Drug and Cosmetic Act, the False Claims Act, thePrescription Drug Marketing Act, anti-kickback laws, and other allegedviolations in connection with off-label promotion of products, pricing andMedicare and/or Medicaid reimbursement.

Because of the broad scope and complexity of these lawsand regulations, the high degree of prosecutorial resources and attention beingdevoted to the sales practices of pharmaceutical companies by law enforcementauthorities, and the risk of potential exclusion from federal governmentreimbursement 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENT (In thousands, except per share data)**

**13.**   COMMITMENTS AND CONTINGENCIES (Continued)

programs, numerouscompanies have determined that it is highly advisable that they enter intosettlement agreements in these matters, particularly those brought by federalauthorities even where such companies believe the investigations are withoutmerit. Companies that have chosen to settle these alleged violations havetypically paid multi-million dollar fines to the government and agreed to abideby corporate integrity agreements.

In September 2004, weannounced that we had received subpoenas from the U.S. Attorney’s Office inPhiladelphia. That same month, we received a voluntary request for informationfrom the Office of the Connecticut Attorney General. Both the subpoenas and thevoluntary request for information appear to be focused on our sales andpromotional practices with respect to ACTIQ, GABITRIL® (tiagabine hydrochloride) and PROVIGIL,including the extent of off-label prescribing of our products by physicians. Weare cooperating with the U.S. Attorney’s Office and the Office of theConnecticut Attorney General, are providing documents and other information toboth offices in response to these and additional requests and are engaged inongoing discussions with both parties. These matters may involve the bringingof criminal charges and fines, and/or civil penalties. We cannot predict ordetermine the outcome of these matters or reasonably estimate the amount orrange of amounts of any fines or penalties that might result from a settlementor an adverse outcome. However, a settlement or an adverse outcome could have amaterial adverse effect on our financial position, liquidity and results ofoperations.

*Derivative Suit*

In January 2007, apurported stockholder of the company filed a derivative suit on behalf ofCephalon in the U.S. District Court for the Eastern District of Pennsylvanianaming each member of our board of directors and our Chief Financial Officer asdefendants. The suit alleges, among other things, that the defendants failed tomaintain adequate internal controls and procedures over the marketing and saleof ACTIQ in violation of their fiduciary duty, and in doing so violated variouscorporate governance and securities law standards and personally benefited fromsuch violations. The complaint seeks an unspecified amount of money damages,with interest, disgorgement of profits and other equitable relief. We believethe plaintiff’s allegations in this matter are without merit.

*Other Matters*

We are a party to certainother litigation in the ordinary course of our business, including, amongothers, European patent oppositions, patent infringement litigation and mattersalleging employment discrimination, product liability and breach of commercialcontract. We do not believe these matters, even if adversely adjudicated orsettled, would have a material adverse effect on our financial condition,results of operations or cash flows.

**Other Commitments**

We have committed to make potential future “milestone”payments to third parties as part of our in-licensing and development programsprimarily in the area of research and development agreements. Paymentsgenerally become due and payable only upon the achievement of certaindevelopmental, regulatory and/or commercial milestones. Because the achievementof these milestones is neither probable nor reasonably estimable, we have notrecorded a liability on our balance sheet for any such contingencies. 

117

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENT (In thousands, except per share data)**

**13.**   COMMITMENTS AND CONTINGENCIES (Continued)

As of December 31,2006, the potential milestone and other contingency payments due under currentcontractual agreements are approximately $857.5 million.

We have committed to makefuture minimum payments to third parties for certain raw material inventories.The minimum purchase commitments total $86.6 million as of December 31,2006, the majority of which relate to modafinil and armodafinil.

**14.   INCOME TAXES**

Thecomponents of income (loss) before income taxes were:

| ** **    | ** ** | **Year Ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States |       | $                                          | 286,136    |   | $ | (163,175 | ) | $ | (28,213 | ) |
| Foreign       |       | (47,882                                    | )          | (81,943 | ) | 29 |   |
| Total         |       | $                                          | 238,254    |   | $ | (245,118 | ) | $ | (28,184 | ) |

 

Thecomponents of the provision (benefit) for income taxes are as follows:

| ** **                     | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current taxes:                 |       |                                       |       |   |   |   |   |
| United States                  |       | $                                          | 61,182     |   | $ | 5,435 |   | $ | 4,074 |   |
| Foreign                        |       | 4,679                                      |       | 3,685 |   | 4,675 |   |
| State                          |       | (487                                       | )          | (1,943 | ) | 3,883 |   |
|                           |       | 65,374                                     |       | 7,177 |   | 12,632 |   |
| Deferred taxes:                |       |                                       |       |   |   |   |   |
| United States                  |       | 34,512                                     |       | (23,287 | ) | 48,021 |   |
| Foreign                        |       | (13,052                                    | )          | (9,096 | ) | (6,681 | ) |
| State                          |       | (8,092                                     | )          | 994 |   | (1,259 | ) |
|                           |       | 13,368                                     |       | (31,389 | ) | 40,081 |   |
| Change in  valuation allowance |       | 14,696                                     |       | (45,952 | ) | (7,084 | ) |
|                           |       | 28,064                                     |       | (77,341 | ) | 32,997 |   |
| Total                          |       | $                                          | 93,438     |   | $ | (70,164 | ) | $ | 45,629 |   |

 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENT (In thousands, except per share data)**

**14.**   INCOME TAXES (Continued)

A reconciliation of theUnited States Federal statutory rate to our effective tax rate is as follows:

| ** **                                                          | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| U.S. Federal  statutory rate—expense (benefit)                 |       | 35.0                                       | %          | (35.0 | )% | (35.0 | )% |
| In-process  research and development                                |       | —                                     |       | 18.6 |   | 230.6 |   |
| Meals and  entertainment                                            |       | 1.0                                        |       | 0.6 |   | 5.8 |   |
| Executive  compensation                                             |       | 1.4                                        |       | 0.7 |   | 3.8 |   |
| Other deductible  expenses                                          |       | (0.3                                       | )          | (0.3 | ) | (6.1 | ) |
| Revision of prior  years’ estimates                            |       | 0.2                                        |       | 0.7 |   | 6.4 |   |
| State income  taxes, net of U.S. federal tax benefit                |       | (2.2                                       | )          | (0.7 | ) | 6.1 |   |
| Tax rate  differential & permanent items on foreign income |       | 1.5                                        |       | 9.5 |   | 1.8 |   |
| Change in  valuation allowance                                      |       | 6.1                                        |       | (18.8 | ) | (25.1 | ) |
| Research and  development credit                                    |       | (1.2                                       | )          | (4.5 | ) | (42.2 | ) |
| Alternative  minimum tax                                            |       | —                                     |       | — |   | 13.5 |   |
| Change in reserve  for contingent liability                         |       | (2.6                                       | )          | 0.8 |   | — |   |
| Other                                                               |       | 0.3                                        |       | (0.2 | ) | 2.3 |   |
| Consolidated effective  tax rate                                    |       | 39.2                                       | %          | (28.6 | )% | 161.9 | % |

 

The tax benefits associated with employee exercises ofnon-qualified stock options and disqualifying dispositions of stock acquiredwith incentive stock options reduce taxes payable or increase the deferred taxasset until we begin paying U.S. federal tax. Tax benefits of$27.2 million and $2.6 million associated with the exercise ofemployee stock options and other equity compensation were recorded toadditional paid-in capital for the years ended December 31, 2006 and 2005,respectively.

Our foreign subsidiaries had $1.8 million ofunremitted earnings at December 31, 2006 and had no unremitted earnings atDecember 31, 2005. To the extent a subsidiary has unremitted earnings,such amounts have been included in the consolidated financial statementswithout giving effect to deferred taxes since it is management’s intent toreinvest such earnings in foreign operations.

