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  **UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549****FORM 10-K**   þ **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934****For the year ended December 31, 2006.****Or**   o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934****For the transition period from                      to                     .****Commission file number 0-18443****MEDICIS PHARMACEUTICAL CORPORATION**(Exact name of registrant as specified in its charter)   Delaware 52-1574808   (State of other jurisdiction (I.R.S. Employer Identification No.)of incorporation or organization)     8125 North Hayden Road , Scottsdale, Arizona 85258-2463   (Address of principal executive office) (Zip Code)Registrant’s telephone number, including area code: (602) 808-8800Securities registered pursuant to Section 12(b) of the Act:Class A common stock, $0.014 par value   New York Stock Exchange Preference Share Purchase Rights   (Name of each exchange on which (Title of each Class)registered)  Securities registered pursuant to Section 12(g) of the Act: NONEIndicate by check mark if the registrant is a well -known seasoned issuer, as defined in Rule 405 of theSecurities Act. Yes þ No oIndicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d)of the Act. Yes o No þIndicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities ExchangeAct of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes þ No oIndicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not becontained, to the best of the registrant’s knowledge, in definitive proxyor information statements incorporated by reference in Part III of thisForm or any amendment to this Form 10-K o.Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non -accelerated filer. See definitionof “accelerated filer and large accelerated filer” in Rule 12b-2 of theExchange Act. (Check one):Large accelerated filer þ          Accelerated filer o          Non-accelerated filer oIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)Yes o No þThe aggregate market value of the voting stock held on June 30, 2006 bynon-affiliates of the registrant was $798,138,672 based on the closingprice of $24.00 per share as reported on the New York Stock Exchange onJune 30, 2006, the last business day of the registrant’s most recentlycompleted second fiscal quarter (calculated by excluding all shares heldby executive officers, directors and holders known to the registrant offive percent or more of the voting power of the registrant’s commonstock, without conceding that such persons are “affiliates” of theregistrant for purposes of the federal securities laws). As of February23, 2007, there were 55,602,652 outstanding shares of Class A commonstock.Documents incorporated by reference:Portions of the Proxy Statement for the registrant’s 2007 Annual Meeting of Shareholders (the “ProxyStatement”) are incorporated herein by reference in Part III of this Form 10-K to the extent stated herein.  
 

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PART IItem 1. BusinessItem 1A. Risk FactorsItem 1B. Unresolved Staff CommentsItem 2. PropertiesItem 3. Legal Proceedings PART IIItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer            Purchases of Equity SecuritiesItem 6. Selected Financial DataItem 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsItem 7A. Quantitative and Qualitative Disclosure About Market RiskItem 8. Financial Statements and Supplementary DataItem 9. Changes in and Disagreements with Accountants and Financial DisclosureItem 9A. Controls and ProceduresItem 9B. Other Information PART III Item 10. Directors and Executive Officers of the RegistrantItem 11. Executive CompensationItem 12. Security Ownership of Certain Beneficial Owners and ManagementItem 13. Certain Relationships and Related TransactionsItem 14. Principal Accountant Fees and Services PART IV SIGNATURESExhibit IndexEX-12EX-21.1EX-23.1EX-31.1EX-31.2EX-32.1EX-32.2

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**PART I**Item 1. Business*Change in Fiscal Year*     Effective December 31, 2005, Medicis Pharmaceutical Corporation (“Medicis”, the “Company”, oras used in the context of “we”, “us” or “our”) changed its fiscal year end from June 30 to December31. This change was made to align our fiscal year end with other companies within our industry.This Form 10-K is intended to cover the audited calendar year January 1, 2006 to December 31, 2006,which we refer to as “2006.” Comparative financial information to 2006 is provided in this Form10-K with respect to the calendar year January 1, 2005 to December 31, 2005, which is unaudited andwe refer to as “2005.” Additional information is provided with respect to the transition periodJuly 1, 2005 through December 31, 2005 (the “Transition Period”), which is audited. We refer tothe period beginning July 1, 2004 and ending June 30, 2005 as “fiscal 2005”, and the periodbeginning July 1, 2003 and ending June 30, 2004 as “fiscal 2004.”*The Company*     Medicis Pharmaceutical Corporation, together with its wholly owned subsidiaries, is a leadingindependent specialty pharmaceutical company focused primarily on helping patients attain a healthyand youthful appearance and self-image through the development and marketing in the U.S. ofproducts for the treatment of dermatological, aesthetic and podiatric conditions. We also marketproducts in Canada for the treatment of dermatological and aesthetic conditions. We believe thatthe U.S. market for dermatological pharmaceutical sales exceeds $5 billion annually. According tothe American Society for Aesthetic Plastic Surgery, a national not-for-profit organization foreducation and research in cosmetic plastic surgery, nearly 11.5 million surgical and non-surgicalcosmetic procedures were performed in the United States during 2005, including approximately 9.3million non-surgical cosmetic procedures.     We have built our business by executing a four-part growth strategy: promoting existingbrands, developing new products and important product line extensions, entering into strategiccollaborations, and acquiring complementary products, technologies and businesses. Our corephilosophy is to cultivate relationships of trust and confidence with the high prescribingdermatologists and podiatrists and the leading plastic surgeons in the United States.     We offer a broad range of products addressing various conditions or aesthetic improvements,including facial wrinkles, acne, fungal infections, rosacea, hyperpigmentation, photoaging,psoriasis, skin and skin-structure infections, seborrheic dermatitis and cosmesis (improvement inthe texture and appearance of skin). We currently offer 17 branded products. Our primary brandsare OMNICEF® (cefdinir), RESTYLANE® (hyaluronic acid), SOLODYN®(minocycline HCl, USP), TRIAZ® (benzoyl peroxide), VANOSTM (fluocinonide)Cream 0.1%, and ZIANATM (clindamycin phosphate 1.2% and tretinoin 0.025%) Gel. Many ofour primary brands currently enjoy branded market leadership in the segments in which they compete.Because of the significance of these brands to our business, we concentrate our sales andmarketing efforts in promoting them to physicians in our target markets. We also sell a number ofother products that are considered less critical to our business.     We develop and obtain marketing and distribution rights to pharmaceutical agents in variousstages of development. For example, in 2006, we obtained the rights to develop, distribute andcommercialize RELOXIN**®** in the U.S., Canada and Japan. We have a variety of productsunder development, ranging from new products to existing product line extensions and reformulationsof existing products. Our product development strategy involves the rapid evaluation andformulation of new therapeutics by obtaining preclinical safety and efficacy data, when possible,followed by rapid safety and efficacy testing in humans. As a result of our increasing financialstrength, we have begun adding long-term projects to our development pipeline. Historically, wehave supplemented our research and development efforts by entering into research and developmentagreements with other pharmaceutical and biotechnology companies.
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     Currently, we outsource our entire product manufacturing needs. The underlying cost to us formanufacturing our products is established in our agreements with outside manufacturers. Because ofthe short-term nature of these agreements, our expenses for manufacturing are not fixed and couldchange from contract to contract.     OMNICEF® is a trademark of Fujisawa Pharmaceutical Co. Ltd. and is used under alicense from Abbott Laboratories, Inc. (“Abbott”). On April 1, 2005, Fujisawa Pharmaceutical Co.Ltd. merged with Yamanouchi Pharmaceutical Co. Ltd., creating Astelles Pharma, Inc.*Our Products*     We currently market 17 branded products. Our sales and marketing efforts are currentlyfocused on our primary brands. The following chart details certain important features of ourprimary brands:     **Brand** **Treatment** **U.S. Market Impact**OMNICEF® A patented oral cephalosporin for skin andskin-structure infections Better pathogen eradication rates compared to mostfrequently prescribed antibiotic for this indicationRESTYLANE® Injectable gel for treatment of moderateto severe facial wrinkles and folds,such as nasolabial folds The leading worldwide injectable dermal fillerSOLODYN® Once daily dosage in the treatment ofinflammatory lesions of non-nodularmoderate to severe acne vulgaris inpatients 12 and older Launched in July 2006 following U.S. Food and Drug Administration (“FDA”) approval on May 8, 2006TRIAZ® Topical patented gel and cleanser andpatent-pending pad treatments for acne A leading branded prescription benzoyl peroxide productVANOS**TM** Super-high potency topical corticosteroidindicated for the relief of the inflammatoryand pruritic manifestations of corticosteroidresponsive dermatoses in patients 12 yearsof age or older Launched in April 2005 following FDA approval on February 11, 2005ZIANA**TM** Once daily topical gel treatment for acnevulgaris in patients 12 and older Approved by the FDA on November 7, 2006. Firstcommercial sales to wholesalers in December 2006and launched in January 2007*Prescription Pharmaceuticals*     Our principal branded prescription pharmaceutical products are described below:     **OMNICEF****®** is indicated for the treatment of uncomplicated skin and skin-structureinfections. Studies show that OMNICEF® has superior pathogen eradication rates versusCephalexin, the most frequently prescribed antibiotic for uncomplicated skin and skin-structureinfections. OMNICEF® has been promoted to dermatologists and podiatrists since May 2001pursuant to our exclusive co-promotion agreement with Abbott. In return, we receive commissionrevenue from Abbott based on prescriptions generated in these categories. Our agreement withAbbott expires in 2013.     **SOLODYN**®, launched to dermatologists in July 2006 after approval by the FDA on May8, 2006, is the only oral minocycline approved for once daily dosage in the treatment ofinflammatory lesions of non-nodular moderate to severe acne vulgaris in patients 12 years of ageand older. SOLODYN® is also the only approved minocycline in extended release tabletform. SOLODYN® is lipid soluble, and its mode of action occurs in the skin and sebum.SOLODYN® is not bioequivalent to any other minocycline products, and is in no wayinterchangeable with other forms of minocycline. SOLODYN® is patented until 2018 by aU.S. patent which covers SOLODYN®‘s unique dissolution rate. Other patents coveringSOLODYN® are to be filed or are pending. SOLODYN® is available byprescription in 45mg, 90mg and 135mg extended release tablet dosages.     **TRIAZ**®, a topical therapy prescribed for the treatment of numerous forms andvarying degrees of acne, is available as a patented gel or cleanser or in a patent-pending pad inthree concentrations. TRIAZ® products are
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manufactured using the active ingredientbenzoyl peroxide in a patented vehicle containing glycolic acid and zinc lactate. Studiesconducted by third parties have shown that benzoyl peroxide is the most efficacious agent availablefor eradicating the bacteria that cause acne with no reported resistance. We introduced theTRIAZ® brand in fiscal 1996. In July 2003, we launched TRIAZ® Pads, thefirst benzoyl peroxide pad available in the U.S. indicated for the topical treatment of acnevulgaris. TRIAZ® is protected by a U.S. patent that expires in 2015.     **VANOS****TM** Cream, launched to dermatologists in April 2005 after approval by the FDA onFebruary 11, 2005, is a super-high potency (Class I) topical corticosteroid indicated for therelief of the inflammatory and pruritic manifestations of corticosteroid responsive dermatoses inpatients 12 years of age or older. The active ingredient in VANOS**TM** is fluocinonide0.1%, and is the only fluocinonide available in the Class I category of topical corticosteroids.Physicians may already be familiar with the fluocinonide 0.05%, the active ingredient in another ofour products, the Class II corticosteroid LIDEX®. Two double blind clinical studieshave demonstrated the efficacy, safety and tolerability of VANOS**TM**. Its base wasformulated to have the cosmetic elegance of a cream, yet behave like an ointment on the skin. Inaddition, physicians have the flexibility of prescribing VANOS**TM** either for once or twicedaily application. VANOS**TM** Cream is protected by a U.S. patent that expires in 2021.     **ZIANA****TM** Gel, which contains clindamycin phosphate 1.2% and tretinoin 0.025%, wasapproved by the FDA on November 7, 2006. Initial shipments of ZIANA**TM** to wholesalersbegan in December 2006, with formal promotional launch to dermatologists occurring in January 2007.ZIANA**TM** is the first and only combination of clindamycin and tretinoin approved for oncedaily use for the topical treatment of acne vulgaris in patients 12 years and older.ZIANA**TM** is also the first and only approved acne product to combine an antibiotic and aretinoid. ZIANA**TM** is protected by a U.S. patent for both composition of matter andmethod that expires in 2020. An additional patent covering composition of matter has been placedbefore the U.S. Patent and Trademark Office to be reissued. Each of these patents cover aspects ofthe unique vehicle which are used to deliver the active ingredients in ZIANA**TM**.ZIANA**TM** is available by prescription in 30 gram and 60 gram tubes.*Dermal Restorative Products*     Our principal branded dermal restorative products are described below:     **RESTYLANE****®****, PERLANE****®****, RESTYLANE FINE LINES****TM** and**SubQ****TM** are injectable, transparent, stabilized hyaluronic acid gels, which require nopatient sensitivity tests in advance of product administration. These products are the onlyparticle-based hyaluronic acid dermal fillers and offer patients a “tissue tailored” result basedon their particular skin type volume augmentation needs. In the United States, the FDA regulatesthese products as medical devices. Medicis offers all four of these products in Canada, and beganoffering RESTYLANE® in the United States on January 6, 2004. PERLANE®,RESTYLANE FINE LINES TM and SubQTM have not yet been approved by the FDA foruse in the United States. We acquired the exclusive U.S. and Canadian rights to these dermalrestorative products from Q-Med AB, a Swedish biotechnology/medical device company and itsaffiliates (collectively “Q-Med”) through license agreements.*Research and Development*     We develop and obtain rights to pharmaceutical agents in various stages of development.Currently, we have a variety of products under development, ranging from new products to existingproduct line extensions and reformulations of existing products. Our product development strategyinvolves the rapid evaluation and formulation of new therapeutics by obtaining preclinical safetyand efficacy data, when possible, followed by rapid safety and efficacy testing in humans. As aresult of our increasing financial strength, we have begun adding long-term projects to ourdevelopment pipeline. Historically, we have supplemented our research and development efforts byentering into research and development agreements with other pharmaceutical and biotechnologycompanies.     On September 26, 2002, we entered into an exclusive license and development agreement with DowPharmaceutical Sciences, Inc. (“Dow”) for the development and commercialization of a patenteddermatologic product, ZIANA**TM**. Under terms of the agreement, as amended, we made aninitial payment of $5.4 million and a development milestone payment of $8.8 million to Dow duringfiscal 2003, a development milestone payment of $2.4 million to Dow during fiscal 2004 anddevelopment milestone payments totaling $11.9 million to Dow during