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**14.**   INCOMETAXES (Continued)

Deferredincome taxes reflect the tax effects of temporary differences between the basesof assets and liabilities recognized for financial reporting purposes and taxpurposes, and net operating loss and tax credit carryforwards. Significantcomponents of net deferred tax assets and deferred tax liabilities are asfollows:

| ** **                                               | ** ** | **At December 31,** | ** ** |
|----------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                               | ** ** | **2006**                      | ** ** | **2005** | ** ** |
| Deferred tax assets:                                     |       |                          |       |   |   |
| Net operating  loss carryforwards                        |       | $                             | 114,557    |   | $ | 104,873 |   |
| Original issue discount                                  |       | 128,006                       |       | 186,536 |   |
| Capitalized research and development expenditures        |       | 17,042                        |       | 24,085 |   |
| Unrealized profit in inventory                           |       | 25,560                        |       | 17,837 |   |
| Research and development tax credits                     |       | 13,641                        |       | 50,458 |   |
| Acquired product rights and intangible assets            |       | 66,409                        |       | 66,802 |   |
| Reserves and accrued expenses                            |       | 29,393                        |       | 23,594 |   |
| Alternative minimum tax credit carryforwards             |       | 4,492                         |       | 6,978 |   |
| Deferred revenue                                         |       | 1,186                         |       | 179 |   |
| Deferred compensation                                    |       | 4,219                         |       | 2,524 |   |
| SFAS 123(R) stock-based compensation expense        |       | 11,348                        |       | — |   |
| Deferred charges on convertible debentures               |       | 11,959                        |       | 9,678 |   |
| Accounts receivable discounts and allowance              |       | 29,160                        |       | 24,932 |   |
| Other, net                                               |       | 3,049                         |       | 4,425 |   |
| Total deferred tax assets                                |       | 460,021                       |       | 522,901 |   |
| Valuation allowance                                      |       | (78,043                       | )          | (76,840 | ) |
| Net deferred tax assets                                  |       | $                             | 381,978    |   | $ | 446,061 |   |
| Deferred tax  liabilities:                               |       |                          |       |   |   |
| Acquired intangible assets from Group Lafon  acquisition |       | $                             | 33,878     |   | $ | 38,068 |   |
| Acquired intangible assets from CIMA LABS  acquisition   |       | 32,157                        |       | 36,063 |   |
| Acquired intangible assets from CTI acquisition          |       | 16,471                        |       | 18,164 |   |
| Acquired intangible assets from Zeneus acquisition       |       | 54,936                        |       | 70,890 |   |
| Deferred revenue                                         |       | 1,772                         |       | — |   |
| Fixed assets                                             |       | 4,458                         |       | 4,930 |   |
| Other comprehensive income                               |       | 6,079                         |       | — |   |
| Other                                                    |       | 2,008                         |       | 584 |   |
| Total deferred tax liabilities                           |       | $                             | 151,759    |   | $ | 168,699 |   |
| Net deferred tax assets                                  |       | $                             | 230,219    |   | $ | 277,362 |   |

 

In accordance with SFAS 109, the above overall netdeferred tax assets for the year ended December 31, 2006 and 2005 arepresented in the Consolidated Balance Sheet as: Current deferred tax assets,net; Non-current deferred tax assets, net; and Long-term deferred taxliabilities, net.

At December 31, 2006, we had gross operating losscarryforwards for U.S. federal income tax purposes of approximately$47.6 million and apportioned state gross operating losses ofapproximately 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**14.**   INCOME TAXES (Continued)

$574.0 million thatexpire in varying years starting in 2007. We also have foreign gross operatinglosses of approximately $224.3 million, of which $4.3 million may becarried forward 5 years, $9.6 million may be carried forward7 years, $2.5 million may be carried forward 15 years and$207.9 million may be carried forward with indefinite expiration dates.The net operating loss carryforwards differ from the accumulated deficitprincipally due to differences in the recognition of certain research anddevelopment expenses for financial and federal income tax reporting and netoperating loss carryforwards acquired in business combinations. Federal andstate research tax credits of $13.6 million are available to offset futuretax liabilities and expire starting in 2007. The amount of U.S. federal netoperating loss carryforwards that can be utilized in any one period will belimited by federal income tax regulations since a change in ownership asdefined in Section 382 of the Internal Revenue Code occurred in the prioryears. We do not believe that such limitation will have a material adverseimpact on the utilization of the net operating loss carryforwards, but we dobelieve it will affect utilization of tax credit carryforwards.

We believe that all of ourdomestic federal net operating loss carryforwards, portions of foreignoperating loss carryforwards, domestic tax credits and certain other deferredtax assets are more likely than not to be recovered. The remaining valuationallowance of $78.0 million and $76.8 million at December 31, 2006 and2005, respectively, consists of certain state tax credits, existing andacquired state and foreign and state operating loss carryforwards that webelieve are not likely to be recovered. A portion of the remaining valuationallowance at December 31, 2006 in the amount of $33.1 million relates toacquired foreign net operating losses for which a reduction in goodwill will berecorded upon release of the associated valuation allowance.

**15.   SELECTEDCONSOLIDATED QUARTERLY FINANCIAL DATA (UNAUDITED)**

| ** **                                                              | ** ** | **2006 Quarter Ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                              | ** ** | **December 31,**            | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** |
| **Statement of Operations Data:**                                       |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Net sales                                                               |       |                             | $          | 473,347 |   |   |   | $ | 470,513 |   |   | $ | 430,725 |   | $ | 345,587 |   |
| Gross profit                                                            |       |                             | 406,134    |   |   |   | 408,157 |   |   | 362,126 |   | 286,694 |   |
| Net income (loss)                                                       |       |                             | $          | (4,909 | ) |   |   | $ | 95,741 |   |   | $ | 50,417 |   | $ | 3,567 |   |
| Basic income (loss) per common share                                    |       |                             | $          | (0.08 | ) |   |   | $ | 1.58 |   |   | $ | 0.83 |   | $ | 0.06 |   |
| Weighted average number of common shares outstanding                    |       |                             | 61,783     |   |   |   | 60,762 |   |   | 60,738 |   | 59,734 |   |
| Diluted income (loss) per common share                                  |       |                             | $          | (0.08 | ) |   |   | $ | 1.43 |   |   | $ | 0.76 |   | $ | 0.05 |   |
| Weighted average  number of common shares outstanding-assuming dilution |       |                             | 61,783     |   |   |   | 67,072 |   |   | 66,654 |   | 73,508 |   |

** **

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**15.**   SELECTED CONSOLIDATED QUARTERLY FINANCIAL DATA (UNAUDITED)(Continued)

 

| ** **                                                              | ** ** | **2005 Quarter Ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                              | ** ** | **December 31,**            | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** |
| **Statement  of Operations Data:**                                      |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Net sales                                                               |       |                             | $          | 322,930 |   |   |   | $ | 294,371 |   |   | $ | 272,608 |   | $ | 266,609 |   |
| Gross profit                                                            |       |                             | 272,800    |   |   |   | 256,742 |   |   | 237,258 |   | 225,495 |   |
| Net income (loss)                                                       |       |                             | $          | 18,073 |   |   |   | $ | 29,343 |   |   | $ | (249,032 | ) | $ | 26,662 |   |
| Basic income (loss) per common share                                    |       |                             | $          | 0.31 |   |   |   | $ | 0.51 |   |   | $ | (4.29 | ) | $ | 0.46 |   |
| Weighted average number of common shares outstanding                    |       |                             | 58,099     |   |   |   | 58,064 |   |   | 58,046 |   | 57,994 |   |
| Diluted income (loss) per common share                                  |       |                             | $          | 0.30 |   |   |   | $ | 0.50 |   |   | $ | (4.29 | ) | $ | 0.44 |   |
| Weighted average  number of common shares outstanding-assuming dilution |       |                             | 60,351     |   |   |   | 59,398 |   |   | 58,046 |   | 65,065 |   |

 

**16.   SEGMENT ANDSUBSIDIARY INFORMATION**

Due to changes in our internal management andreporting structure in the second quarter of 2005, our chief operating decisionmaker now evaluates performance and makes decisions based on two segments,United States and Europe. As a result of this change, we have revised oursegment reporting to include inter-segment sales and pre-tax income forthese two segments as required by SFAS No. 131 “Disclosure about Segmentsof an Enterprise and Related Information” (“SFAS 131”). Prior to the secondquarter of 2005, we disclosed financial information for the United States andEurope in order to satisfy the geographical requirements of SFAS 131 but didnot present inter-segment sales and pre-tax income for these twosegments.

Revenue and pre-tax income (loss) for the years ended December 31,2006, 2005 and 2004, and long-lived assets as of December 31, 2006 and December 31,2005 are provided below:

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**16.**   SEGMENTAND SUBSIDIARY INFORMATION (Continued)

Revenuesfor the years ended December 31:

| ** **                             | ** ** | **2006**                 | ** ** |
|----------------------------------------|------------|--------------------------|------------|
| ** **                             | ** ** | **United   States** | ** ** | **Europe** | ** ** | **Total** | ** ** |
| Sales:                                 |       |                     |       |   |   |   |   |
| PROVIGIL                               |       | $                        | 691,779    |   | $ | 43,052 |   | $ | 734,831 |   |
| GABITRIL                               |       | 54,971                   |       | 4,316 |   | 59,287 |   |
| CNS                                    |       | 746,750                  |       | 47,368 |   | 794,118 |   |
| ACTIQ                                  |       | 550,390                  |       | 27,252 |   | 577,642 |   |
| Generic OTFC                           |       | 54,801                   |       | — |   | 54,801 |   |
| FENTORA                                |       | 29,250                   |       | — |   | 29,250 |   |
| Pain                                   |       | 634,441                  |       | 27,252 |   | 661,693 |   |
| Other                                  |       | 56,084                   |       | 208,277 |   | 264,361 |   |
| Total Sales                            |       | 1,437,275                |       | 282,897 |   | 1,720,172 |   |
| Other Revenues                         |       | 35,399                   |       | 8,498 |   | 43,897 |   |
| Total External Revenues                |       | 1,472,674                |       | 291,395 |   | 1,764,069 |   |
| Inter-Segment  Revenues                |       | 14,806                   |       | 88,879 |   | 103,685 |   |
| Elimination of  Inter-Segment Revenues |       | (14,806                  | )          | (88,879 | ) | (103,685 | ) |
| Total Revenues                         |       | $                        | 1,472,674  |   | $ | 291,395 |   | $ | 1,764,069 |   |

 

| ** **                             | ** ** | **2005**                 | ** ** |
|----------------------------------------|------------|--------------------------|------------|
| ** **                             | ** ** | **United   States** | ** ** | **Europe** | ** ** | **Total** | ** ** |
| Sales:                                 |       |                     |       |   |   |   |   |
| PROVIGIL                               |       | $                        | 475,557    |   | $ | 37,248 |   | $ | 512,805 |   |
| GABITRIL                               |       | 66,517                   |       | 5,741 |   | 72,258 |   |
| CNS                                    |       | 542,074                  |       | 42,989 |   | 585,063 |   |
| Pain                                   |       | 394,676                  |       | 17,102 |   | 411,778 |   |
| Other                                  |       | 49,695                   |       | 109,982 |   | 159,677 |   |
| Total Sales                            |       | 986,445                  |       | 170,073 |   | 1,156,518 |   |
| Other Revenues                         |       | 47,587                   |       | 7,787 |   | 55,374 |   |
| Total External Revenues                |       | 1,034,032                |       | 177,860 |   | 1,211,892 |   |
| Inter-Segment  Revenues                |       | 12,372                   |       | 85,705 |   | 98,077 |   |
| Elimination of  Inter-Segment Revenues |       | (12,372                  | )          | (85,705 | ) | (98,077 | ) |
| Total Revenues                         |       | $                        | 1,034,032  |   | $ | 177,860 |   | $ | 1,211,892 |   |

 

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**CEPHALON, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**16.**   SEGMENT ANDSUBSIDIARY INFORMATION (Continued)

| ** **                             | ** ** | **2004**                 | ** ** |
|----------------------------------------|------------|--------------------------|------------|
| ** **                             | ** ** | **United   States** | ** ** | **Europe** | ** ** | **Total** | ** ** |
| Sales:                                 |       |                     |       |   |   |   |   |
| PROVIGIL                               |       | $                        | 406,238    |   | $ | 33,429 |   | $ | 439,667 |   |
| GABITRIL                               |       | 87,349                   |       | 6,815 |   | 94,164 |   |
| CNS                                    |       | 493,587                  |       | 40,244 |   | 533,831 |   |
| Pain                                   |       | 337,072                  |       | 7,925 |   | 344,997 |   |
| Other                                  |       | 13,270                   |       | 88,277 |   | 101,547 |   |
| Total Sales                            |       | 843,929                  |       | 136,446 |   | 980,375 |   |
| Other Revenues                         |       | 28,749                   |       | 6,301 |   | 35,050 |   |
| Total External Revenues                |       | 872,678                  |       | 142,747 |   | 1,015,425 |   |
| Inter-Segment  Revenues                |       | 13,623                   |       | 44,097 |   | 57,720 |   |
| Elimination of  Inter-Segment Revenues |       | (13,623                  | )          | (44,097 | ) | (57,720 | ) |
| Total Revenues                         |       | $                        | 872,678    |   | $ | 142,747 |   | $ | 1,015,425 |   |

 

| ** **                          | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Income (loss) before  income taxes: |       |                        |       |                        |       |                        |       |   |   |   |   |   |   |
| United States                       |       |                        | $          | 286,136                     |       |                        |       | $ | (163,175 | ) |   |   | $ | (28,213 | ) |   |
| Europe                              |       |                        | (47,882    | )                           |       |                        | (81,943    | ) |   |   | 29 |   |   |
| Total                               |       |                        | $          | 238,254                     |       |                        |       | $ | (245,118 | ) |   |   | $ | (28,184 | ) |   |

 

| ** **         | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** | ** ** | ** ** |
|--------------------|------------|-----------------------------|------------|-----------------------------|------------|------------|------------|
| Long-lived assets: |       |                        |       |                        |       |       |       |   |   |   |   |   |   |
| United States      |       |                        | $          | 1,172,071                   |       |       |       | $ | 1,084,619 |   |   |   |   |   |   |
| Europe             |       |                        | 675,561    |                        |       |       | 685,750    |   |   |   |   |   |   |
| Total              |       |                        | $          | 1,847,632                   |       |       |       | $ | 1,770,369 |   |   |   |   |   |   |

 

We perform our annual testof impairment of goodwill as of July 1. At December 31, 2006, we had$267.9 million of goodwill in our United States segment and$199.3 million in our Europe segment. At December 31, 2005, we had$281.6 million of goodwill in our United States segment and$87.9 million in our Europe segment. We completed our annual test ofimpairment of goodwill in each segment at July 1, 2006 and concluded thatgoodwill was not impaired.

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**ITEM 9.   CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

None.

**ITEM 9A.   CONTROLSAND PROCEDURES**

**(a)**   **Evaluationof Disclosure Controls and Procedures**

Our management,with the participation of our Chief Executive Officer and Chief FinancialOfficer, evaluated the effectiveness of our disclosure controls and proceduresas of the end of the period covered by this Annual Report on Form 10-K.Based on that evaluation, the Chief Executive Officer and Chief FinancialOfficer concluded that our disclosure controls and procedures as of the end ofthe period covered by this Annual Report on Form 10-K have beendesigned and are functioning effectively to provide reasonable assurance thatthe information required to be disclosed by us in reports filed under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms. We believethat a controls system, no matter how well designed and operated, cannot provideabsolute assurance that the objectives of the controls system are met, and noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within a company have been detected.

**(b)**   **Management’sAnnual Report on Internal Control over Financial Reporting**

Management’s Reporton Internal Control over Financial Reporting is included in Part II, Item8 of this Annual Report on Form 10-K and incorporated into this Item9A by reference.

**(c)**   **AttestationReport of the Registered Public Accounting Firm**

Management’sassessment of the effectiveness of internal control over financial reporting asof December 31, 2006 has been audited by PricewaterhouseCoopers LLP, anindependent registered public accounting firm, as stated in their reportincluded in Part II, Item 8 of this Annual Report on Form 10-Kand incorporated into this Item 9A by reference.

**(d)**   **Change inInternal Control over Financial Reporting**

There have been no changesin our internal control over financial reporting during our most recent fiscalquarter that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

**ITEM 9B.   OTHERINFORMATION**

Not applicable.

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**PART III**

**ITEM 10.   DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**

**Directors**

The information requiredby Item 10 is incorporated herein by reference to the information containedunder the caption “Proposal 1—Election of Directors” in our definitive proxystatement related to the 2007 annual meeting of stockholders.