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the Transition Period. Thesepayments were recorded as charges to research and development expense in the periods in which themilestones were achieved. During the quarter ended December 31, 2006, ZIANA**TM** wasapproved by the FDA and, in accordance with the agreement between the parties, we made anadditional payment of $1.0 million to Dow for the achievement of this milestone. The $1.0 millionpayment was recorded as a long-lived asset in our consolidated balance sheets.     On July 15, 2004, we entered into an exclusive license agreement and other ancillary documentswith Q-Med to market, distribute and commercialize in the United States and Canada Q-Med’s productcurrently known as SubQ TM. Q-Med has the exclusive right to manufactureSubQ TM for Medicis. SubQ TM is currently not approved foruse in the United States. Under the terms of the license agreement, Medicis Aesthetics HoldingsInc., a wholly owned subsidiary of Medicis, licenses SubQ TM for approximately$80.0 million, due as follows: approximately $30.0 million paid on July 15, 2004, which wasrecorded as research and development expense during the first quarter of fiscal 2005; approximately$10.0 million upon successful completion of certain clinical milestones; approximately $20.0million upon the satisfaction of certain defined regulatory milestones; and approximately $20.0million upon U.S. launch of SubQ TM. We also will make additional milestonepayments to Q-Med upon the achievement of certain commercial milestones.SubQ TM is comprised of the same NASHA TM substance asRESTYLANE®, PERLANE® and RESTYLANE FINE LINES TM with alarger gel particle size and has patent protection until at least 2015 in the United States.     On December 13, 2004, we entered into an exclusive development and license agreement and otherancillary agreements with Ansata Therapeutics, Inc. (“Ansata”). The development and licenseagreement granted us the exclusive, worldwide rights to Ansata’s early stage, proprietaryantimicrobial peptide technology. In accordance with the development and license agreement, wepaid $5.0 million upon signing of the contract, and would have been required to make additionalpayments for the achievement of certain developmental milestones. In June 2006, the developmentproject was terminated. We have no current or future obligations related to this project. Theinitial $5.0 million payment was recorded as a charge to research and development expense duringthe second quarter of fiscal 2005.     On January 28, 2005, we amended our strategic alliance with AAIPharma, Inc. (“AAIPharma”)previously initiated in June 2002 for the development, commercialization and license of adermatologic product, SOLODYN®. The consummation of the amendment did not affect thetiming of the development project. The amendment allowed for the immediate transfer of the workproduct as defined under the agreement, as well as the product’s management and development, to us,and provided that AAIPharma would continue to assist us with the development of SOLODYN®on a fee for services basis. We had no financial obligations to pay AAIPharma on the attainment ofadditional clinical milestones, but we incurred approximately $8.3 million as a charge to researchand development expense during the third quarter of fiscal 2005, as part of the amendment and theassumption of all liabilities associated with the project. SOLODYN® was approved by theFDA on May 8, 2006.     On March 17, 2006, we entered into a development and distribution agreement with Ipsen,whereby Ipsen granted Aesthetica Ltd., our wholly-owned subsidiary, rights to develop, distributeand commercialize Ipsen’s botulinum toxin type A product in the United States, Canada and Japan foraesthetic use by physicians. The product is commonly referred to as RELOXIN® in theU.S. aesthetic market and DYSPORT® in medical and aesthetic markets outside the U.S.The product is not currently approved for use in the U.S., Canada or Japan. Upon execution of thedevelopment and distribution agreement, we made an initial payment to Ipsen in the amount of $90.1million in consideration for the exclusive distribution rights in the U.S., Canada and Japan. Wewill pay Ipsen an additional $26.5 million upon successful completion of various clinical andregulatory milestones, $75.0 million upon the product’s approval by the FDA and $2.0 million uponregulatory approval of the product in Japan. Ipsen will manufacture and provide the product to usfor the term of the agreement, which extends to September 2019. Ipsen will receive a royalty basedon sales and a supply price, the total of which is equivalent toapproximately 30% of net sales as defined under the agreement. Under the terms of theagreement, we are responsible for all remaining research and development costs associated withobtaining the product’s approval in the U.S., Canada and Japan.     Additionally, Medicis and Ipsen agreed to negotiate and enter into an agreement relating tothe exclusive distribution and development rights of the product for the aesthetic market inEurope, and subsequently in certain other markets. Under the terms of the U.S., Canada and Japanagreement, we were obligated to make an additional
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$35.1 million payment, as amended, to Ipsen ifthis agreement was not entered into by April 15, 2006. On April 13, 2006, Medicis and Ipsen agreedto extend this deadline to July 15, 2006. In connection with this extension, we paid Ipsenapproximately $12.9 million in April 2006, which would be applied against the total obligation, inthe event an agreement was not entered into by the extended deadline. On July 17, 2006, Medicisand Ipsen agreed that the two companies would not pursue an agreement for the commercialization ofthe product outside of the U.S., Canada and Japan. On July 17, 2006, we made the additional $22.2million payment to Ipsen, representing the remaining portion of the $35.1 million total obligation,resulting from the discontinuance of negotiations for other territories.     The initial $90.1 million payment and the $35.1 million obligation was recognized as a chargeto research and development expense during 2006.     On June 19, 2006, we entered into an exclusive start-up development agreement with a companyfor the development of a dermatologic product. Under terms of the agreement, we made an initialpayment of $1.0 million upon execution of the agreement, and are required to pay a milestonepayment of $3.0 million upon execution of a Development and License Agreement between the parties.In addition, we will pay approximately $16.0 million upon successful completion of certain clinicalmilestones and approximately $12.0 million upon the first commercial sales of the product in theU.S. We also will make additional milestone payments upon the achievement of certain commercialmilestones. The $1.0 million payment was recognized as a charge to research and developmentexpense during 2006.     We incurred total research and development costs for all of our sponsored and unreimbursedco-sponsored pharmaceutical projects for 2006, the Transition Period, the corresponding six-monthperiod of 2004, fiscal 2005, fiscal 2004 and fiscal 2003 of $161.3 million, $22.4 million, $45.1million, $65.7 million and $16.5 million, respectively. Research and development costs for 2006include $125.2 million paid to Ipsen pursuant to the RELOXIN® development agreements and$1.0 million paid pursuant to the agreement discussed above. Research and development costs forthe Transition Period include $11.9 million paid to Dow pursuant to the development agreement.Research and development costs for the corresponding six-month period of 2004 include $30.0 millionrelated to our license agreement with Q-Med related to the SubQTM product, and $5.0million related to our development and license agreement with Ansata. Research and developmentcosts for fiscal 2005 include $30.0 million related to our license agreement with Q-Med related tothe SubQTM product, $5.0 million related to our development and license agreement withAnsata, and $8.3 million related to our research and development collaboration with AAIPharma.Research and development costs for fiscal 2004 include $2.4 million paid to Dow pursuant to thedevelopment agreement.*Sales and Marketing*     Our combined dedicated sales force, consisting of 167 employees as of December 31, 2006,focuses on high patient volume dermatologists, plastic surgeons and podiatrists. Since arelatively small number of physicians are responsible for writing a majority of dermatological andpodiatric prescriptions and performing dermal aesthetic procedures, we believe that the size of oursales force, including its currently ongoing expansion, is appropriate to reach our targetphysicians. Our therapeutic dermatology and podiatric sales forces consist of 95 employees whoregularly call on approximately 9,600 dermatologists and 1,100 podiatrists. Our dermal aestheticsales force consists of 72 employees who regularly call on leading plastic surgeons, facial plasticsurgeons, dermatologists and dermatologic surgeons. We also have seven national account managerswho regularly call on major drug wholesalers, managed care organizations, large retail chains,formularies and related organizations.     We cultivate relationships of trust and confidence with the high prescribing dermatologistsand podiatrists and the leading plastic surgeons in the United States. We use a variety ofmarketing techniques to promote our products including sampling, journal advertising, promotionalmaterials, specialty publications, coupons, money-back or product replacement guarantees,educational conferences and informational websites.     We believe we have created an attractive incentive program for our sales force that is basedupon goals in prescription growth, market share achievement and customer service.
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*Warehousing and Distribution*     We utilize an independent national warehousing corporation to store and distribute ourproducts from primarily two regional warehouses in Nevada and Georgia, as well as additionalwarehouses in Maryland and North Carolina. Upon the receipt of a purchase order through electronicdata input (“EDI”), phone, mail or facsimile, the order is processed through our inventorymanagement systems and is transmitted electronically to the appropriate warehouse for picking andpacking. Upon shipment, the warehouse sends back to us via EDI the necessary information toautomatically process the invoice in a timely manner.*Customers*     Our customers include certain of the nation’s leading wholesale pharmaceutical distributors,such as Cardinal Health, Inc. (“Cardinal”) and McKesson Corporation (“McKesson”) and other majordrug chains. During 2006, the Transition Period, the comparable six-month period in 2004, fiscal2005 and fiscal 2004, these customers accounted for the following portions of our net revenues:                               Comparable              Six-Month          Transition Period      2006 Period in 2004 Fiscal 2005 Fiscal 2004McKesson  56.8%  54.9%  50.8%  51.2%  36.9%Cardinal  19.3%  18.9%  19.7%  21.8%  23.8%     McKesson is our sole distributor of our RESTYLANE® products in the United Statesand Canada. RESTYLANE® was our highest-selling product during 2006, the TransitionPeriod and fiscal 2005.*Seasonality*     Our business, taken as a whole, is not materially affected by seasonal factors, although asubstantial portion of our prescription product revenues has been recognized in the last month ofeach quarter and we schedule our inventory purchases to meet anticipated customer demand. As aresult, relatively small delays in the receipt of manufactured products by us could result inrevenues being deferred or lost.*Manufacturing*     We currently outsource all of our manufacturing needs, and we are required by the FDA tocontract only with manufacturers who comply with current Good Manufacturing Practices (“cGMP”)regulations and other applicable laws and regulations. Typically our manufacturing contracts areshort-term. We review our manufacturing arrangements on a regular basis and assess the viabilityof alternative manufacturers if our current manufacturers are unable to fulfill our needs. If anyof our manufacturing partners are unable to perform their obligations under our manufacturingagreements or if any of our manufacturing agreements are terminated, we may experience a disruptionin the manufacturing of the applicable product which would adversely affect our results ofoperations.     Our TRIAZ® and ZIANA**TM** branded products are manufactured by ContractPharmaceuticals Limited pursuant to a manufacturing agreement that automatically renews on anannual basis, unless terminated by either party.     Our OMNICEF® branded product, which we promote through a license agreement withAbbott, is manufactured, warehoused and distributed by Abbott. The license agreement expires in2013.     Our RESTYLANE® branded products in the U.S. and Canada are manufactured by Q-Medpursuant to a long-term supply agreement that expires no earlier than 2013.
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     Our SOLODYN® branded product is manufactured by AAIPharma pursuant to a long-termsupply agreement that expires in 2010, unless extended by mutual agreement. We are also in theprocess of qualifying an alternative manufacturing facility for SOLODYN®.     Our VANOS**TM** branded product is manufactured by Patheon under a supply agreement thatautomatically renews on an annual basis, unless terminated by either party.*Raw Materials*     We and the manufacturers of our products rely on suppliers of raw materials used in theproduction of our products. Some of these materials are available from only one source and othersmay become available from only one source. Any disruption in the supply of raw materials or anincrease in the cost of raw materials to our manufacturers could have a significant effect on theirability to supply us with our products.*License and Royalty Agreements*     Pursuant to license agreements with third parties, we have acquired rights to manufacture, useor market certain of our existing products, as well as many of our development products andtechnologies. Such agreements typically contain provisions requiring us to use our best efforts orotherwise exercise diligence in pursuing market development for such products in order to maintainthe rights granted under the agreements and may be canceled upon our failure to perform our paymentor other obligations. In addition, we have licensed certain rights to manufacture, use and sellcertain of our technologies outside the United States and Canada to various licensees.*Trademarks, Patents and Proprietary Rights*     We believe that trademark protection is an important part of establishing product and brandrecognition. We own a number of registered trademarks and trademark applications. U.S. federalregistrations for trademarks remain in force for 10 years and may be renewed every 10 years afterissuance, provided the mark is still being used in commerce.     We have obtained and licensed a number of patents covering key aspects of our products,including a U.S. patent expiring in October 2015 covering various formulations ofTRIAZ®, a U.S. patent expiring in October of 2015 covering RESTYLANE®, a U.S.patent expiring in February of 2018 covering SOLODYN® tablets, five U.S. patentsexpiring in June and August of 2020 covering the PLEXION® cleanser formulation and thePLEXION® TS (topical suspension) and PLEXION® SCT formulations, two U.S.patents expiring in February of 2015 and August of 2020 covering ZIANATM Gel, and a U.S.patent expiring in December 2021 covering VANOSTM Cream. We have patent applicationspending relating to SOLODYN®, ZIANA**TM** Gel and our LOPROX® Shampooformulation. We are also pursuing several other U.S. and foreign patent applications.     We rely and expect to continue to rely upon unpatented proprietary know-how and technologicalinnovation in the development and manufacture of many of our principal products. Our policy is torequire all our employees, consultants and advisors to enter into confidentiality agreements withus.     Our success with our products will depend, in part, on our ability to obtain, and successfullydefend if challenged, patent or other proprietary protection. However, the issuance of a patent isnot conclusive as to its validity or as to the enforceable scope of the claims of the patent.Accordingly, our patents may not prevent other companies from developing similar or functionallyequivalent products or from successfully challenging the validity of our patents. As a result, ifour patent applications are not approved or, even if approved, such patents are circumvented or notupheld in a legal proceeding, our ability to competitively exploit our patented products andtechnologies may be significantly reduced. Also, such patents may or may not provide competitiveadvantages fortheir respective products or they may be challenged or circumvented by competitors, in whichcase our ability to commercially exploit these products may be diminished.