**Executive Officers**

The information concerningour executive officers required by this Item 10 is provided under the caption “ExecutiveOfficers of the Registrant” in Part I hereof.

**Section 16(a) BeneficialOwnership Reporting Compliance**

The information concerningSection 16(a) Beneficial Ownership Reporting Compliance by ourdirectors and executive officers is incorporated by reference to theinformation contained under the caption “Section 16(a) Beneficial OwnershipReporting Compliance” in our definitive proxy statement related to the 2007annual meeting of stockholders.

**Code of Ethics**

The information concerningour Code of Ethics is incorporated by reference to the information containedunder the caption “Governance of the Company—Does the Company have a “Code ofEthics’?” in our definitive proxy statement related to the 2007 annual meetingof stockholders.

**ITEM 11.   EXECUTIVECOMPENSATION**

The information requiredby this Item 11 is incorporated by reference to the information contained inour definitive proxy statement for the 2007 annual meeting of stockholders.

**ITEM 12.   SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS**

The information requiredby Item 12 is incorporated by reference to the information contained in ourdefinitive proxy statement for the 2007 annual meeting of stockholders.

**ITEM 13.   CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE**

The information requiredby Item 13 is incorporated by reference to the information contained in ourdefinitive proxy statement for the 2007 annual meeting of stockholders.

**ITEM 14.   PRINCIPALACCOUNTING FEES AND SERVICES**

The information requiredby Item 14 is incorporated by reference to the information contained in ourdefinitive proxy statement for the 2007 annual meeting of stockholders.

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**PART IV**

**ITEM 15.**         EXHIBITSAND FINANCIAL STATEMENT SCHEDULES

**(a)****          DOCUMENTSFILED AS PART OF THIS REPORT**

The following is a list of our consolidated financialstatements and our subsidiaries and supplementary data included in this AnnualReport on Form 10-K under Item 8 of Part II hereof:

| **1. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA** |
|---------------------------------------------------|
|                                              | Report of Management. |
|                                              | Report of Independent  Registered Public Accounting Firm. |
|                                              | Consolidated Balance  Sheets as of December 31, 2006 and 2005. |
|                                              | Consolidated Statements  of Operations for the years ended December 31, 2006, 2005 and 2004. |
|                                              | Consolidated Statements  of Stockholders’ Equity for the years ended December 31, 2006, 2005 and  2004. |
|                                              | Consolidated Statements  of Cash Flows for the years ended December 31, 2006, 2005 and 2004. |
|                                              | Notes to Consolidated  Financial Statements. |
| **2. FINANCIAL STATEMENT  SCHEDULES**             |
|                                              | Schedule II—Valuation  and Qualifying Accounts. |

 

Schedules, other than those listed above, are omittedbecause they are not applicable or are not required, or because the requiredinformation is included in the consolidated financial statements or notesthereto.

**(b) EXHIBITS**

Thefollowing is a list of exhibits filed as part of this annual report on Form 10-K.Where so indicated by footnote, exhibits that were previously filed areincorporated by reference. For exhibits incorporated by reference, the locationof the exhibit in the previous filing is indicated.

| Exhibit No. | ** ** | ** **                                                                                                                                                                                                                                                                                                                           | ** ** | **Description** | ** ** | ** ** |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|------------|
| 2.1              |       | Agreement  and Plan of Merger by and among Cephalon, Inc., Cepsal Acquisition  Corp., Salmedix, Inc., David S. Kabakoff, Arnold L. Oronsky, and Paul  Klingenstein dated May 12, 2005., filed as Exhibit 2.1 to the  Company’s Quarterly Report on Form 10-Q for the period ended  June 30, 2005. |
| 2.2              |       | Share Purchase Agreement dated as of  December 5, 2005 between Cephalon, Inc., Cephalon International  Holdings, Inc. and certain shareholders of Zeneus Holdings Limited,  filed as Exhibit 2.1 to the Company’s Current Report on Form 8-K  filed on December 22, 2005.                         |
| 3.1(a)           |       | Restated Certificate of Incorporation, as amended,  filed as Exhibit 3.1 to the Company’s Annual Report on Form 10-K  for the year ended December 31, 1996.                                                                                                                                                      |
| 3.1(b)           |       | Certificate of Amendment of Restated Certificate of  Incorporation, filed as Exhibit 3.1 to the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002.                                                                                                                                     |
| 3.2              |       | Bylaws of the Registrant, as amended and restated,  filed as Exhibit 3.2 to the Company’s Current Report on Form 8-K  filed on October 21, 2005.                                                                                                                                                                 |
| 4.1              |       | Specimen copy of stock certificate for shares of  Common Stock of the Registrant, filed as Exhibit 4.1 to the Company’s  Annual Report on Form 10-K for the year ended December 31,  1993.                                                                                                                       |

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| 4.2(a)        |   | Second Amended and Restated Rights Agreement, dated  October 27, 2003 between Cephalon, Inc. and StockTrans, Inc.  as Rights Agent, filed as Exhibit 1 to the Company’s Form 8-A/12G  on October 27, 2003.                                                                                                                                                                                                                                                                 |
|---------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.2(b)        |   | Agreement of Appointment and Joinder and Amendment  No. 1 to the Second Amended and Restated Rights Agreement, dated as of  February 9, 2007, by and between Cephalon, Inc. and American Stock  Transfer & Trust Company, as Rights Agent, filed as  Exhibit 10.1 to the Company’s Current Report on Form 8-K  filed on February 13, 2007.                                                                                                                        |
| 4.3(a)        |   | Form of Series A Warrant to purchasers of  Units including a limited partnership interest in Cephalon Clinical Partners,  L.P., filed as Exhibit 10.4 to the Company’s Registration Statement on  Form S-3 (Registration No. 333-56816) filed on  January 7, 1993.                                                                                                                                                                                                         |
| 4.3(b)        |   | Form of Series B Warrant to purchasers of  Units including a limited partnership interest in Cephalon Clinical Partners,  L.P., filed as Exhibit 10.5 to the Company’s Registration Statement on  Form S-3 (Registration No. 333-56816) filed on  January 7, 1993.                                                                                                                                                                                                         |
| 4.4(a)        |   | Indenture dated as of June 11, 2003 between the  Registrant and U.S. Bank National Association, filed as Exhibit 4.1 to  the Company’s Quarterly Report on Form 10-Q for the period ended  June 30, 2003.                                                                                                                                                                                                                                                                            |
| 4.4(b)        |   | Registration Rights Agreement, dated as of  June 11, 2003, between Cephalon, Inc. and Credit Suisse First  Boston LLC, CIBC World Markets Corp., J.P. Morgan Securities Inc., Morgan  Stanley & Co. Incorporated, SG Cowen Securities Corporation, ABN  AMRO Rothschild LLC, Citigroup Global Markets Inc. and Lehman Brothers Inc.,  as Initial Purchasers, filed as Exhibit 10.4 to the Company’s Quarterly  Report on Form 10-Q for the period ended June 30, 2003. |
| 4.5(a)        |   | Indenture dated as of December 20, 2004 between  the Registrant and U.S. Bank National Association, filed as Exhibit 4.l to  the Company’s Current Report on Form 8-K filed on  December 21, 2004.                                                                                                                                                                                                                                                                                   |
| 4.5(b)        |   | Registration Rights Agreement, dated as of  December 20, 2004, between Cephalon, Inc. and U.S. Bank, National  Association, filed as Exhibit 4.2 to the Company’s Current Report on  Form 8-K filed on December 21, 2004.                                                                                                                                                                                                                                                       |
| 4.6(a)        |   | Indenture, dated June 7, 2005, between  Cephalon, Inc. and U.S. Bank, National Association, as trustee,  previously filed as Exhibit 4.1 to the Company’s Current Report on  Form 8-K filed on June 8, 2005.                                                                                                                                                                                                                                                                    |
| 4.6(b)        |   | Form of 2.00% convertible senior subordinated  notes due 2015, previously filed as Exhibit 4.2 to the Company’s Current  Report on Form 8-K filed on June 8, 2005.                                                                                                                                                                                                                                                                                                                   |
| †10.1(a) |   | Executive Severance Agreement between Frank  Baldino, Jr. and Cephalon, Inc. dated July 25, 2002, filed as  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q  for the period ending June 30, 2002.                                                                                                                                                                                                                                                              |
| †10.1(b) |   | Form of Executive Severance Agreement between  Certain Executives and Cephalon, Inc. dated July 25, 2002, filed as  Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q  for the period ending June 30, 2002.                                                                                                                                                                                                                                                      |
| †10.1(c) |   | List of Executive Officers subject to the  Form of Severance Agreement between Certain Executive Officers and the  Company (see Exhibit 10.1(b) above), filed as Exhibit 10.3 to  the Company’s Current Report on Form 8-K filed on November 6,  2006.                                                                                                                                                                                                                     |
| †10.1(d) |   | Separation Agreement by and between  Cephalon, Inc. and Paul Blake dated as of August 23, 2006, filed as  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q  for the period ended September 30, 2006.                                                                                                                                                                                                                                                                 |

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| †10.2 (a) |   | Cephalon, Inc. 2005 Management Incentive  Compensation Plan, filed as Exhibit 10.1 to the Company’s Current Report  on Form 8-K filed on February 8, 2005.                                                                                                                        |
|----------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| †10.2(b)  |   | Cephalon, Inc. 2006 Management Incentive  Compensation Plan, filed as Exhibit 10.1 to the Company’s Current Report  on Form 8-K filed on February 2, 2006.                                                                                                                        |
| †10.3(a)  |   | Cephalon, Inc. Amended and Restated 1987 Stock  Option Plan, filed as Exhibit 10.7 to the Transition Report on  Form 10-K for transition period January 1, 1991 to  December 31, 1991, as amended by Amendment No. 1 filed on  September 4, 1992.                       |
| †10.3(b)  |   | Cephalon, Inc. 2000 Equity Compensation Plan  for Employees and Key Advisors, as amended and restated, effective as of  May 15, 2002, filed as Exhibit 99.1 to the Company’s Registration  Statement on Form S-8 (Registration No. 333-106115)  filed on June 13, 2003. |
| †10.3(c)  |   | Cephalon, Inc. 2000 Equity Compensation  Plan—Form of Employee Non-Qualified Stock Option, filed as  Exhibit 10.3(a) to the Company’s Quarterly Report on Form 10-Q  for the period ended September 30, 2004.                                                      |
| †10.3(d)  |   | Cephalon, Inc. 2000 Equity Compensation  Plan—Form of Nonqualified Stock Option Agreement for Employees (For  Grants Made On or After October 17, 2005), filed as Exhibit 10.3 to  the Company’s Current Report on Form 8-K filed on October 21,  2005.            |
| †10.3(e)  |   | Cephalon, Inc. 1995 Equity Compensation Plan,  as amended and restated, effective as of May 15, 2002, filed as  Exhibit 99.1 to the Company’s Registration Statement on Form S-8  (Registration No. 333-106112) filed on June 13, 2003.                                 |
| †10.3(f)  |   | Amendment No. 2004-1 to the  Cephalon, Inc. 1995 Equity Compensation Plan, effective as of  May 13, 2004, filed as Exhibit 99.1 to the Company’s Registration  Statement on Form S-8 (Registration No. 333-118611)  filed on August 27, 2004.                      |
| †10.3(g)  |   | Amendment No. 2006-1 to the  Cephalon, Inc. 2004 Equity Compensation Plan, effective as of  May 17, 2006, filed as Exhibit 10.1 to the Company’s Current Report  on Form 8-K filed on May 17, 2006.                                                                     |
| †10.3(h)  |   | Cephalon, Inc. 2004 Equity Compensation  Plan—Employee Restricted Stock Grant Term Sheet, filed as Exhibit 99.1  to the Company’s Current Report on Form 8-K filed on  December 17, 2004.                                                                                    |
| †10.3(i)  |   | Cephalon, Inc. 2004 Equity Compensation Plan—Form of  Non-Employee Director Non-Qualified Stock Option, filed as  Exhibit 10.3(c) to the Company’s Quarterly Report on Form 10-Q  for the period ended September 30, 2004.                                         |
| †10.3(j)  |   | Cephalon, Inc. 2004 Equity Compensation  Plan—Form of Employee Non-Qualified Stock Option, filed as  Exhibit 10.3(d) to the Company’s Quarterly Report on Form 10-Q  for the period ended September 30, 2004.                                                      |
| †10.3(k)  |   | Cephalon, Inc. 2004 Equity Compensation  Plan—Form of Employee Incentive Stock Option, filed as  Exhibit 10.3(e) to the Company’s Quarterly Report on Form 10-Q  for the period ended September 30, 2004.                                                          |
| †10.3(l)  |   | Cephalon, Inc. 2004 Equity Compensation  Plan—Form of Incentive Stock Option Agreement for Employees (For Grants  Made On or After October 17, 2005), filed as Exhibit 10.1 to the  Company’s Current Report on Form 8-K filed on October 21,  2005.               |
| †10.3(m)  |   | Cephalon, Inc. 2004 Equity Compensation  Plan—Form of Nonqualified Stock Option Agreement for Employees (For  Grants Made On or After October 17, 2005), filed as Exhibit 10.2 to  the Company’s Current Report on Form 8-K filed on October 21,  2005.            |

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| †10.3(n) |   | Cephalon, Inc. 2004 Equity Compensation  Plan—Form of Nonqualified Stock Option Agreement for Non-Employee  Directors (For Grants Made On or After October 17, 2005) (Initial Grants  Upon Joining Board), filed as Exhibit 10.4 to the Company’s Current  Report on Form 8-K filed on October 21, 2005.                                                                                                |
|---------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| †10.3(o) |   | Cephalon, Inc. 2004 Equity Compensation  Plan—Form of Nonqualified Stock Option Agreement for Non-Employee  Directors (For Grants Made On or After October 17, 2005) (Annual Grants  to Non-Employee Directors) filed as Exhibit 10.5 to the Company’s  Current Report on Form 8-K filed on October 21, 2005.                                                                                           |
| †10.3(p) |   | Cephalon, Inc. Amended and Restated Non-Qualified  Deferred Compensation Plan, filed as Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed on December 7, 2005.                                                                                                                                                                                                                                           |
| †10.4(a) |   | Summary of Agreement for Payment of Services between  Cephalon, Inc. and its Board of Directors, as approved May 13,  2004, filed as Exhibit 10.4 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2004.                                                                                                                                                                              |
| †10.4(b) |   | Summary of Agreement for Payment of Services between  Cephalon, Inc. and its Board of Directors, dated May 18, 2005,  filed as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q  for the period ended June 30, 2005.                                                                                                                                                                                   |
| †10.4(c) |   | Summary of Oral Agreement for Payment of Services  between Cephalon, Inc. and its Board of Directors, dated August 2,  2006, filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K  filed on August 2, 2006.                                                                                                                                                                                          |
| 10.5(a)       |   | License Agreement, dated May 15, 1992 between  Cephalon, Inc. and Kyowa Hakko Kogyo Co., Ltd., filed as  Exhibit 10.6 to the Transition Report on Form 10-K for  transition period January 1, 1991 to December 31, 1991, as amended  by Amendment No. 1 filed on September 4, 1992 on Form 8.                                                                                                      |
| 10.5(b)       |   | Letter agreement, dated March 6, 1995 amending  the License Agreement between Cephalon, Inc. and Kyowa Hakko Kogyo Co.,  Ltd., filed as Exhibit 10.4(b) to the Company’s Annual Report on  Form 10-K for the year ended December 31, 1994.                                                                                                                                                                   |
| 10.5(c)       |   | Letter agreement, dated May 11, 1999 amending  the License Agreement between Cephalon, Inc. and Kyowa Hakko Kogyo Co.,  Ltd., filed as Exhibit 10.4(c) to the Company’s Annual Report on  Form 10-K for the year ended December 31, 1999. (1)                                                                                                                                                                |
| 10.6          |   | Supply, Distribution and License Agreement, dated as  of July 27, 1993 between Kyowa Hakko Kogyo Co., Ltd. and  Cephalon, Inc., filed as Exhibit 10.3 to the Company’s Registration  Statement on Form S-3 (Registration No. 33-73896) filed  on January 10, 1994. (1)                                                                                                                                       |
| 10.7(a)       |   | Distribution, License and Supply Agreement, dated  December 7, 1999, between Anesta Corp. and Elan Pharma International  Limited, filed as Exhibit 10.18 to Anesta Corp.’s Annual Report on  Form 10-K for the year ended December 31, 1999. (1)                                                                                                                                                                       |
| 10.7(b)       |   | Intellectual Property Sale, Amendment and  Termination Agreement dated October 2, 2002, amending the Distribution,  License and Supply Agreement, dated as of December 7, 1999, and as  amended from time to time thereafter, by and between Anesta Corp. and Elan  Pharma International Limited, filed as Exhibit 10.1 to the Company’s  Quarterly Report on Form 10-Q for the period ended  September 30, 2002. |
| 10.7(c)       |   | Termination and Asset Sale and Purchase Agreement, dated  March 13, 2000 between Abbott Laboratories, Inc. and Anesta Corp.,  filed as Exhibit 10.19 to Anesta Corp.’s Quarterly Report on  Form 10-Q for the period ended March 31, 2000. (1)                                                                                                                                                                    |