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     From time to time, we may need to obtain licenses to patents and other proprietary rights heldby third parties to develop, manufacture and market our products. If we are unable to timely obtainthese licenses on commercially reasonable terms, our ability to commercially exploit such productsmay be inhibited or prevented.*Competition*     The pharmaceutical and dermal aesthetics industries are characterized by intense competition,rapid product development and technological change. Numerous companies are engaged in thedevelopment, manufacture and marketing of health care products competitive with those that weoffer. As a result, competition is intense among manufacturers of prescription pharmaceuticals anddermal injection products, such as for our primary brands.     Many of our competitors are large, well-established pharmaceutical, chemical, cosmetic orhealth care companies with considerably greater financial, marketing, sales and technical resourcesthan those available to us. Additionally, many of our present and potential competitors haveresearch and development capabilities that may allow them to develop new or improved products thatmay compete with our product lines. Our products could be rendered obsolete or made uneconomicalby the development of new products to treat the conditions addressed by our products, technologicaladvances affecting the cost of production, or marketing or pricing actions by one or more of ourcompetitors. Each of our products competes for a share of the existing market with numerousproducts that have become standard treatments recommended or prescribed by dermatologists andpodiatrists and administered by plastic surgeons and aesthetic dermatologists. In addition toproduct development, testing, approval and marketing, industry consolidation, product quality andprice, product technology, reputation, customer service and access to technical information areother competitive factors affecting the pharmaceutical industry.     The largest competitors for our prescription dermatological products include Allergan,Galderma, Johnson & Johnson, Sanofi-Aventis, Stiefel Laboratories, Warner Chilcott and others.Several of our primary prescription brands compete or may compete in the near future with generic(non-branded) pharmaceuticals, which claim to offer equivalent therapeutic benefits at a lowercost. In some cases, insurers, third-party payors and pharmacies seek to encourage the use ofgeneric products, making branded products less attractive, from a cost perspective, to buyers.     Our facial aesthetics products compete against Allergan and others. On June 5, 2006, Allerganannounced that the FDA had approved its dermal filler product JuvédermTM. Allergan is alarger company than Medicis, and has greater financial, marketing, sales and technical resourcesthan those available to us. Other dermal filler products, such as Artes Medical’sArtefill®, BioForm Medical’s Radiesse®, and a cosmetic tissue augmentationproduct developed by Anika Therapeutics, Inc. have also recently been approved by the FDA.Patients may differentiate these products from RESTYLANE® based on price, efficacyand/or duration, which may appeal to some patients. In addition, there are several dermal fillerproducts under development and/or in the FDA pipeline for approval which claim to offer equivalentor greater facial aesthetic benefits to RESTYLANE® and, if approved, the companiesproducing such products could charge less to doctors for their products.*Government Regulation*     The manufacture and sale of biological products, drugs and medical devices are subject toregulation principally by the FDA, but also by other federal agencies and state and localauthorities in the United States, and by comparable agencies in certain foreign countries. TheFederal Trade Commission (“FTC”), the FDA and state and local authorities regulate the advertisingof over-the-counter drugs and cosmetics. The Federal Food, Drug and Cosmetics Act and theregulations promulgated thereunder, and other federal and state statutes and regulations, govern,among other things, the testing, manufacture, safety, effectiveness, labeling, storage, recordkeeping, approval, sale, distribution, advertising and promotion of our products.     Our RESTYLANE® dermal filler product is a medical device intended for human use andis subject to regulation by the FDA in the United States. Unless an exemption applies, eachmedical device in the U.S. must have a Premarket Approval Application (“PMA”) in accordance withthe Federal Food, Drug, and Cosmetic Act, as amended, or a 510(k) clearance (a demonstration thatthe new device is “substantially equivalent” to a device already on the market).RESTYLANE® and non-collagen dermal fillers are subject to PMA regulations that requirepremarket review of clinical data on safety and effectiveness. FDA device regulations for PMAsgenerally require
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reasonable assurance of safety and effectiveness prior to marketing, includingsafety and efficacy data obtained under clinical protocols approved under an Investigational DeviceExemption (“IDE”) and the manufacturing of the device requires compliance with “quality systemsregulations” (“QSRs”), as verified by detailed FDA investigations of manufacturing facilities.These regulations also require post-approval reporting of alleged product defects, recalls andcertain adverse experiences to the FDA. Generally, FDA regulations divide medical devices intothree classes. Class I devices are subject to general controls that require compliance with deviceestablishment registration, product listing, labeling, QSRs and other general requirements that arealso applicable to all classes of medical devices but, at least currently, most are not subject topre-market review. Class II devices are subject to special controls in addition to generalcontrols and generally require the submission of a premarket notification (501(k) clearance) beforemarketing is permitted. Class III devices are subject to the most comprehensive regulation and inmost cases, other than those remain grandfathered based on clinical use before 1976, requiresubmission to the FDA of a PMA application that includes biocompatibility, manufacturing andclinical data supporting the safety and effectiveness of the device as well as compliance with thesame provisions applicable to all medical devices such as QSRs. Annual reports must be submittedto the FDA, as well as descriptions of certain adverse events that are reported to the sponsorwithin specified timeframes of receipt of such reports. RESTYLANE® is regulated as aClass III PMA-required medical device. RESTYLANE® has been approved by the FDA under aPMA.     In general, products falling within the FDA’s definition of “new drugs” require premarketapproval by the FDA. Products falling within the FDA’s definition of “cosmetics” or of “drugs” (ifthey are not also “new drugs”) and that are generally recognized as “safe and effective” do notrequire premarketing clearance although all drugs must comply with a host of post-marketregulations, including manufacture under cGMP and adverse experience reporting. The steps requiredbefore a “new drug” may be marketed, shipped or sold in the United States include (i) preclinicallaboratory and animal testing of pharmacology and toxicology; (ii) manufacture under cGMP; (iii)submission to the FDA of an Investigational New Drug (or “IND”) application, which must becomeeffective before clinical trials may commence; (iv) at least two adequate and well-controlledclinical trials to establish the safety and efficacy of the drug (for some applications, the FDAmay accept one large clinical trial) beyond those human clinical trials necessary to establish asafe dose and to identify the human absorption, distribution, metabolism and excretion of theactive ingredient as applicable; (v) submission to the FDA of a New Drug Application (or “NDA”);and (vi) FDA approval of the NDA. In addition to obtaining FDA approval for each product, eachdrug-manufacturing establishment must be registered with, and approved through a pre-approvalapplication (PAI) by, the FDA.     New drugs may also be approved by the agency pursuant to an ANDA for generic drugs if the sameactive ingredient has previously been approved by the agency and the original sponsor of the NDA nolonger has patent protection or statutory marketing exclusivity. Approval of an ANDA does notgenerally require the submission of clinical data on the safety and effectiveness of the drugproduct if in an oral or parental dosage form. Clinical studies may be required for certaintopical ANDAs. However, even if no clinical studies are required, the applicant must providedissolution and/or metabolic studies to show that the active ingredient in an oral generic drugsponsor’s application is comparably available to the patent as the original product in the NDA uponwhich the ANDA is based.     Preclinical or biocompatibility testing is generally conducted on laboratory animals toevaluate the potential safety and toxicity of a drug. The results of these studies are submitted tothe FDA as a part of an IND or IDE application, which must be approved before clinical trials inhumans can begin. Typically, clinical evaluation of new drugs involves a time consuming and costlythree-phase process. In Phase I, clinical trials are conducted with a small number of subjects todetermine the early safety profile, the relationship of safety to dose, and thepattern of drug distribution and metabolism. In Phase II, one or more clinical trials areconducted with groups of patients afflicted with a specific disease to determine preliminaryefficacy and expanded evidence of safety and to determine the degree of effect, if any, as comparedto the current treatment regimen. In Phase III, at least two large-scale, multi-center,comparative trials are conducted with patients afflicted with a target disease to providesufficient confirmatory data to support the efficacy and safety required by the FDA. The FDAclosely monitors the progress of each of the three phases of clinical trials and may, at itsdiscretion, re-evaluate, alter, suspend or terminate the testing based upon the data that have beenaccumulated to that point and its assessment of the risk/benefit ratio to the patient.     FDA approval is required before a ‘new drug’ product may be marketed in the United States.However, many historically over-the-counter (“OTC”) drugs are exempt from the FDA’s premarketapproval requirements. In
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1972, the FDA instituted the ongoing OTC Drug Review to evaluate thesafety and effectiveness of all active ingredients and associated labeling (“OTC drugs”) that wereproven to be in the market before enactment of the Drug Amendments of 1962. Through this process,the FDA issues monographs that set forth the specific active ingredients, dosages, indications andlabeling statements for OTC drugs that the FDA will consider generally recognized as safe andeffective and therefore not subject to premarket approval. Before issuance of a final OTC drugmonograph as a federal regulation, OTC drugs are classified by the FDA in one of three categories:Category I ingredients and labeling which are deemed “safe and effective for over-the-counter use;”Category II ingredients and labeling which are deemed “not generally recognized as safe andeffective for over-the-counter use;” and Category III ingredients and labeling which are deemed“possibly safe and effective with studies ongoing.” Based upon the results of these ongoingstudies and pursuant to a court order, the FDA is required to reclassify all Category IIIingredients as either Category I or Category II before issuance of a final monograph through noticeand comment rule-making. For certain categories of OTC drugs not yet subject to a final monograph,the FDA usually permits such drugs to continue to be marketed until a final monograph becomeseffective, unless the drug will pose a potential health hazard to consumers. Stated differently,the FDA generally permits continued marketing only of any Category I products and those CategoryIII products that are “safe but unknown efficacy” products during the pendency of a finalmonograph. Drugs subject to final monographs, as well as drugs that are subject only to proposedmonographs, are also and separately subject to various FDA regulations concerning, for example,cGMP, general and specific OTC labeling requirements and prohibitions against promotion forconditions other than those stated in the labeling. OTC drug manufacturing facilities are subjectto FDA inspection, and failure to comply with applicable regulatory requirements may lead toadministrative or judicially imposed penalties.     Each of the active ingredients in LOPROX® products and OMNICEF® productshave been approved by the FDA under an NDA. The active ingredient in DYNACIN® brandedproducts has been approved by the FDA under an ANDA. The active ingredient in theTRIAZ® products has been classified as a Category III ingredient under a tentative finalFDA monograph for OTC use in treatment of labeled conditions. The FDA has requested, and a taskforce of the Non-Prescription Drug Manufacturers Association (or “NDMA”), a trade association ofOTC drug manufacturers, has undertaken further studies to confirm that benzoyl peroxide, an activeingredient in the TRIAZ®products, is not a tumor promoter when tested in conjunctionwith UV light exposure. The TRIAZ® products, which we sell on a prescription basis,have the same ingredients at the same dosage levels as the OTC products. When the FDA issues thefinal monograph, one of several possible outcomes that may occur is that we may be required by theFDA to discontinue sales of TRIAZ® products until and unless we file an NDA coveringsuch product. There can be no assurance as to the results of these studies or any FDA action toreclassify benzoyl peroxide. In addition, there can be no assurance that adverse test results wouldnot result in withdrawal of TRIAZ® products from marketing. An adverse decision by theFDA with respect to the safety of benzoyl peroxide could result in the assertion of productliability claims against us and could have a material adverse effect on our business, financialcondition and results of operations.     Our TRIAZ®branded products must meet the composition and labeling requirementsestablished by the FDA for products containing their respective basic ingredients. We believe thatcompliance with those established standards avoids the requirement for premarket clearance of theseproducts. There can be no assurance that the FDA will not take a contrary position in the future.Our PLEXION® branded products, which contain the activeingredients sodium sulfacetamide and sulfur, are marketed under the FDA compliance policyentitled “Marketed New Drugs without Approved NDAs or ANDAs.”     We believe that certain of our products, as they are promoted and intended by us for use, areexempt from being considered “new drugs” based upon the introduction date of their activeingredients and therefore do not require premarket clearance. There can be no assurance that theFDA will not take a contrary position in the future. If the FDA were to do so, we may be requiredto seek FDA approval for these products, market these products as over-the-counter products orwithdraw such products from the market. We believe that these products are compliant withapplicable regulations governing product safety, use of ingredients, labeling, promotion andmanufacturing methods.     We also will be subject to foreign regulatory authorities governing clinical trials andpharmaceutical sales for products we seek to market outside the United States. Whether or not FDAapproval has been obtained, approval of a product by the comparable regulatory authorities offoreign countries must be obtained before marketing the
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product in those countries. The approvalprocess varies from country to country, the approval process time required may be longer or shorterthan that required for FDA approval, and any foreign regulatory agency may refuse to approve anyproduct we submit for review.*Our History*     We filed our certificate of incorporation with the Secretary of State of Delaware on July 28,1988. We completed our initial public offering during our fiscal year ended June 30, 1990, andlaunched our initial pharmaceutical products during our fiscal year ended June 30, 1991. Duringour fiscal year ended June 30, 2003, we acquired the exclusive U.S. and Canada license to theRESTYLANE® family of products.*Financial Information About Segments*     We operate in one significant business segment: Pharmaceuticals. Our current pharmaceuticalfranchises are divided between the dermatological and non-dermatological fields. Information onrevenues, operating income, identifiable assets and supplemental revenue of our business franchisesappears in the consolidated financial statements included in Item 8 hereof.*Employees*     At December 31, 2006, we had 391 full-time employees. No employees are subject to acollective bargaining agreement. We believe our relationship with our employees is good.*Available Information*     We make available free of charge on or through our Internet website, www.medicis.com, ourannual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and allamendments to those reports, if any, filed or furnished pursuant to Section 13(a) of 15(d) of theSecurities Exchange Act of 1934, as amended, as soon as reasonably practicable after they areelectronically filed with, or furnished to, the Securities and Exchange Commission. We also makeavailable free of charge on or through our website our Business Code of Conduct and Ethics,Corporate Governance Guidelines, Nominating and Corporate Governance Committee Charter,Compensation Committee Charter and Audit Committee Charter. The information contained on ourwebsite is not intended to be incorporated into this annual report on Form 10-K.Item 1A. Risk Factors     Our statements in this report, other reports that we file with the Securities and ExchangeCommission (“SEC”), our press releases and in public statements of our officers and corporatespokespersons contain forward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, Section 21 of the Securities Exchange Act of 1934, as amended,and the Private Securities Litigation Reform Act of 1995. You canidentify these statements by the fact that they do not relate strictly to historical or currentevents, and contain words such as “anticipate,” “estimate,” “expect,” “project,” “intend,” “will,”“plan,” “believe,” “should,” “outlook,” “could,” “target” and other words of similar meaning inconnection with discussion of future operating or financial performance. These include statementsrelating to future actions, prospective products or product approvals, future performance orresults of current and anticipated products, sales efforts, expenses, the outcome of contingenciessuch as legal proceedings and financial results. These statements are based on certain assumptionsmade by us based on our experience and perception of historical trends, current conditions,expected future developments and other factors we believe are appropriate in the circumstances.Such statements are subject to a number of assumptions, risks and uncertainties, many of which arebeyond our control. These forward-looking statements reflect the current views of seniormanagement with respect to future events and financial performance. No assurances can be given,however, that these activities, events or developments will occur or that such results will beachieved, and actual results may vary materially from those anticipated in any forward-lookingstatement. Any such forward-looking statements, whether made in this report or elsewhere, shouldbe considered in context of the various disclosures made by us about our businesses including,without limitation, the risk factors discussed below. We do not plan to
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update any suchforward-looking statements and expressly disclaim any duty to update the information contained inthis filing except as required by law.     We operate in a rapidly changing environment that involves a number of risks. The followingdiscussion highlights some of these risks and others are discussed elsewhere in this report. Theseand other risks could materially and adversely affect our business, financial condition, prospects,operating results or cash flows.*Risks Related To Our Business**We derive a majority of our sales from our primary products, and any factor adversely affectingsales of these products would harm our business, financial condition and results of operations.*     We believe that the prescription volume of our primary prescription products, in particular,SOLODYN®, and sales of our dermal aesthetic product, RESTYLANE®, willcontinue to constitute a significant portion of our sales for the foreseeable future. Accordingly,any factor adversely affecting our sales related to these products, individually or collectively,could harm our business, financial condition and results of operations. On June 5, 2006, Allerganannounced that the FDA had approved its JuvédermTM dermal filler family of products.Allergan began marketing these products in January 2007. Other dermal filler products, such asArtefill®, Radiesse®, and a cosmetic tissue augmentation product developed byAnika Therapeutics, Inc. have also recently been approved by the FDA. Patients may differentiatethese products from RESTYLANE® based on price, efficacy and/or duration, which mayappeal to some patients. In addition, there are several dermal filler products under developmentand/or in the FDA pipeline for approval which claim to offer equivalent or greater facial aestheticbenefits to RESTYLANE® and, if approved, the companies producing such products couldcharge less to doctors for their products. Many of our primary prescription products may besubject to generic competition in the near future. Each of our primary products could be renderedobsolete or uneconomical by competitive changes, including generic competition.     Sales related to our primary prescription products and RESTYLANE® could also beadversely affected by other factors, including: **•** manufacturing or supply interruptions;  **•** the development of new competitive pharmaceuticals and technological advances totreat the conditions addressed by our primary products, including the introduction ofnew products into the marketplace;  **•** generic competition;  **•** marketing or pricing actions by one or more of our competitors;  **•** regulatory action by the FDA and other government regulatory agencies;  **•** importation of other dermal fillers;  **•** changes in the prescribing or procedural practices of dermatologists, plasticsurgeons and/or podiatrists;  **•** changes in the reimbursement or substitution policies of third-party payors or retail pharmacies;  **•** product liability claims;  **•** the outcome of disputes relating to trademarks, patents, license agreements and other rights;  **•** changes in state and federal law that adversely affect our ability to market ourproducts to dermatologists, plastic surgeons and/or podiatrists; and  **•** restrictions on travel affecting the ability of our sales force to market toprescribing physicians and plastic surgeons in person.
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*Our operating results and financial condition may fluctuate.*     Our operating results and financial condition may fluctuate from quarter to quarter and yearto year for a number of reasons. The following events or occurrences, among others, could causefluctuations in our financial performance from period to period: **•** development of new competitive products or generics by others;  **•** the timing and receipt of FDA approvals or lack of approvals;  **•** changes in the amount we spend to develop, acquire or license new products,technologies or businesses;  **•** untimely contingent research and development payments under our third-party productdevelopment agreements;  **•** changes in the amount we spend to promote our products;  **•** delays between our expenditures to acquire new products, technologies or businessesand the generation of revenues from those acquired products, technologies orbusinesses;  **•** changes in treatment practices of physicians that currently prescribe our products;  **•** changes in reimbursement policies of health plans and other similar health insurers,including changes that affect newly developed or newly acquired products;  **•** increases in the cost of raw materials used to manufacture our products;  **•** manufacturing and supply interruptions, including failure to comply withmanufacturing specifications;  **•** changes in prescription levels and the effect of economic changes in hurricane andother natural disaster-affected areas;  **•** the impact on our employees, customers, patients, manufacturers, suppliers, vendors,and other companies we do business with and the resulting impact on the results ofoperations associated with the possible mutation of the avian form of influenza frombirds or other animal species to humans, current human morbidity, and mortality levelspersist following such potential mutation;  **•** the mix of products that we sell during any time period;  **•** lower than expected demand for our products;  **•** our responses to price competition;  **•** expenditures as a result of legal actions;  **•** market acceptance of our products;  **•** the impairment and write-down of goodwill or other intangible assets;  **•** implementation of new or revised accounting or tax rules or policies;  **•** disposition of primary products, technologies and other rights;  **•** termination or expiration of, or the outcome of disputes relating to, trademarks,patents, license agreements and other rights;  **•** increases in insurance rates for existing products and the cost of insurance for newproducts;  **•** general economic and industry conditions, including changes in interest ratesaffecting returns on cash balances and investments that affect customer demand;  **•** seasonality of demand for our products;  **•** our level of research and development activities;  **•** new accounting standards and/or changes to existing accounting standards that wouldhave a material effect on our consolidated financial position, results of operations orcash flows;  **•** costs and outcomes of any tax audits or any litigation involving intellectualproperty, customers or other issues; and  **•** timing of revenue recognition related to licensing agreements and/or strategiccollaborations.     As a result, we believe that period-to-period comparisons of our results of operations are notnecessarily meaningful, and these comparisons should not be relied upon as an indication of futureperformance. The above factors may cause our operating results to fluctuate and adversely affectour financial condition and results of operations.
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*We will be unable to meet our anticipated development and commercialization timelines if clinicaltrials for our products are unsuccessful, delayed, or additional information is required by theFDA.*     The production and marketing of our products and our ongoing research and development,pre-clinical testing and clinical trials activities are subject to extensive regulation and reviewby numerous governmental authorities. Before obtaining regulatory approvals for the commercialsale of any products, we and/or our partners must demonstrate through pre-clinical testing andclinical trials that our products are safe and effective for use in humans. Conducting clinicaltrials is a lengthy, time-consuming and expensive process. In addition to testing and approvalprocedures, extensive regulations also govern marketing, manufacturing, distribution, labeling andrecord-keeping procedures.     Completion of clinical trials may take several years or more. Our commencement and rate ofcompletion of clinical trials may be delayed by many factors, including: **•** lack of efficacy during the clinical trials;  **•** unforeseen safety issues;  **•** slower than expected patient recruitment;  **•** failure of Medicis, investigators, or other contractors to strictly adhere tofederal regulations governing the conduct and data collection procedures involved inclinical trials;  **•** development of issues that might delay or impede performance by a contractor;  **•** errors in clinical documentation or at the clinical locations;  **•** government or regulatory delays; and  **•** unanticipated requests from the FDA for new or additional information.     The results from pre-clinical testing and early clinical trials are often not predictive ofresults obtained in later clinical trials. A number of new products have shown promising resultsin clinical trials, but subsequently failed to establish sufficient safety and efficacy data toobtain necessary regulatory approvals. Data obtained from pre-clinical and clinical activities aresusceptible to varying interpretations, which may delay, limit or prevent regulatory approval. Inaddition, regulatory delays or rejections may be encountered as a result of many factors, includingperceived defects in the design of the clinical trials and changes in regulatory policy during theperiod of product development. Any delays in, or termination of, our clinical trials couldmaterially and adversely affect our development and commercialization timelines, which couldadversely affect our financial condition, results of operations and cash flows.*If we are unable to secure and protect our intellectual property and proprietary rights, or if ourintellectual property rights are found to infringe upon the intellectual property rights of otherparties, our business could suffer.*     Our success depends in part on our ability to obtain patents or rights to patents, protecttrade secrets, operate without infringing upon the proprietary rights of others, and prevent othersfrom infringing on our patents, trademarks, service marks and other intellectual property rights.     We believe that the protection of our trademarks and service marks is an important factor inproduct recognition and in our ability to maintain or increase market share. If we do notadequately protect our rights in our various trademarks and service marks from infringement, theirvalue to us could be lost or diminished. If the marks we use are found to infringe upon thetrademark or service mark of another company, we could be forced to stop using those marks and, asa result, we could lose the value of those marks and could be liable for damages caused by aninfringement.     The patents and patent applications in which we have an interest may be challenged as to theirvalidity or enforceability. Challenges may result in potentially significant harm to our business.The cost of responding to these challenges and the inherent costs to defend the validity of ourpatents, including the prosecution ofinfringements and the related litigation, could be substantial. Such litigation also could requirea substantial commitment of our management’s time.
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     We are pursuing several United States patent applications; although we cannot be sure that anyof these patents will ever be issued. We also have acquired rights under certain patents andpatent applications in connection with our licenses to distribute products and by assignment ofrights to patents and patent applications from certain of our consultants and officers. Thesepatents and patent applications may be subject to claims of rights by third parties. If there areconflicting claims to the same patent or patent application, we may not prevail and, even if we dohave some rights in a patent or patent application, those rights may not be sufficient for themarketing and distribution of products covered by the patent or patent application.     The ownership of a patent or an interest in a patent does not always provide significantprotection. Others may independently develop similar technologies or design around the patentedaspects of our technology. We only conduct patent searches to determine whether our productsinfringe upon any existing patents when we think such searches are appropriate. As a result, theproducts and technologies we currently market, and those we may market in the future, may infringeon patents and other rights owned by others. If we are unsuccessful in any challenge to themarketing and sale of our products or technologies, we may be required to license the disputedrights, if the holder of those rights is willing to license such rights, otherwise we may berequired to cease marketing the challenged products, or to modify our products to avoid infringingupon those rights. A claim or finding of infringement regarding one of our products could harm ourbusiness, financial condition and results of operations. The costs of responding to infringementclaims could be substantial and could require a substantial commitment of our management’s time.The expiration of patents may expose our products to additional competition.     We also rely upon trade secrets, unpatented proprietary know-how and continuing technologicalinnovation in developing and manufacturing many of our primary products. It is our policy torequire all of our employees, consultants and advisors to enter into confidentiality agreementsprohibiting them from taking or disclosing our proprietary information and technology.Nevertheless, these agreements may not provide meaningful protection for our trade secrets andproprietary know-how if they are used or disclosed. Despite all of the precautions we may take,people who are not parties to confidentiality agreements may obtain access to our trade secrets orknow-how. In addition, others may independently develop similar or equivalent trade secrets orknow-how.*If Q-Med is unable to protect its intellectual property and proprietary rights with respect to ourdermal filler products, our business could suffer.*     RESTYLANE®, PERLANE®, RESTYLANE FINE LINESTM andSubQTM currently have patent protection in the United States until 2015, and theexclusivity period of the license granted to us by Q-Med will terminate on the later of (i) theexpiration of the last patent covering the products or (ii) upon the licensed know-how becomingpublicly known. If the validity or enforceability of these patents is successfully challenged, thecost to us could be significant and our business may be harmed. For example, if any suchchallenges are successful, Q-Med may be unable to supply products to us. As a result, we may beunable to market, distribute and commercialize the products or it may no longer be profitable forus to do so.*We may not be able to collect all scheduled license payments from BioMarin.*     As part of our asset purchase agreement, license agreement and securities purchase agreementwith BioMarin Pharmaceutical Inc. (“BioMarin”) discussed in Note 8 to our consolidated financialstatements, BioMarin will make license payments to us of $1.75 million per quarter for the sixquarters beginning in January 2007 and $1.5 million per quarter for the subsequent four quartersbeginning in July 2008. While we did receive all scheduled quarterly license payments during 2006,the Transition Period and during the fiscal year ending June 30, 2005, we cannot give anyassurances as to BioMarin’s continuing ability to make payments to us. Currently, our revenuerecognition of these payments is on a cash basis. In addition, we cannot give any assurances as toBioMarin’s ability to make the $70.6 million payment to us in 2009 for the purchase of all of theoutstanding shares of Ascent Pediatrics. If BioMarin defaults on its obligations to make therequired payments, we may beforced to incur indebtedness or otherwise reallocate our financial resources to cover the lossof these expected cash payments.