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| 10.7(d)   |   | Technology License Agreement, dated  September 16, 1985, as amended through December 3, 1993 between  Anesta Corp. and the University of Utah Research Foundation, filed as  Exhibit 10.6 to Anesta Corp.’s Registration Statement on Form S-1  (File No. 33-72608) filed on May 31, 1996. (1) |
|-----------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.8(a)   |   | GABITRIL Product Agreement, dated October 31,  2000 between Cephalon, Inc. and Abbott Laboratories, filed as  Exhibit 10.13(b) to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2000. (1)                                                                          |
| 10.8(b)   |   | Toll Manufacturing and Packaging Agreement, dated  October 31, 2000 between Cephalon, Inc. and Abbott Laboratories,  filed as Exhibit 10.13(c) to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2000. (1)                                                          |
| 10.8(c)   |   | First Amendment to Toll Manufacturing and Packaging  Agreement by and between Abbott Laboratories and Cephalon, Inc. dated  October 1, 2004, filed as Exhibit 10.8(c) to the Company’s  Annual Report on Form 10-K for the year ended December 31,  2004. (1)                                  |
| 10.9(a)   |   | License and Supply Agreement dated July 7, 2004  between Barr Laboratories, Inc. and Cephalon, Inc., filed as  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q  for the period ended September 30, 2004 (1)                                                                        |
| 10.9(b)   |   | Amendment No. 1 to the License and Supply  Agreement between Barr Laboratories, Inc. and Cephalon, Inc. dated  July 9, 2004, filed as Exhibit 10.2 to the Company’s Quarterly  Report on Form 10-Q for the period ended September 30, 2004.                                               |
| 10.10     |   | Decision and Order of the Federal Trade Commission  in the matter of Cephalon, Inc. and CIMA LABS INC. dated August 9,  2004, filed as Exhibit 10.1(c) to the Company’s Quarterly Report on  Form 10-Q for the period ended September 30, 2004.                                                |
| 10.11     |   | Sale and Purchase Agreement dated as of  December 8, 2004 by and between Sanofi-Synthelabo France and  Cephalon France, previously filed as Exhibit 10.19 to the Company’s  Annual Report on Form 10-K for the year ended December 31,  2004. (1)                                                        |
| 10.12     |   | Acquisition Agreement by and among Cell  Therapeutics, Inc., CTI Technologies, Inc. and Cephalon, Inc.  dated June 10, 2005, incorporated by reference from Exhibit 10.1 to  Cell Therapeutics’ Current Report on Form 8-K filed on  June 14, 2005.                                       |
| 10.13(a)  |   | License and Collaboration Agreement between  Alkermes, Inc. and Cephalon, Inc. dated as of June 23, 2005,  filed as Exhibit 10.5(a) to the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2005. (1)                                                               |
| 10.13(b)  |   | Supply Agreement between Alkermes, Inc. and  Cephalon, Inc. dated as of June 23, 2005, filed as  Exhibit 10.5(b) to the Company’s Quarterly Report on Form 10-Q  for the period ended June 30, 2005. (1)                                                                                  |
| *10.13(c) |   | Amendment to the Supply Agreement between  Alkermes, Inc. and Cephalon, Inc. dated as of December 21,  2006. (2)                                                                                                                                                                                                   |
| *10.13(d) |   | Amendment to the License and Collaboration Agreement  between Alkermes, Inc. and Cephalon, Inc. dated as of  December 21, 2006.(2)                                                                                                                                                                                 |
| 10.14     |   | Co-Promotion Agreement by and between  Cephalon, Inc. and McNeil Consumer & Specialty Pharmaceuticals,  a division of McNeil-PPC, Inc., dated August 31, 2005, filed  as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q  for the period ended September 30, 2005. (1)    |
| 10.15(a)  |   | Office Lease between The Multi-Employer  Property Trust and Cephalon, Inc. dated January 14, 2004, filed as  Exhibit 10.20(a) to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2004. (1)                                                                      |

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| 10.15(b) |   | First Amendment to Lease, entered into as of  May 11, 2006, by and between the NewTower Trust Company Multi-Employer  Property Trust (f/k/a the Multi-Employer Property Trust), and  Cephalon, Inc., filed as Exhibit 10.1 to the Company’s Quarterly  Report on Form 10-Q for the period ended June 30, 2006. (2)                                             |
|----------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.15(c) |   | Consent to Sublease between The Multi-Employer  Property Trust, Systems & Computer Technology Corporation and  Cephalon, Inc. dated April 2, 2004, filed as Exhibit 10.20(b) to  the Company’s Annual Report on Form 10-K for the year ended  December 31, 2004. (1)                                                                             |
| 10.16(a) |   | Wiley Post Plaza Lease, dated December 7, 1994  between Anesta Corp. and Asset Management Services, filed as  Exhibit 10.13 to Anesta Corp.’s Annual Report on Form 10-K  (File No. 0-23160) for the year ended December 31, 1994.                                                                                                                             |
| 10.16(b) |   | Amendment No. 1 to Wiley Post Plaza Lease  between Anesta Corp. and Asset Management Services dated October 26,  1996, filed as Exhibit 10.11(b) to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2003.                                                                                                                       |
| 10.16(c) |   | Amendment No. 2 to Wiley Post Plaza Lease  between Anesta Corp. and Asset Management Services dated January 7,  1997, filed as Exhibit 10.11(c) to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2003.                                                                                                                        |
| 10.16(d) |   | Amendment No. 3 to Wiley Post Plaza Lease  between Anesta Corp. and Asset Management Services dated September 30,  1998, filed as Exhibit 10.11(d) to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2003.                                                                                                                     |
| 10.16(e) |   | Amendment No. 4 to Wiley Post Plaza Lease  between Anesta Corp. and Asset Management Services dated February 29,  2000, filed as Exhibit 10.11(e) to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2003.                                                                                                                      |
| 10.16(f) |   | Amendment No. 5 to Wiley Post Plaza Lease  between Anesta Corp. and Asset Management Services dated July 20, 2001,  filed as Exhibit 10.11(f) to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2003.                                                                                                                          |
| 10.16(g) |   | Amendment No. 6 to Wiley Post Plaza Lease  between Anesta Corp. and Asset Management Services dated July 20, 2001,  filed as Exhibit 10.11(g) to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2003.                                                                                                                          |
| 10.16(h) |   | Amendment No. 7 to Wiley Post Plaza Lease between  Anesta Corp. and Asset Management Services dated July 20, 2001, filed as  Exhibit 10.11(h) to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2003.                                                                                                                          |
| 10.16(i) |   | Amendment No. 8 to Wiley Post Plaza Lease  between Anesta Corp. and Asset Management Services dated October 14,  2002, filed as Exhibit 10.11(i) to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2003.                                                                                                                       |
| 10.16(j) |   | Amendment No. 9 to Wiley Post Plaza Lease  between Anesta Corp. and Asset Management Services dated May 15, 2003,  filed as Exhibit 10.11(j) to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2003. (1)                                                                                                                       |
| 10.16(k) |   | Amendment No. 10 to Wiley Post Plaza Lease  between Anesta Corp. and Wiley Post Plaza, L.C. dated June 24, 2004,  filed as Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q  for the period ended June 30, 2004. (1)                                                                                                                           |
| 10.17(a) |   | Amended and Restated Agreement of Limited  Partnership, dated as of June 22, 1992 by and among Cephalon Development  Corporation, as general partner, and each of the limited partners of Cephalon  Clinical Partners, L.P., filed as Exhibit 10.1 to the Company’s  Registration Statement on Form S-3 (Registration No. 33-56816)  filed on January 7, 1993. |