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*We depend upon our key personnel and our ability to attract, train, and retain employees.*     Our success depends significantly on the continued individual and collective contributions ofour senior management team, and Jonah Shacknai, our Chairman and Chief Executive Officer, inparticular. While we have entered into employment agreements with many members of our seniormanagement team, the loss of the services of any member of our senior management for any reason orthe inability to hire and retain experienced management personnel could adversely affect ourability to execute our business plan and harm our operating results. In addition, our futuresuccess depends on our ability to hire, train and retain skilled employees. Competition for theseemployees is intense.*Our continued growth depends upon our ability to develop new products.*     We have internally developed potential pharmaceutical compounds and agents. We also haveacquired the rights to certain potential compounds and agents in various stages of development. Wecurrently have a variety of new products in various stages of research and development and areworking on possible improvements, extensions and reformulations of some existing products. Theseresearch and development activities, as well as the clinical testing and regulatory approvalprocess, which must be completed before commercial quantities of these developments can be sold,will require significant commitments of personnel and financial resources. We cannot assure youthat we will be able to develop a product or technology in a timely manner, or at all. Delays inthe research, development, testing or approval processes will cause a corresponding delay inrevenue generation from those products. Regardless of whether they are ever released to themarket, the expense of such processes will have already been incurred.     We reevaluate our research and development efforts regularly to assess whether our efforts todevelop a particular product or technology are progressing at a rate that justifies our continuedexpenditures. On the basis of these reevaluations, we have abandoned in the past, and may abandonin the future, our efforts on a particular product or technology. Products that we research ordevelop may not be successfully commercialized. If we fail to take a product or technology fromthe development stage to market on a timely basis, we may incur significant expenses without anear-term financial return.     We have in the past, and may in the future, supplement our internal research and developmentby entering into research and development agreements with other pharmaceutical companies. We may,upon entering into such agreements, be required to make significant up-front payments to fund theprojects. We cannot be sure, however, that we will be able to locate adequate research partners orthat supplemental research will be available on terms acceptable to us in the future. If we areunable to enter into additional research partnership arrangements, we may incur additional costs tocontinue research and development internally or abandon certain projects. Even if we are able toenter into collaborations, we cannot assure you that these arrangements will result in successfulproduct development or commercialization.     There is also a risk that our products may not gain market acceptance among physicians,patients and the medical community generally. The degree of market acceptance of any medicaldevice or other product that we develop will depend on a number of factors, including demonstratedclinical efficacy and safety, cost-effectiveness, potential advantages over alternative products,and our marketing and distribution capabilities. Physicians will not recommend our products untilclinical data or other factors demonstrate their safety and efficacy compared to other competingproducts. Even if the clinical safety and efficacy of using our products is established,physicians may elect to not recommend using them for any number of other reasons, including whetherour products best meet the particular needs of the individual patient.*We may acquire companies in the future and these acquisitions could disrupt our business. Inaddition, we may not obtain the benefits that the acquisitions were intended to create.*     As part of our business strategy, we regularly consider and, as appropriate, make acquisitionsof technologies, products and businesses that we believe are complementary to our business.Acquisitions typicallyentail many risks and could result in difficulties in integrating the operations, personnel,technologies and products of
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the companies acquired, some of which may result in significantcharges to earnings. If we are unable to successfully integrate our acquisitions with our existingbusiness, we may not obtain the advantages that the acquisitions were intended to create, which maymaterially adversely affect our business, results of operations, financial condition and cashflows, our ability to develop and introduce new products and the market price of our stock. Inaddition, in connection with acquisitions, we could experience disruption in our business oremployee base, or key employees of companies that we acquire may seek employment elsewhere,including with our competitors. Furthermore, the products of companies we acquire may overlap withour products or those of our customers, creating conflicts with existing relationships or withother commitments that are detrimental to the combined businesses.*We may not be able to identify and acquire products, technologies and businesses on acceptableterms, if at all, which may constrain our growth.*     Our strategy for continued growth includes the acquisition of products, technologies andbusinesses. These acquisitions could involve acquiring other pharmaceutical companies’ assets,products or technologies. In addition, we may seek to obtain licenses or other rights to develop,manufacture and distribute products. We cannot be certain that we will be able to identifysuitable acquisition or licensing candidates, if they will be accretive in the near future, or ifany will be available on acceptable terms. Other pharmaceutical companies, with greater financial,marketing and sales resources than we have, have also tried to grow through similar acquisition andlicensing strategies. Because of their greater resources, our competitors may be able to offerbetter terms for an acquisition or license than we can offer, or they may be able to demonstrate agreater ability to market licensed products. In addition, even if we identify potentialacquisitions and enter into definitive agreements relating to such acquisitions, we may not be ableto consummate planned acquisitions on the terms originally agreed upon or at all. For example, onMarch 20, 2005, we entered into an agreement and plan of merger with Inamed, pursuant to which weagreed to acquire Inamed. On December 13, 2005, we entered into a merger termination agreementwith Inamed following Allergan Inc.’s exchange offer for all outstanding shares of Inamed, whichwas commenced on November 21, 2005.*Our success depends on our ability to manage our growth.*     We have experienced a period of rapid growth from both acquisitions and internal expansion ofour operations. This growth has placed significant demands on our human and financial resources.We must continue to improve our operational, financial and management information controls andsystems and effectively motivate, train and manage our employees to properly manage this growth.Even if these steps are taken, we cannot be sure that our acquisitions will be integratedsuccessfully into our business operations. If we are not able to successfully integrate ouracquisitions, we may not obtain the advantages that the acquisitions were intended to create. Inaddition, if we do not manage this growth effectively, maintain the quality of our products despitethe demands on our resources and retain key personnel, our business could be harmed.*Implementation of our new enterprise resource planning system could cause business interruptionsand negatively affect our profitability and cash flows.*     During 2007, we will be developing and will begin implementing a new enterprise resourceplanning (“ERP”) system to help us integrate and improve the financial and operational aspects ofour business. The design and implementation of an ERP system involves risks such as cost overruns,project delays and business interruption. A significant amount of our resources will be committedto the ERP project, and we may experience challenges in designing and implementing the new ERPsystem that could adversely affect our operations and our ability to timely and accurately processand report key components of our financial position. If we experience a material businessinterruption as a result of our design and implementation of our new ERP system, it could have amaterial adverse effect on our business, results of operations and cash flows.*We depend on licenses from others, and any loss of such licenses could harm our business, marketshare and profitability.*     We have acquired the rights to manufacture, use and market certain products, including certainof our primary products. We also expect to continue to obtain licenses for other products andtechnologies in the future.
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Our license agreements generally require us to develop a market forthe licensed products. If we do not develop these markets within specified time frames, thelicensors may be entitled to terminate these license agreements.     We may fail to fulfill our obligations under any particular license agreement for variousreasons, including insufficient resources to adequately develop and market a product, and lack ofmarket development despite our diligence and lack of product acceptance. Our failure to fulfillour obligations could result in the loss of our rights under a license agreement.     Our inability to continue the distribution of any particular licensed product could harm ourbusiness, market share and profitability. Also, certain products we license are used in connectionwith other products we own or license. A loss of a license in such circumstances could materiallyharm our ability to market and distribute these other products.*We depend on a limited number of customers, and if we lose any of them, our business could beharmed.*     Our customers include some of the United States’ leading wholesale pharmaceuticaldistributors, such as Cardinal, McKesson, and major drug chains. During 2006, McKesson andCardinal accounted for 56.8% and 19.3%, respectively, of our net revenues. During the TransitionPeriod, McKesson and Cardinal accounted for 54.9% and 18.9%, respectively, of our net revenues.During fiscal 2005, McKesson and Cardinal accounted for 51.2%, and 21.8%, respectively, of our netrevenues. The loss of any of these customers’ accounts or a material reduction in their purchasescould harm our business, financial condition or results of operations. In addition, we may facepricing pressure from our customers. McKesson is our sole distributor of our RESTYLANE®products in the United States and Canada.*The consolidation of drug wholesalers could increase competition and pricing pressures throughoutthe pharmaceutical industry.*     We sell our pharmaceutical products primarily through major wholesalers. These customerscomprise a significant part of the distribution network for pharmaceutical products in the UnitedStates. This distribution network is continuing to undergo significant consolidation marked bymergers and acquisitions. As a result, a smaller number of large wholesale distributors control asignificant share of the market. In addition, the number of independent drug stores and smallchains has decreased as retail consolidation has occurred. Further consolidation among, or anyfinancial difficulties of, distributors or retailers could result in the combination or eliminationof warehouses which may result in product returns to our company, cause a reduction in theinventory levels of distributors and retailers, result in reductions in purchases of our products,increase competitive and pricing pressures on pharmaceutical manufacturers, any of which could harmour business, financial condition and results of operations.*We rely on others to manufacture our products.*     Currently, we outsource our entire product manufacturing needs. Typically, our manufacturingcontracts are short-term. We are dependent upon renewing agreements with our existingmanufacturers or finding replacement manufacturers to satisfy our requirements. As a result, wecannot be certain that manufacturing sources will continue to be available or that we can continueto outsource the manufacturing of our products on reasonable or acceptable terms.     The underlying cost to us for manufacturing our products is established in our agreements withthese outside manufacturers. Because of the short-term nature of these agreements, our expensesfor manufacturing are not fixed and could change from contract to contract. If the cost ofproduction increases, our gross margins could be negatively affected.     In addition, we rely on outside manufacturers to provide us with an adequate and reliablesupply of our products on a timely basis. Loss of a supplier or any difficulties that arise in thesupply chain could significantly affect our inventories and supply of products available for sale.We do not have alternative sources of supply for all of our products. If a primary supplier of anyof our primary products is unable to fulfill our requirements for any
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reason, it could reduce oursales, margins and market share, as well as harm our overall business and financial results. If weare unable to supply sufficient amounts of our products on a timely basis, our revenues and marketshare could decrease and, correspondingly, our profitability could decrease.     Under several exclusive supply agreements, with certain exceptions, we must purchase most ofour product supply from specific manufacturers. If any of these exclusive manufacturer or supplierrelationships were terminated, we would be forced to find a replacement manufacturer or supplier.The FDA requires that all manufacturers used by pharmaceutical companies comply with the FDA’sregulations, including the cGMP regulations applicable to manufacturing processes. The cGMPvalidation of a new facility and the approval of that manufacturer for a new drug product may takea year or more before manufacture can begin at the facility. Delays in obtaining FDA validation ofa replacement manufacturing facility could cause an interruption in the supply of our products.Although we have business interruption insurance covering the loss of income for up to 12 months,which may mitigate the harm to us from the interruption of the manufacturing of our largest sellingproducts caused by certain events, the loss of a manufacturer could still cause a reduction in oursales, margins and market share, as well as harm our overall business and financial results.*We and our third-party manufacturers rely on a limited number of suppliers of the raw materials ofour products. A disruption in supply of raw material would be disruptive to our inventory supply.*     We and the manufacturers of our products rely on suppliers of raw materials used in theproduction of our products. Some of these materials are available from only one source and othersmay become available from only one source. We try to maintain inventory levels that are no greaterthan necessary to meet our current projections, which could have the affect of exacerbating supplyproblems. Any interruption in the supply of finished products could hinder our ability to timelydistribute finished products. If we are unable to obtain adequate product supplies to satisfy ourcustomers’ orders, we may lose those orders and our customers may cancel other orders and stock andsell competing products. This, in turn, could cause a loss of our market share and reduce ourrevenues. In addition, any disruption in the supply of raw materials or an increase in the cost ofraw materials to our manufacturers could have a significant effect on their ability to supply uswith our products, which would adversely affect our financial condition and results of operations.*We could experience difficulties in obtaining supplies of RESTYLANE**®**,PERLANE**®**, RESTYLANE FINE LINES**TM**and SubQ**TM**.*     The manufacturing process to create bulk non-animal stabilized hyaluronic acid necessary toproduce RESTYLANE®, PERLANE®, RESTYLANE FINE LINESTM andSubQTM products is technically complex and requires significant lead-time. Any failureby us to accurately forecast demand for finished product could result in an interruption in thesupply of RESTYLANE®, PERLANE®, RESTYLANE FINE LINESTM andSubQTM products and a resulting decrease in sales of the products.     We depend exclusively on Q-Med for our supply of RESTYLANE®, PERLANE®,RESTYLANE FINE LINESTM and SubQTM products. There are currently noalternative suppliers of these products. Q-Med has committed to supply RESTYLANE® to usunder a long-term license that is subject to customary conditions and our delivery of specifiedmilestone payments. Q-Med manufactures RESTYLANE®, PERLANE®, RESTYLANE FINELINESTM and SubQTM at its facility in Uppsala, Sweden. We cannot be certainthat Q-Med will be able to meet our current or future supply requirements. Any impairment ofQ-Med’s manufacturing capacities could significantly affect our inventories and our supply ofproducts available for sale.*Supply interruptions may disrupt our inventory levels and the availability of our products.*     Numerous factors could cause interruptions in the supply of our finished products, including: **•** timing, scheduling and prioritization of production by our contract manufacturers;  **•** labor interruptions;  **•** changes in our sources for manufacturing;  **•** the timing and delivery of domestic and international shipments;
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 **•** our failure to locate and obtain replacement manufacturers as needed on a timely basis;  **•** conditions affecting the cost and availability of raw materials; and  **•** hurricanes and other natural disasters.     We estimate customer demand for our prescription products primarily through use of third partysyndicated data sources which track prescriptions written by health care providers and dispensed bylicensed pharmacies. The data represents extrapolations from information provided only by certainpharmacies, and are estimates of historical demand levels. We estimate customer demand for ournon-prescription products primarily through internal data that we compile. We observe trends fromthese data, and, coupled with certain proprietary information, prepare demand forecasts that arethe basis for purchase orders for finished and component inventory from our third partymanufacturers and suppliers. Our forecasts may fail to accurately anticipate ultimate customerdemand for products. Overestimates of demand may result in excessive inventory production andunderestimates may result in inadequate supply of our products in channels of distribution.     We sell our products primarily to major wholesalers and retail pharmacy chains. Approximately75% of our gross revenues are derived from two major drug wholesale concerns. While we attempt toestimate inventory levels of our products at our major wholesale customers by using historicalprescription information, historical purchase patterns, and limited inventory level information byproduct type, this process is inherently imprecise. Rarely do wholesale customers provide uscomplete inventory levels at regional distribution centers, or within their national distributionsystems. We rely wholly upon our wholesale and drug chain customers to effect the distributionallocation of our products.     We periodically offer promotions to wholesale and chain drugstore customers to encouragedispensing of our prescription products, consistent with prescriptions written by licensed healthcare providers. Because many of our prescription products compete in multi-source markets, it isimportant for us to ensure the licensed health care providers’ dispensing instructions arefulfilled with our branded products and are not substituted with a generic product or anothertherapeutic alternative product which may be contrary to the licensed health care providers’recommended prescribed Medicis brand. We believe that a critical component of our brand protectionprogram is maintenance of full product availability at drugstore and wholesale customers. Webelieve such availability reduces the probability of local and regional product substitutions,shortages and backorders, which could result in lost sales. We expect to continue providingfavorable terms to wholesale and retail drug chain customers as may be necessary to ensure thefullest possible distribution of our branded products within the pharmaceutical chain of commerce.     We cannot control or influence greatly the purchasing patterns of our wholesale and retaildrug chain customers. They are highly sophisticated customers that purchase our products in amanner consistent with their industry practices and, presumably, based upon their projected demandlevels. Purchases by any given customer, during any given period, may be above or below actualprescription volumes of any of our products during the same period, resulting in fluctuations inproduct inventory in the distribution channel. Any decision made by management to reduce wholesaleinventory levels will decrease our product revenue.*Fluctuations in demand for our products create inventory maintenance uncertainties.*     As a result of customer buying patterns, a substantial portion of our prescription productrevenues has been recognized in the last month of each quarter, and we schedule our inventorypurchases to meet anticipated customer demand. As a result, miscalculation of customer demand orrelatively small delays in our receipt of manufactured products could result in revenues beingdeferred or lost. Our operating expenses are based upon anticipated sales levels, and a highpercentage of our operating expenses are relatively fixed in the short term. Depending on thecustomer, we recognize revenue at the time of shipment to the customer, or at the time of receiptby the customer, net of estimated provisions. Consequently, variations in the timing ofrevenue recognition could cause significant fluctuations in operating results from period to periodand may result in unanticipated periodic earnings shortfalls or losses.