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| 10.17(b)  |   | Amended and Restated Product Development Agreement,  dated as of August 11, 1992 between Cephalon, Inc. and Cephalon  Clinical Partners, L.P., filed as Exhibit 10.2 to the Company’s  Registration Statement on Form S-3 (Registration No. 33-56816)  filed on January 7, 1993.                                                                                                             |
|-----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.17(c)  |   | Purchase Agreement, dated as of August 11, 1992  by and between Cephalon, Inc. and each of the limited partners of  Cephalon Clinical Partners, L.P., filed as Exhibit 10.3 to the Company’s  Registration Statement on Form S-3 (Registration No. 33-56816)  filed on January 7, 1993.                                                                                                      |
| 10.17(d)  |   | Pledge Agreement, dated as of August 11, 1992  by and between Cephalon, Inc. and Cephalon Clinical Partners, L.P.,  filed as Exhibit 10.8 to the Company’s Registration Statement on  Form S-3 (Registration No. 33-56816) filed on  January 7, 1993.                                                                                                                                        |
| 10.17(e)  |   | Promissory Note, dated as of August 11, 1992  issued by Cephalon Clinical Partners, L.P. to Cephalon, Inc., filed as  Exhibit 10.9 to the Company’s Registration Statement on Form S-3  (Registration No. 33-56816) filed on January 7, 1993.                                                                                                                                                |
| 10.17(f)  |   | Form of Promissory Note, issued by each of the  limited partners of Cephalon Clinical partners, L.P. to Cephalon Clinical  Partners, L.P., filed as Exhibit 10.10 to the Company’s Registration  Statement on Form S-3 (Registration No. 33-56816) filed  on January 7, 1993.                                                                                                                     |
| 10.18(a)  |   | ISDA Master Agreement dated January 22, 2003,  between Credit Suisse First Boston International and Cephalon, Inc.,  including Schedule to the Master Agreement dated as of January 22, 2003,  filed as Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q  for the period ended March 31, 2003.                                                                                    |
| 10.18(b)  |   | ISDA Credit Support Annex to the Schedule to the  ISDA Master Agreement dated as of January 22, 2003 between Credit Suisse  First Boston International and Cephalon, Inc., including the Elections  and Variables to the ISDA Credit Support Annex dated as of January 22,  2003, filed as Exhibit 10.2 to the Company’s Quarterly Report on  Form 10-Q for the period ended March 31, 2003. |
| 10.18(c)  |   | Letter Agreement Confirmation dated January 22,  2003, between Credit Suisse First Boston International and Cephalon, Inc,  filed as Exhibit 10.3 to the Company’s Quarterly Report on Form 10-Q  for the period ended March 31, 2003.                                                                                                                                                                 |
| 10.18(d)  |   | Termination of Letter Agreement dated July 22,  2005, between Credit Suisse First Boston International and  Cephalon, Inc., filed as Exhibit 10.2 to the Company’s Quarterly  Report on Form 10-Q for the period ended September 30, 2005.                                                                                                                                                        |
| 10.19(a)  |   | Five Year Warrant, dated June 6, 2003, between  the Company and Credit Suisse First Boston International filed as  Exhibit 99.d(3) to the Company’s Schedule TO-I dated  November 16, 2004.                                                                                                                                                                                                            |
| 10.19(b)  |   | Seven Year Warrant, dated June 6, 2003, between  the Company and Credit Suisse First Boston International filed as  Exhibit 99.d(4) to the Company’s Schedule TO-I dated  November 16, 2004.                                                                                                                                                                                                           |
| 10.19(c)  |   | Five Year Convertible Note Hedge, dated  December 3, 2004, between the Company and Credit Suisse First Boston  International, filed as Exhibit 99.d(5) to the Company’s Schedule  TO-I/A dated December 14, 2004.                                                                                                                                                                                      |
| 10.19(d)  |   | Seven Year Convertible Note Hedge, dated  December 3, 2004, between the Company and Credit Suisse First Boston  International, filed as Exhibit 99.d(6) to the Company’s Schedule  TO-I/A dated December 14, 2004.                                                                                                                                                                                     |
| *10.19(e) |   | Amendment to Five Year Warrant, dated  December 13, 2006, between the Company and Credit Suisse International  (f/k/a Credit Suisse First Boston International).                                                                                                                                                                                                                                                           |

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| *10.19(f) |   | Amendment to Seven Year Warrant, dated  December 13, 2006, between the Company and Credit Suisse International  (f/k/a Credit Suisse First Boston International).                                                                                                                             |
|-----------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| *10.19(g) |   | Form of Five Year Convertible Note Hedge  Amendment, dated December 13, 2006, between the Company and Credit  Suisse International (f/k/a Credit Suisse First Boston International).                                                                                                     |
| *10.19(h) |   | Form of Seven Year Convertible Note Hedge  Amendment, dated December 13, 2006, between the Company and Credit  Suisse International (f/k/a Credit Suisse First Boston International).                                                                                                    |
| 10.20(a)  |   | Convertible Note Hedge Confirmation, dated as of  June 2, 2005, between the Company and Deutsche Bank AG, filed as  Exhibit 10.1 to the Company’s Current Report on Form 8-K  filed on June 8, 2005.                                                                      |
| 10.20(b)  |   | Warrant Confirmation, dated as of June 2, 2005,  between the Company and Deutsche Bank AG, filed as Exhibit 10.2 to the  Company’s Current Report on Form 8-K filed on June 8, 2005.                                                                                      |
| 10.20(c)  |   | Amendment to Hedge Confirmation dated as of  June 2, 2005 by and among the Company, Deutsche Bank AG, New York and  Deutsche Bank AG, London, filed as Exhibit 10.1 to the Company’s Current  Report on Form 8-K filed on July 7, 2005.                                   |
| 10.20(d)  |   | Hedge Confirmation dated as of June 28, 2005 by  and among the Company, Deutsche Bank AG, New York and Deutsche Bank AG,  London, filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K  filed on July 7, 2005.                                               |
| 10.20(e)  |   | Amendment to Warrant Confirmation dated as of  June 2, 2005 by and among the Company, Deutsche Bank AG, New York and  Deutsche Bank AG, London, filed as Exhibit 10.3 to the Company’s Current  Report on Form 8-K filed on July 7, 2005.                                 |
| *10.20(f) |   | Termination and Assignment Agreement, dated as of  December 19, 2006, between Deutsche Bank AG and Cephalon, Inc.                                                                                                                                                                        |
| 10.21(a)  |   | Agreement dated as of December 8, 2005 by and  between Cephalon, Inc., Teva Pharmaceutical Industries Ltd., and Teva  Pharmaceuticals USA, Inc., filed as Exhibit 10.21 to the Company’s  Annual Report on Form 10-K for the year ended December 31,  2005. (1) |
| 10.21(b)  |   | Settlement Agreement dated as of December 22,  2005 by and between Cephalon, Inc. and Ranbaxy Laboratories Limited.,  filed as Exhibit 10.22 to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2005. (1)                                  |
| 10.21(c)  |   | Settlement Agreement dated January 9, 2006 by  and between the Company and Mylan Pharmaceuticals Inc., filed as  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q  for the period ended March 31, 2006. (1)                                                    |
| 10.21(d)  |   | Provigil Settlement Agreement dated February 1,  2006 by and between the Company and Barr Laboratories, Inc., filed as  Exhibit 10.2 to the Company’s Quarterly Report on Form 10-Q  for the period ended March 31, 2006. (1)                                        |
| 10.21(e)  |   | Modafinil License and Supply Agreement dated as of  February 1, 2006 by and between the Company and Barr  Laboratories, Inc., filed as Exhibit 10.3 to the Company’s  Quarterly Report on Form 10-Q for the period ended March 31,  2006. (1)                        |
| 10.21(f)  |   | Actiq Settlement Agreement dated February 1,  2006 by and among the Company, the University of Utah Research Foundation and  Barr Laboratories, Inc., filed as Exhibit 10.4 to the Company’ Quarterly  Report on Form 10-Q for the period ended March 31, 2006. (1)  |
| 10.21(g)  |   | Actiq Supplemental License and Supply Agreement  dated as of February 1, 2006 by and between the Company and Barr  Laboratories, Inc., filed as Exhibit 10.5 to the Company’s Quarterly  Report on Form 10-Q for the period ended March 31, 2006. (1)                |