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*We selectively outsource certain non-sales and non-marketing services, and cannot assure you thatwe will be able to obtain adequate supplies of such services on acceptable terms.*     To enable us to focus on our core marketing and sales activities, we selectively outsourcecertain non-sales and non-marketing functions, such as laboratory research, manufacturing andwarehousing. As we expand our activities in these areas, additional financial resources areexpected to be utilized. We typically do not enter into long-term manufacturing contracts withthird party manufacturers. Whether or not such contracts exist, we cannot assure you that we willbe able to obtain adequate supplies of such services or products in a timely fashion, on acceptableterms, or at all.*Importation of products from Canada and other countries into the United States may lower the priceswe receive for our products.*     Our products are subject to competition from lower priced versions of our products andcompeting products from Canada and other countries where government price controls or other marketdynamics result in lower prices. The ability of patients and other customers to obtain these lowerpriced imports has grown significantly as a result of the Internet, an expansion of pharmacies inCanada and elsewhere targeted to American purchasers, the increase in United States-basedbusinesses affiliated with Canadian pharmacies marketing to American purchasers, and other factors.Most of these foreign imports are illegal under current United States law. However, the volume ofimports continues to rise due to the limited enforcement resources of the FDA and the United StatesCustoms Service, and there is increased political pressure to permit the imports as a mechanism forexpanding access to lower priced medicines.     In December 2003, Congress enacted the Medicare Prescription Drug, Improvement andModernization Act of 2003. This law contains provisions that may change United States import lawsand expand consumers’ ability to import lower priced versions of our and competing products fromCanada, where there are government price controls. These changes to United States import laws willnot take effect unless and until the Secretary of Health and Human Services certifies that thechanges will lead to substantial savings for consumers and will not create a public health safetyissue. The former Secretary of Health and Human Services did not make such a certification.However, it is possible that the current Secretary or a subsequent Secretary could make thecertification in the future. As directed by Congress, a task force on drug importation recentlyconducted a comprehensive study regarding the circumstances under which drug importation could besafely conducted and the consequences of importation on the health, medical costs and developmentof new medicines for United States consumers. The task force issued its report in December 2004,finding that there are significant safety and economic issues that must be addressed beforeimportation of prescription drugs is permitted, and the current Secretary has not yet announced anyplans to make the required certification. In addition, federal legislative proposals have been madeto implement the changes to the United States import laws without any certification, and to broadenpermissible imports in other ways. Even if the changes to the United States import laws do nottake effect, and other changes are not enacted, imports from Canada and elsewhere may continue toincrease due to market and political forces, and the limited enforcement resources of the FDA, theUnited States Customs Service and other government agencies.     The importation of foreign products adversely affects our profitability in the United States.This impact could become more significant in the future, and the impact could be even greater ifthere is a further change in the law or if state or local governments take further steps tofacilitate the importation of products from abroad.*If we become subject to product liability claims, our earnings and financial condition couldsuffer.*     We are exposed to risks of product liability claims from allegations that our productsresulted in adverse effects to the patient or others. These risks exist even with respect to thoseproducts that are approved for commercial sale by the FDA and manufactured in facilities licensedand regulated by the FDA.     In addition to our desire to reduce the scope of our potential exposure to these types ofclaims, many of our customers require us to maintain product liability insurance as a condition ofconducting business with us. We currently carry product liability insurance in the amount of $50.0million per claim and $50.0 million in the
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aggregate on a claims-made basis. Nevertheless, thisinsurance may not be sufficient to cover all claims made against us. Insurance coverage isexpensive and may be difficult to obtain. As a result, we cannot be certain that our currentcoverage will continue to be available in the future on reasonable terms, if at all. If we areliable for any product liability claims in excess of our coverage or outside of our coverage, thecost and expense of such liability could cause our earnings and financial condition to suffer.*Rising insurance costs could negatively impact profitability.*     The cost of insurance, including workers compensation, product liability and general liabilityinsurance, have risen significantly in recent years and may increase in the future. In response,we may increase deductibles and/or decrease certain coverages to mitigate these costs. Theseincreases, and our increased risk due to increased deductibles and reduced coverages, could have anegative impact on our results of operations, financial condition and cash flows.*If we suffer negative publicity concerning the safety of our products, our sales may be harmed andwe may be forced to withdraw products.*     Physicians and potential patients may have a number of concerns about the safety of ourproducts, whether or not such concerns have a basis in generally accepted science or peer-reviewedscientific research. Negative publicity, whether accurate or inaccurate, concerning our productscould reduce market or governmental acceptance of our products and could result in decreasedproduct demand or product withdrawal. In addition, significant negative publicity could result inan increased number of product liability claims, whether or not these claims are supported byapplicable law.*RESTYLANE**® is a consumer product and as such, it is susceptible to changes in populartrends and applicable laws, which could adversely affect sales or product margins of RESTYLANE®.*     RESTYLANE® is a consumer product. If we fail to anticipate, identify or react tocompetitive products or if consumer preferences in the cosmetic marketplace shift to othertreatments for the treatment of fine lines, wrinkles and deep facial folds, we may experience adecline in demand for RESTYLANE®. In addition, the popular media has at times in thepast produced, and may continue in the future to produce, negative reports regarding the efficacy,safety or side effects of facial aesthetic products. Consumer perceptions of RESTYLANE®may be negatively impacted by these reports and other reasons.     Demand for RESTYLANE® may be materially adversely affected by changing economicconditions. Generally, the costs of cosmetic procedures are borne by individuals withoutreimbursement from their medical insurance providers or government programs. Individuals may beless willing to incur the costs of these procedures in weak or uncertain economic environments, anddemand for RESTYLANE® could be adversely affected.*We may not be able to repurchase the Old Notes and New Notes when required.*     In June 2002, we sold Contingent Convertible Senior Notes, due in 2032 (the “Old Notes”), inthe amount of $400.0 million. In August 2003, we exchanged approximately $230.8 million inprincipal of these Old Notes for approximately $283.9 million of our Contingent Convertible SeniorNotes due in 2033 (the “New Notes”).     On June 4, 2007, 2012 and 2017 and upon the occurrence of a change in control, holders of theremaining Old Notes may require us to offer to repurchase their Old Notes for cash. On June 4,2008, 2013 and 2018 and upon the occurrence of a change in control, holders of the New Notes mayrequire us to offer to repurchase their New Notes for cash. We may not have sufficient funds atthe time of any such events to make the required repurchases.     The source of funds for any repurchase required as a result of any such events will be ouravailable cash or cash generated from operating activities or other sources, including borrowings,sales of assets, sales of equity or funds provided by a new controlling entity. We cannot assureyou, however, that sufficient funds will be available at the time of any such events to make anyrequired repurchases of the Notes tendered. Furthermore, the use of
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available cash to fund therepurchase of the Old Notes or New Notes may impair our ability to obtain additional financing inthe future.*Our publicly-filed reports are reviewed by the SEC from time to time and any significant changesrequired as a result of any such review may result in material liability to us, and have a materialadverse impact on the trading price of our common stock.*     The reports of publicly-traded companies are subject to review by the SEC from time to timefor the purpose of assisting companies in complying with applicable disclosure requirements and toenhance the overall effectiveness of companies’ public filings, and comprehensive reviews of suchreports are now required at least every three years under the Sarbanes-Oxley Act of 2002. SECreviews may be initiated at any time. While we believe that our previously filed SEC reportscomply, and we intend that all future reports will comply in all material respects with thepublished rules and regulations of the SEC, we could be required to modify or reformulateinformation contained in prior filings as a result of an SEC review. Any modification orreformulation of information contained in such reports could be significant and result in materialliability to us and have a material adverse impact on the trading price of our common stock.*Unanticipated changes in our tax rates or exposure to additional income tax liabilities couldaffect our profitability.*     We are subject to income taxes in both the U.S. and other foreign jurisdictions. Oureffective tax rate could be adversely affected by changes in the mix of earnings in countries withdifferent statutory tax rates, changes in the valuation of deferred tax assets and liabilities,changes in or interpretations of tax laws including pending tax law changes (such as the researchand development credit), changes in our manufacturing activities and changes in our future levelsof research and development spending. In addition, we are subject to the continuous examination ofour income tax returns by the Internal Revenue Service and other tax authorities. We regularlyassess the likelihood of outcomes resulting from these examinations to determine the adequacy ofour provision for income taxes. There can be no assurance that the outcomes from these continuousexaminations will not have an adverse effect on our provision for income taxes and estimated incometax liabilities.*Risks Related to Our Industry**The growth of managed care organizations, other third-party reimbursement policies, stateregulatory agencies and retailer fulfillment policies may harm our pricing, which may reduce ourmarket share and margins.*     Our operating results and business success depend in large part on the availability ofadequate third-party payor reimbursement to patients for our prescription-brand products. Thesethird-party payors include governmental entities such as Medicaid, private health insurers andmanaged care organizations. Because of the size of the patient population covered by managed careorganizations, marketing of prescription drugs to them and the pharmacy benefit managers that servemany of these organizations has become important to our business.     The trend toward managed healthcare in the United States and the growth of managed careorganizations could significantly influence the purchase of pharmaceutical products, resulting inlower prices and a reduction in product demand. Managed care organizations and other third partypayors try to negotiate the pricing of medical services and products to control their costs.Managed care organizations and pharmacy benefit managers typically develop formularies to reducetheir cost for medications. Formularies can be based on the prices and therapeutic benefits of theavailable products. Due to their lower costs, generic products are often favored. The breadth ofthe products covered by formularies varies considerably from one managed care organization toanother, and many formularies include alternative and competitive products for treatment ofparticular medical conditions. Exclusion of a product from a formulary can lead to its sharplyreduced usage in the managed care organization patientpopulation. Payment or reimbursement of only a portion of the cost of our prescriptionproducts could make our products less attractive, from a net-cost perspective, to patients,suppliers and prescribing physicians. We cannot be certain that the reimbursement policies of theseentities will be adequate for our pharmaceutical products to compete on a price basis. If ourproducts are not included within an adequate number of formularies or adequate reimbursement levelsare not provided, or if those policies increasingly favor generic products, our market share andgross margins could be harmed, as could our business, financial condition, results of operationsand cash flows.
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     In addition, healthcare reform could affect our ability to sell our products and may have amaterial adverse effect on our business, results of operations, financial condition and cash flows.     Some of our products are not of a type generally eligible for reimbursement. It is possiblethat products manufactured by others could address the same effects as our products and be subjectto reimbursement. If this were the case, some of our products may be unable to compete on a pricebasis. In addition, decisions by state regulatory agencies, including state pharmacy boards,and/or retail pharmacies may require substitution of generic for branded products, may prefercompetitors’ products over our own, and may impair our pricing and thereby constrain our marketshare and growth.     Managed care initiatives to control costs have influenced primary-care physicians to referfewer patients to dermatologists and other specialists. Further reductions in these referralscould reduce the size of our potential market, and harm our business, financial condition, resultsof operations and cash flows.*We are subject to extensive governmental regulation.*     Pharmaceutical companies are subject to significant regulation by a number of national, stateand local governments and agencies. The FDA administers requirements covering testing,manufacturing, safety, effectiveness, labeling, storage, record keeping, approval, sampling,advertising and promotion of our products. Several states have also instituted laws andregulations covering some of these same areas. In addition, the FTC and state and localauthorities regulate the advertising of over-the-counter drugs and cosmetics. Failure to complywith applicable regulatory requirements could, among other things, result in: **•** fines;  **•** changes to advertising;  **•** suspensions of regulatory approvals of products;  **•** product recalls;  **•** delays in product distribution, marketing and sale; and  **•** civil or criminal sanctions.     Our prescription and over-the-counter products receive FDA review regarding their safety andeffectiveness. However, the FDA is permitted to revisit and change its prior determinations. Wecannot be sure that the FDA will not change its position with regard to the safety or effectivenessof our products. If the FDA’s position changes, we may be required to change our labeling orformulations or cease to manufacture and market the challenged products. Even prior to any formalregulatory action, we could voluntarily decide to cease distribution and sale or recall any of ourproducts if concerns about their safety or effectiveness develop.     Before marketing any drug that is considered a “new drug” by the FDA, the FDA must provide itsapproval of the product. All products which are considered drugs which are not “new drugs” andthat generally are recognized by the FDA as safe and effective for use do not require the FDA’sapproval. We believe that some of our products, as they are promoted and intended for use, areexempt from treatment as “new drugs” and are not subject to approval by the FDA. The FDA, however,could take a contrary position, and we could be required to seek FDA approval of those products andthe marketing of those products. We could also be required to withdraw those products from themarket. For example, in the August 29, 2006 Federal Register, the FDA issued a notice of proposedrulemaking to categorically establish that over-the-counter skin bleaching drug products are notgenerally recognized as safe and effective and are misbranded. If the proposed rule is adopted,all manufacturers of skinbleaching products would be required to remove their products from the market and obtain FDAapproval prior to re-entering the U.S. market. The FDA has issued a Guidance document entitled “Marketed Unapproved Drugs — Compliance PolicyGuide.” During a public workshop on January 9, 2007 concerning this Guidance, the FDA was reportedto have stated the intention to accelerate its evaluation of suchproducts. ESOTERICA® is an over-the-counterproduct line that we sell that contains bleaching products that would be regulated by the proposedrule and if that occurs we do not currently intend to invest in obtaining an approved NDA for thisproduct line. This product accounted for approximately $2.0 million in net revenues during 2006.
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     Sales representative activities may also be subject to the Voluntary Compliance Guidanceissued for pharmaceutical manufacturers by the Office of Inspector General (“OIG”) of theDepartment of Health and Human Services, as well as state laws and regulations. We haveestablished compliance program policies and training programs for our sales force, which we believeare appropriate. The OIG and/or state law enforcement entities, however, could take a contraryposition, and we could be required to modify our sales representative activities. See Item 3.Legal Proceedings of this Form 10-K.*If we market products in a manner that violates health care fraud and abuse laws, we may be subjectto civil or criminal penalties.*     Federal health care program anti-kickback statutes prohibit, among other things, knowingly andwillfully offering, paying, soliciting or receiving remuneration to induce, or in return forpurchasing, leasing, ordering or arranging for the purchase, lease or order of any health care itemor service reimbursable under Medicare, Medicaid, or other federally financed health care programs.This statute has been interpreted to apply to arrangements between pharmaceutical manufacturers onone hand and prescribers, purchasers and formulary managers on the other. Although there are anumber of statutory exemptions and regulatory safe harbors protecting certain common activitiesfrom prosecution, the exemptions and safe harbors are drawn narrowly, and practices that involveremuneration intended to induce prescribing, purchasing, or recommending may be subject to scrutinyif they do not qualify for an exemption or safe harbor. Although we believe that we are incompliance, our practices may be determined to fail to meet all of the criteria for safe harborprotection from anti-kickback liability.     Federal false claims laws prohibit any person from knowingly presenting, or causing to bepresented, a false claim for payment to the federal government, or knowingly making, or causing tobe made, a false statement to get a false claim paid. Pharmaceutical companies have beenprosecuted under these laws for a variety of alleged promotional and marketing activities, such asallegedly providing free product to customers with the expectation that the customers would billfederal programs for the product; reporting to pricing services inflated average wholesale pricesthat were then used by federal programs to set reimbursement rates; engaging in off-label promotionthat caused claims to be submitted to Medicaid for non-covered off-label uses; and submittinginflated best price information to the Medicaid Rebate Program. The majority of states also havestatutes or regulations similar to the federal anti-kickback law and false claims laws, which applyto items and services reimbursed under Medicaid and other state programs, or, in several states,apply regardless of the payor. Sanctions under these federal and state laws may include civilmonetary penalties, exclusion of a manufacturer’s products from reimbursement under governmentprograms, criminal fines, and imprisonment. Because of the breadth of these laws and thenarrowness of the safe harbors, it is possible that some of our business activities could besubject to challenge under one or more of such laws. The government notified us on December 14,2004, that it is investigating claims that we violated the federal False Claims Act in connectionwith the alleged off-label marketing and promotion of LOPROX® and LOPROX® TSproducts to pediatricians during periods prior to our May 2004 disposition of our pediatric salesdivision. On or around October 5, 2006, the parties agreed in principle to resolve all federal andstate civil claims against us for approximately $9.8 million. Asof December 31, 2006, we have accrued a loss contingency of$10.2 million for this matter in connection with the possibilityof additional expenses related to the settlement amount. On or about October12, 2006, the Company and the United States Attorney’s Office for the District of Kansas enteredinto a Nonprosecution Agreement wherein the government agreed not to prosecute the Company for anyalleged criminal violations relating to the alleged off-label marketing and promotion ofLOPROX®. In exchange for the government’s agreement not to pursue any criminal chargesagainst us, we have agreed to continue cooperating with the government in its ongoing investigationinto whether our past and present employees and officers may have violated federal criminal lawregarding alleged off-label marketing and promotion of LOPROX® to pediatricians. Noindividuals have been designated as targets of the investigation. Any such claims,prosecutions or other proceedings, with respect to our past and present employees and officers, thecost of their defense and fines and penalties resulting therefrom could have a material impact onour reputation, business and financial condition. The Company also is engaged in discussions withthe Office of Inspector General of the Department of Health and Human Services (“IG”) to resolveany potential administrative claims the IG may have arising out of the government’s investigationinto the Company’s marketing and promotion of LOPROX®. See Item 3. Legal Proceedings ofthis Form 10-K
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*Obtaining FDA and other regulatory approvals is time consuming, expensive and uncertain.*     The process of obtaining FDA and other regulatory approvals is time consuming and expensive.Clinical trials are required and the marketing and manufacturing of pharmaceutical products aresubject to rigorous testing procedures. We may not be able to obtain FDA approval to conductclinical trials or to manufacture or market any of the products we develop, acquire or license on atimely basis or at all. Moreover, the costs to obtain approvals could be considerable, and thefailure to obtain or delays in obtaining an approval could significantly harm our businessperformance and financial results. Even if pre-marketing approval from the FDA is received, the FDAis authorized to impose post-marketing requirements such as: **•** testing and surveillance to monitor the product and its continued compliance withregulatory requirements;  **•** submitting products for inspection and, if any inspection reveals that the productis not in compliance, prohibiting the sale of all products from the same lot;  **•** suspending manufacturing;  **•** switching status from prescription to over-the-counter drug;  **•** recalling products; and  **•** withdrawing marketing clearance.     In their regulation of advertising, the FDA and FTC from time to time issue correspondence topharmaceutical companies alleging that some advertising or promotional practices are false,misleading or deceptive. The FDA has the power to impose a wide array of sanctions on companies forsuch advertising practices, and the receipt of correspondence from the FDA alleging these practicescould result in the following: **•** incurring substantial expenses, including fines, penalties, legal fees and costs tocomply with the FDA’s requirements;  **•** changes in the methods of marketing and selling products;  **•** taking FDA-mandated corrective action, which may include placing advertisements orsending letters to physicians rescinding previous advertisements or promotion; and  **•** disruption in the distribution of products and loss of sales until compliance withthe FDA’s position is obtained.     In recent years, various legislative proposals have been offered in Congress and in some statelegislatures that include major changes in the health care system. These proposals have includedprice or patient reimbursement constraints on medicines, restrictions on access to certainproducts, reimportation of products from Canada or other sources and mandatory substitution ofgeneric for branded products. We cannot predict the outcome of such initiatives, and it isdifficult to predict the future impact of the broad and expanding legislative and regulatoryrequirements affecting us.*We face significant competition within our industry.*     The pharmaceutical and dermal aesthetics industries are highly competitive. Competition in ourindustry occurs on a variety of fronts, including: **•** developing and bringing new products to market before others;  **•** developing new technologies to improve existing products;  **•** developing new products to provide the same benefits as existing products at less cost; and  **•** developing new products to provide benefits superior to those of existing products.     The intensely competitive environment requires an ongoing, extensive search for technologicalinnovations and the ability to market products effectively. Consequently, we must continue todevelop and introduce products in a timely and cost-efficient manner to effectively compete in themarketplace and maintain our revenue and gross margins.
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     Our competitors vary depending upon product categories. Many of our competitors are large,well-established companies in the fields of pharmaceuticals, chemicals, cosmetics and health care.Among our largest competitors are Allergan, Galderma, Johnson & Johnson, Sanofi-Aventis, StiefelLaboratories, Warner Chilcott and others.     Many of these companies have greater resources than we do to devote to marketing, sales,research and development and acquisitions. As a result, they have a greater ability to undertakemore extensive research and development, marketing and pricing policy programs. It is possiblethat our competitors may develop new or improved products to treat the same conditions as ourproducts or make technological advances reducing their cost of production so that they may engagein price competition through aggressive pricing policies to secure a greater market share to ourdetriment. These competitors also may develop products that make our current or future productsobsolete. Any of these events could significantly harm our business, financial condition andresults of operations, including reducing our market share, gross margins, and cash flows.     We sell and distribute prescription brands, medical devices and over-the-counter products.Each of these products competes with products produced by others to treat the same conditions.Several of our prescription products compete with generic pharmaceuticals, which claim to offerequivalent benefit at a lower cost. In some cases, insurers and other health care paymentorganizations try to encourage the use of these less expensive generic brands through theirprescription benefits coverage and reimbursement policies. These organizations may make the genericalternative more attractive to the patient by providing different amounts of reimbursement so thatthe net cost of the generic product to the patient is less than the net cost of our prescriptionbrand product. Aggressive pricing policies by our generic product competitors and the prescriptionbenefits policies of third party payors could cause us to lose market share or force us to reduceour gross margins in response.     There are several dermal filler products under development and/or in the FDA pipeline forapproval which claim to offer equivalent or greater facial aesthetic benefits toRESTYLANE® and, if approved, the companies producing such products could charge less todoctors for their products.Item 1B. Unresolved Staff Comments     We have received no written comments regarding our periodic or current reports from the staffof the SEC that were issued 180 days or more preceding the end of 2006 and that remain unresolved.Item 2. Properties     Our office space in Scottsdale, Arizona has approximately 75,000 square feet under an amendedlease agreement that expires in December 2010. The average annual expense under the amended leaseagreement is approximately $2.1 million. The lease contains certain rent escalation clauses and,upon expiration, can be renewed for two additional periods of five years each.     During July 2006, we executed a lease agreement for new headquarter office space toaccommodate our expected long-term growth. The first phase is for approximately 150,000 squarefeet with the right to expand. Occupancy of the new headquarter office space, which is locatedapproximately one mile from our current headquarter office space in Scottsdale, Arizona, isexpected to occur in 2008. The term of the lease is twelve years.     During October 2006, we executed an interim lease agreement for additional headquarter officespace to accommodate our current needs and future growth. Approximately 21,000 square feet ofoffice space is being leased for a period of three years. Occupancy of the additional headquarteroffice space, which is located approximately one mile from our current headquarter office space inScottsdale, Arizona, is expected to occur in 2007.     Medicis Aesthetics Canada Ltd., a wholly owned subsidiary, presently leases approximately3,600 square feet of office space in Toronto, Ontario, Canada, under a lease agreement that expiresin February 2008.     Rent expense was approximately $2.2 million, $1.2 million, $1.1 million, $2.3 million and $2.1million for 2006, the Transition Period, the comparable six-month period in 2004, fiscal 2005 andfiscal 2004, respectively.
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Item 3. Legal Proceedings     The government notified us on December 14, 2004, that it is investigating claims that weviolated the federal False Claims Act in connection with the alleged off-label marketing andpromotion of LOPROX® and LOPROX® TS products to pediatricians during periodsprior to our May 2004 disposition of our pediatric sales division. On or around October 5, 2006the parties agreed in principle to resolve all federal and state civil claims against us for $9.8million. As of December 31, 2006, we have accrued aloss contingency of $10.2 million for this matter in connectionwith the possibility of additional expenses related to the settlementamount.     On or about October 12, 2006, we and the United States Attorney’s Office for the District ofKansas entered into a Nonprosecution Agreement wherein the government agreed not to prosecute usfor any alleged criminal violations relating to the alleged off-label marketing and promotion ofLOPROX®. In exchange for the government’s agreement not to pursue any criminal chargesagainst us, we have agreed to continue cooperating with the government in its ongoing investigationinto whether past and present employees and officers may have violated federal criminal lawregarding alleged off-label marketing and promotion of LOPROX® to pediatricians. No individualshave been designated as targets of the investigation. Any such claims, prosecutions or otherproceedings, with respect to our past and present employees and officers, the cost of their defenseand fines and penalties resulting therefrom could have a material impact on our reputation,business and financial condition.     We are also engaged in discussions with the Office of Inspector General of the Department ofHealth and Human Services (“IG”) to resolve any potential administrative claims the IG may havearising out of the government’s investigation into the Company’s marketing and promotion ofLOPROX®.     On October 27, 2005, we filed suit against Upsher-Smith Laboratories, Inc. of Plymouth,Minnesota and against Prasco Laboratories of Cincinnati, Ohio for infringement of Patent No.6,905,675 entitled “Sulfur Containing Dermatological Compositions and Methods for Reducing Malodorsin Dermatological Compositions” covering our sodium sulfacetamide/sulfur technology. Thisintellectual property is related to our PLEXION® Cleanser product. The suit was filedin the U.S. District Court for the District of Arizona, and seeks an award of damages, as well as apreliminary and a permanent injunction. A hearing on our preliminary injunction motion was heardon March 8 and March 9, 2006. On May 2, 2006, an orderdenying the motion for a preliminary injunction was received byMedicis. The Court has entered an order staying this case until theconclusion of a patent reexamination request submitted by Medicis.     OnJune 22, 2006, Medicis and Aventis-Sanofi (themanufacturer ofLOPROX®Gel), filed a complaint in the U.S. District Court for the Districtof Minnesota against Paddock Laboratories, asserting that Paddock'sproposed generic version of Medicis’LOPROX®Gel product will infringe one or more claims of one of theCompany’s patents onLOPROX®Gel. Paddock filed an answer and counterclaims and later amendedthese filings, denying infringement and seeking fees and costs. OnDecember 7, 2006, plaintiffs served Paddock with a covenant notto sue for infringement of the ‘656 patent based on the productsthat are the subject of Paddock’s current ANDA, and filed theirreply to Paddock’s counterclaims, which included a denial ofPaddock’s allegations that the ’337 patent claims areinvalid, unenforceable and not infringed. On January 26, 2007,the Court entered a stipulated Amended Pretrial Scheduling Order,extending all pre-trial and discovery dates in the case by30 days to allow the parties to engage in discussions.
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     In addition to the matters discussed above, we and certain of our subsidiaries are parties toother actions and proceedings incident to our business, including litigation regarding ourintellectual property, challenges to the enforceability or validity of our intellectual propertyand claims that our products infringe on the intellectual property rights of others. We recordcontingent liabilities resulting from claims against us when it is probable (as that word isdefined in Statement of Financial Accounting Standards No. 5) that a liability has been incurredand the amount of the loss is reasonably estimable. We disclose material contingent liabilitieswhen there is a reasonable possibility that the ultimate loss will exceed the recorded liability.Estimating probable losses requires analysis of multiple factors, in some cases including judgmentsabout the potential actions of third-party claimants and courts. Therefore, actual losses in anyfuture period are inherently uncertain. In all of the cases noted where we are the defendant, webelieve we have meritorious defenses to the claims in these actions and resolution of these matterswill not have a material adverse effect on our business, financial condition, or results ofoperation; however, the results of the proceedings are uncertain, and there can be no assurance tothat effect.**PART II**Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities*Description of Registrant’s Securities, Price Range of Common Stock and Dividends Declared*     Medicis’ Class A common stock trades on the New York Stock Exchange under the symbol “MRX”.The following table sets forth the high and low sale prices for our Class A common stock on the NewYork Stock Exchange for the fiscal periods indicated:                       **DIVIDENDS**  **HIGH** **LOW** **DECLARED**FISCAL YEAR ENDED DECEMBER 31, 2006            First Quarter $34.40  $28.20  $0.03 Second Quarter  34.90   23.54   0.03 Third Quarter  32.46   22.57   0.03 Fourth Quarter  40.31   32.08   0.03              TRANSITION PERIOD            Three Months Ended September 30, 2005 $35.45  $31.08  $0.03 Three Months Ended December 31, 2005  35.16   26.30   0.03              FISCAL YEAR ENDED JUNE 30, 2005            First Quarter $40.65  $32.85  $0.03 Second Quarter  41.00   34.64   0.03 Third Quarter  37.67   28.69   0.03 Fourth Quarter  31.97   26.80   0.03      On February 23, 2007, the last reported sale price on the New York Stock Exchange forMedicis’ Class A common stock was $37.81 per share. As of such date, there were approximately 201holders of record of Class A common stock.
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*Dividend Policy*     We do not have a dividend policy. Since July 2003, we have paid quarterly cash dividendsaggregating approximately $21.8 million on our common stock. In addition, on December 14, 2006, wedeclared a cash dividend of $0.03 per issued and outstanding share of common stock payable onJanuary 31, 2007 to our stockholders of record at the close of business on January 2, 2007. Priorto these dividends, we had not paid a cash dividend on our common stock. Any future determinationsto pay cash dividends will be at the discretion of our Board of Directors and will be dependentupon our financial condition, operating results, capital requirements and other factors that ourBoard of Directors deems relevant.     Our 1.5% Contingent Convertible Senior Notes due 2033 require an adjustment to the conversionprice if the cumulative aggregate of all current and prior dividend increases above $0.025 pershare would result in at least a one percent (1%) increase in the conversion price. This thresholdhas not been reached and no adjustment to the conversion price has been made.*Recent Sales of Unregistered Securities*     None.*Equity Compensation Plan Information*     Information required to be included about our equity compensation plan is incorporated byreference to the material under the caption “Equity Compensation Plan Information” in the proxystatement for our 2007 annual meeting of stockholders.