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| 10.21(h) |   | Settlement and License Agreement dated  August 2, 2006 by and between the Company, Carlsbad  Technology, Inc. and Watson Pharmaceuticals, Inc., filed as  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q  for the period ended September 30, 2006. (2) |
|----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.22    |   | Form of Aircraft Time Share Agreement between  Cephalon, Inc. and certain executive officers, filed as  Exhibit 10.1 to the Company’s Current Report on Form 8-K  filed November 6, 2006.                                                                                |
| 10.23    |   | Co-Promotion Agreement dated as of June 12,  2006 by and between the Company and Takeda Pharmaceuticals North  America, Inc., filed as Exhibit 10.2 to the Company’s Quarterly  Report on Form 10-Q for the period ended June 30, 2006. (2)                              |
| *12.1    |   | Statement Regarding Computation of Ratios                                                                                                                                                                                                                                                              |
| *21      |   | List of Subsidiaries                                                                                                                                                                                                                                                                                   |
| *23.1    |   | Consent of PricewaterhouseCoopers LLP.                                                                                                                                                                                                                                                                 |
| *31.1    |   | Certification Pursuant to 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                    |
| *31.2    |   | Certification Pursuant to 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                    |
| *32.1    |   | Certification Pursuant to 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                    |
| *32.2    |   | Certification 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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*                    Filedherewith.

†                    Compensationplans and arrangements for executives and others.

(1)          Portionsof the Exhibit have been omitted and have been filed separately pursuantto an application for confidential treatment granted by the Securities andExchange Commission.

(2)          Portionsof the Exhibit have been omitted and have been filed separately pursuantto an application for confidential treatment filed with the Securities andExchange Commission pursuant to Rule 24b-2 under the SecuritiesExchange Act of 1934, as amended.

PROVIGIL, ACTIQ, FENTORA,GABITRIL, SPARLON, NUVIGIL, TREANDA, TRISENOX, DURASOLV, ORASOLV, ORAVESCENT,SPASFON LYOC, PARALYOC, PROXALYOC, LOPERAMIDE LYOC, SPASFON, FONZYLANE, MYOCET,ABELCET and MYOTROPHIN are trademarks or registered trademarks of Cephalon, Inc.or its subsidiaries. All other brands and names used herein are trademarks oftheir respective owners.

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**CEPHALON, INC.AND SUBSIDIARIESSCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS(In thousands)**

| **Year Ended December 31,**            | ** ** | ** ** | ** ** | **Balance at  Beginning of  the Year** | ** ** | **Additions  (Deductions)(1)** | ** ** | **Other  Additions  (Deductions)(2)** | ** ** | **Balance at  End of  the Year** | ** ** |
|-------------------------------------------------------|------------|------------|------------|-------------------------------------------------------|------------|--------------------------------|------------|---------------------------------------|------------|-------------------------------------------------|------------|
| Reserve for sales  discounts, returns and allowances: |       |       |       |                                                  |       |                           |       |                                  |       |                                            |       |   |   |   |   |   |   |
| 2006                                                  |       |       | $          | 72,935                                                |       |                           |       | $                                     | 171,293    |                                            |       |   | $ | (159,248 | ) |   |   | $ | 84,980 |   |   |
| 2005                                                  |       |       | $          | 42,092                                                |       |                           |       | $                                     | 179,099    |                                            |       |   | $ | (148,256 | ) |   |   | $ | 72,935 |   |   |
| 2004                                                  |       |       | $          | 22,679                                                |       |                           |       | $                                     | 100,302    |                                            |       |   | $ | (80,889 | ) |   |   | $ | 42,092 |   |   |
| Reserve for inventories:                              |       |       |       |                                                  |       |                           |       |                                  |       |                                            |       |   |   |   |   |   |   |
| 2006                                                  |       |       | $          | 2,265                                                 |       |                           |       | $                                     | 20,855     |                                            |       |   | $ | (10,020 | ) |   |   | $ | 13,100 |   |   |
| 2005                                                  |       |       | $          | 1,909                                                 |       |                           |       | $                                     | 758        |                                            |       |   | $ | (402 | ) |   |   | $ | 2,265 |   |   |
| 2004                                                  |       |       | $          | 2,451                                                 |       |                           |       | $                                     | (633       | )                                               |       |   | $ | 91 |   |   |   | $ | 1,909 |   |   |
| Reserve for income tax  valuation allowance:          |       |       |       |                                                  |       |                           |       |                                  |       |                                            |       |   |   |   |   |   |   |
| 2006                                                  |       |       | $          | 76,840                                                |       |                           |       | $                                     | 14,696     |                                            |       |   | $ | (13,493 | ) |   |   | $ | 78,043 |   |   |
| 2005                                                  |       |       | $          | 49,895                                                |       |                           |       | $                                     | (45,952    | )                                               |       |   | $ | 72,897 |   |   |   | $ | 76,840 |   |   |
| 2004                                                  |       |       | $          | 48,675                                                |       |                           |       | $                                     | (7,084     | )                                               |       |   | $ | 8,304 |   |   |   | $ | 49,895 |   |   |

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(1)          Amounts representcharges and reductions to expenses and revenue.

(2)          Amounts representutilization and adjustments of balance sheet reserve accounts.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

| Date: February 28, 2007 |                |                                  |
|------------------------------|---------------------|---------------------------------------|
|                         | CEPHALON, INC. |
|                         | By:                 | /s/  FRANK BALDINO, JR.          |
|                         |                | Frank  Baldino, Jr., Ph.D.       |
|                         |                | Chairman  and Chief Executive Officer |
|                              |                     |                                       |  |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated.

|                                 | **Signature** | ** **                                            | ** ** | ** **              | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|---------------------------------|---------------|-------------------------------------------------------|------------|-------------------------|-----------|------------|------------|------------|----------|------------|
| /s/ FRANK  BALDINO, JR.    |          | Chairman and  Chief Executive Officer                 |       | February 28,  2007 |
| Frank  Baldino, Jr., Ph.D. |          | (Principal executive  officer)                        |       |                    |
| /s/ J. KEVIN  BUCHI J.          |          | Executive Vice  President and Chief Financial Officer |       | February 28,  2007 |
| Kevin  Buchi                    |          | (Principal financial and  accounting officer)         |       |                    |
| /s/ WILLIAM P.  EGAN            |          | Director                                              |       | February 28,  2007 |
| William  P. Egan                |          |                                                  |       |                    |
| /s/ MARTYN D.  GREENACRE        |          | Director                                              |       | February 28,  2007 |
| Martyn  D. Greenacre            |          |                                                  |       |                    |
| /s/ VAUGHN M.  KAILIAN          |          | Director                                              |       | February 28,  2007 |
| Vaughn  M. Kailian              |          |                                                  |       |                    |
| /s/ KEVIN E.  MOLEY             |          | Director                                              |       | February 28,  2007 |
| Kevin  E. Moley                 |          |                                                  |       |                    |
| /s/ CHARLES A.  SANDERS         |          | Director                                              |       | February 28,  2007 |
| Charles  A. Sanders, M.D.       |          |                                                  |       |                    |
| /s/ GAIL R.  WILENSKY           |          | Director                                              |       | February 28,  2007 |
| Gail  R. Wilensky, Ph.D.        |          |                                                  |       |                    |
| /s/ DENNIS L.  WINGER           |          | Director                                              |       | February 28,  2007 |
| Dennis L. Winger                |          |                                                  |       |                    |

 

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