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Item 6. Selected Financial Data     The following table sets forth selected consolidated financial data for the year endedDecember 31, 2006 and 2005, the Transition Period, and the corresponding six-month period in 2004.The data for December 31, 2006 and the Transition Period is derived from our audited consolidatedfinancial statements and accompanying notes, while the data for the year ended December 31, 2005and the six-month period ended December 31, 2004 is derived from our unaudited consolidatedfinancial statements. The comparability of the periods presented is impacted by certain productrights and business acquisitions and dispositions. Gross profit does not include amortization ofour intangible assets.                   **Year**  **Year**      **Six Months**   **Ended**  **Ended**  **Transition**  **Ended**   **Dec. 31, 2006**  **Dec. 31, 2005**  **Period**  **Dec. 31, 2004**   **(in thousands, except per share amounts)** **Statements of Operations Data:**                Net product revenues $333,625  $313,684  $155,569  $146,999 Net contract revenues  15,617   46,002   8,385   34,168              Net revenues  349,242   359,686   163,954   181,167 Gross profit (a)  307,501   307,398   139,843   153,897 Operating expenses:                Selling, general and administrative  206,822(b)  149,607(d)  80,189(g)  65,736(i)Impairment of long-lived assets  52,586   9,171   9,171   — Research and development  161,837(c)  42,903(e)  22,367(h)  45,140(j)Depreciation and amortization  23,048   24,548   12,420   10,222              Total operating expenses  444,293   226,229   124,147   121,098                               Operating (loss) income  (136,792)  81,169   15,696   32,799 Other:                Other income, net  —   59,801(f)  59,801(f)  — Net interest income (expense)  20,147   5,804   4,726   (248)Income tax benefit (expense)  40,796   (53,288)  (30,502)  (11,328)                              Net (loss) income $(75,849) $93,486  $49,721  $21,223                               Basic net (loss) income per share $(1.39) $1.72  $0.92  $0.38              Diluted net (loss) income per share $(1.39) $1.44(k) $0.76  $0.34              Cash dividend declared per common share $0.12  $0.12  $0.06  $0.06              Basic common shares outstanding  54,688   54,290   54,323   55,972              Diluted common shares outstanding  54,688   69,558(k)  69,772   72,160               (a) Amounts exclude $20.0 million, $21.6 million, $10.9 million and $8.9 million of amortizationexpense related to acquired intangible assets for the year ended December 31, 2006 and 2005,the Transition Period, and the six months ended December 31,2004, respectively. (b) Includes approximately $24.5 million of compensation expense related to stock options andrestricted stock, $10.2 million related to a loss contingency for a legal matter and $1.8million related to a settlement of a dispute related to our merger with Ascent. (c) Includes approximately $125.2 million paid to Ipsen related to the RELOXIN®development and distribution agreement and approximately $1.6 million of compensation expenserelated to stock options and restricted stock. (d) Includes approximately $13.9 million of compensation expense related to stock options andrestricted stock recognized during the Transition Period and approximately $6.0 million ofintegration planning costs incurred related to the proposed Inamed transaction during thethree months ended June 30, 2005 and three months ended September 30, 2005.
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(e) Includes approximately $8.3 million paid to AAIPharma related to a research and developmentcollaboration, $11.9 million related to a research and development collaboration with Dow andapproximately $1.0 million of compensation expense related to stock options and restrictedstock. (f) Represents a termination fee of $90.5 million received from Inamed upon the termination ofthe proposed merger with Inamed, net of a termination fee paid to an investment banker and theexpensing of accumulated transactions costs of $27.0 million, and integration costs incurredduring the three months ended December 31, 2005 of $3.7 million. (g) Includes approximately $13.9 million of compensation expense related to stock options andrestricted stock recognized during the Transition Period and approximately $0.7 million ofintegration planning costs incurred related to the proposed Inamed transaction during thethree months ended September 30, 2005. (h) Includes approximately $11.9 million related to a research and development collaboration withDow and approximately $1.0 million of compensation expense related to stock options andrestricted stock. (i) Includes approximately $1.3 million of professional fees related to research and developmentcollaborations with Ansata and Q-Med. (j) Includes $5.0 million paid to Ansata related to an exclusive development and licenseagreement and $30.0 million paid to Q-Med related to an exclusive license agreement for thedevelopment of SubQTM. (k) Diluted net income per common share for the unaudited year ended December 31, 2005 wascalculated by using the average of the periodic diluted common shares outstanding during theyear. For the period from January 1, 2005 to June 30, 2005, diluted common shares outstandingwas calculated using APB Opinion No. 25, while for the period from July 1, 2005 to December31, 2005, diluted common shares outstanding was calculated using SFAS 123R. The Companyadopted SFAS No. 123R effective July 1, 2005.
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     The cash flow data for the year ended December 31, 2005 and the six months ended December 31,2004, is unaudited.           **December 31,**  **2006** **2005**  **(in thousands)****Balance Sheet Data:**        Cash, cash equivalents and short-terminvestments $554,261(a) $742,532 Working capital  550,022   692,453 Long-term investments  130,290   — Total assets  1,069,286   1,145,954 Long-term debt  453,065   453,065 Stockholders’ equity  509,559   543,487                                **Six Months**  **Year Ended** **Year Ended** **Transition** **Ended**  **Dec. 31, 2006** **Dec. 31, 2005** **Period** **Dec. 31, 2004**  **(in thousands)****Cash Flow Data:**                Net cash (used in) provided byoperating activities $(40,963)(b) $232,506(c) $147,990(c) $45,465 Net cash (used in) provided byinvesting activities  (216,915)  187,994   123,665   76,158 Net cash provided by (used in) byfinancing activities  14,278   (5,137)  (2,792)  (137,447) (a) Decrease in cash, cash equivalents and short-term investments from December 31, 2005 toDecember 31, 2006 primarily due to payments totaling $125.2 million made to Ipsen relatedto a development and distribution agreement for the development of RELOXIN®,payment of the $27.4 million contingent payment related to the merger with Ascent, andpayments totaling $35.7 million for income taxes during 2006. In addition, approximately$130.3 million of our available-for-sale investments have been treated as long-term assetsas of December 31, 2006, based on their expected maturities. (b) Net cash used in operating activities for the year ended December 31, 2006 includedpayments totaling $125.2 million made to Ipsen related to a development and distributionagreement for the development of RELOXIN®. (c) Net cash provided by operating activities for the year ended December 31, 2005 and theTransition Period included a $90.5 million termination received from Inamed related to thetermination of a proposed merger.
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     The following selected consolidated financial data for the four-year period ended June 30,2005 is derived from our audited consolidated financial statements and accompanying notes. Thecomparability of the years presented is impacted by certain product rights and businessacquisitions and dispositions. All business acquisitions were accounted for under the purchasemethod and accordingly, the results of operations reflect the financial results of each businessacquisition from the date of the acquisition. Certain business acquisitions resulted in thewrite-off of in-process research and development resulting from an independent valuation. Grossprofit does not include amortization of the related intangible assets.                   **FISCAL YEAR ENDED JUNE 30,**   **2005**  **2004**  **2003**  **2002**   **(in thousands, except per share amounts)** **Statements of Operations Data:**                Net product revenues $305,114  $291,607  $241,909  $211,248 Net contract revenues  71,785   12,115   5,630   1,559              Net revenues  376,899   303,722   247,539   212,807 Gross profit (a)  321,452   257,116   209,279   177,042 Operating expenses:                Selling, general and administrative  135,154(b)  118,253   91,648   77,314 Research and development  65,676(c)  16,494(d)  29,568(e)  15,132(f)In-process research and development  —   —   —   6,217 Depreciation and amortization  22,350   16,794   10,125   7,928              Total operating expenses  223,180   151,541   131,341   106,591                               Operating income  98,272   105,575   77,938   70,451 Other:                Net interest income (expense)  830   (758)  (278)  8,533 Loss on early extinguishment of debt  —   (58,660)  —   — Income tax expense  (34,112)  (15,317)  (26,404)  (28,960)                              Net income $64,990  $30,840  $51,256  $50,024                               Basic net income per share $1.18  $0.55  $0.94  $0.83              Diluted net income per share $1.01  $0.52  $0.84  $0.79              Cash dividend declared per common share $0.12  $0.10  $0.025   —              Basic common shares outstanding  55,196   55,618   54,376   60,536              Diluted common shares outstanding  70,909   72,481   70,191   63,828               (a) Amounts exclude $19.6 million, $14.9 million, $9.2 million and $7.1 million for amortizationexpense related to acquired intangible assets in fiscal 2005, 2004, 2003 and 2002,respectively. (b) Includes approximately $5.3 million of business integration planning costs related to theproposed merger with Inamed, and approximately $1.3 million of professional fees related toresearch and development collaborations with AAIPharma, Ansata and Q-Med. (c) Includes approximately $8.3 million paid to AAIPharma related to a research and developmentcollaboration, $5.0 million paid to Ansata related to an exclusive development and licenseagreement and $30.0 million paid to Q-Med related to an exclusive license agreement for thedevelopment of SubQTM. (d) Includes approximately $2.4 million paid to Dow for a research and development collaboration. (e) Includes $14.2 million paid to Dow for a research and development collaboration andapproximately $6.0 million paid to AAIPharma for a research and development collaboration. (f) Includes $7.7 million paid to AAIPharma for a research and development collaboration.
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                   **JUNE 30,**  **2005** **2004** **2003** **2002**  **(in thousands)****Balance Sheet Data:**                Cash, cash equivalents, restricted cashand short-term investments $603,568  $634,040  $552,663  $577,576 Working capital  600,070   666,743   576,781   611,259 Total assets  1,043,251   1,078,384   932,841   876,273 Long-term debt  453,065   453,067   400,000   400,000 Stockholders’ equity  486,346   555,303   461,121   429,059                    **FISCAL YEAR ENDED JUNE 30,**  **2005** **2004** **2003** **2002**  **(in thousands)****Cash Flow Data:**                Net cash provided by operating activities $129,981  $127,964  $84,667  $73,542 Net cash provided by (used in) investingactivities  140,487   (166,341)  (113,709)  (341,660)Net cash (used in) provided by financingactivities  (139,793)  40,621   (23,343)  254,938 
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations     The following Management’s Discussion and Analysis of Financial Condition and Resultsof Operations (“MD&A”) summarizes the significant factors affecting our results of operations,liquidity, capital resources and contractual obligations, as well as discusses our criticalaccounting policies and estimates. You should read the following discussion and analysistogether with our consolidated financial statements, including the related notes, which areincluded in this report on Form 10-K. Certain information contained in the discussion andanalysis set forth below and elsewhere in this report, including information with respect toour plans and strategy for our business and related financing, includes forward-lookingstatements that involve risks and uncertainties. See “Risk Factors” in Item 1A of this Form10-K for a discussion of important factors that could cause actual results to differmaterially from the results described in or implied by the forward-looking statements in thisreport. Our MD&A is composed of four major sections; Executive Summary, Results ofOperations, Liquidity and Capital Resources and Critical Accounting Policies and Estimates.Change in Fiscal Year     Effective December 31, 2005, we changed our fiscal year end from June 30 to December 31. Thischange was made to align our fiscal year end with other companies within our industry. This MD&Ais intended to cover the audited calendar year January 1, 2006 to December 31, 2006, which we referto as “2006.” Comparative financial information to 2006 is provided in this Form 10-K with respectto the calendar year January 1, 2005 to December 31, 2005, which is unaudited and we refer to as“2005.” Additional information is provided with respect to the transition period July 1, 2005through December 31, 2005 (the “Transition Period”), which is audited. We refer to the periodbeginning July 1, 2004 and ending June 30, 2005 as “fiscal 2005”, and the period beginning July 1,2003 and ending June 30, 2004 as “fiscal 2004”.Executive Summary     We are a leading independent specialty pharmaceutical company focused primarily on helpingpatients attain a healthy and youthful appearance and self-image through the development andmarketing in the U.S. of products for the treatment of dermatological, aesthetic and podiatricconditions. We also market products in Canada for the treatment of dermatological and aestheticconditions. We offer a broad range of products addressing various conditions or aestheticsimprovements, including dermal fillers, acne, fungal infections, rosacea, hyperpigmentation,photoaging, psoriasis, skin and skin-structure infections, seborrheic dermatitis and cosmesis(improvement in the texture and appearance of skin).     Our current product lines are divided between the dermatological and non-dermatologicalfields. Our dermatological field represents products for the treatment of acne and acne-relateddermatological conditions and non-acne dermatological conditions. Our non-dermatological fieldrepresents products for the treatment of asthma (until May 2004), urea cycle disorder and contractrevenue. Our acne and acne-related dermatological product lines include DYNACIN®,PLEXION®, SOLODYN®, TRIAZ® and ZIANATM. Our non-acnedermatological product lines include LOPROX®, OMNICEF®, RESTYLANE®and VANOSTM. Our non-dermatological product lines include AMMONUL®,BUPHENYL® and ORAPRED®. ORAPRED® was licensed to BioMarin in May2004. Our non-dermatological field also includes contract revenues associated with licensingagreements and authorized generic agreements.*Key Aspects of Our Business*     We derive a majority of our revenue from our primary products: OMNICEF®,RESTYLANE®, SOLODYN®, TRIAZ®, VANOSTM andZIANATM. We believe that sales of our primary products and PERLANE®, whichis not currently approved for use by the FDA in the U.S., will constitute a significant portion ofour sales for the foreseeable future.     We have built our business by executing a four-part growth strategy: promoting existingbrands, developing new products and important product line extensions, entering into strategiccollaborations and acquiring complementary products, technologies and businesses. Our core philosophy is tocultivate relationships of trust and
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confidence with the high prescribing dermatologists andpodiatrists and the leading plastic surgeons in the United States.     As a result of customer buying patterns, a substantial portion of our product revenues hasbeen recognized in the last month of each quarter, and we schedule our inventory purchases to meetanticipated customer demand. As a result, miscalculation of customer demand or relatively smalldelays in our receipt of manufactured products could result in revenues being deferred or lost.Our operating expenses are based upon anticipated sales levels, and a high percentage of ouroperating expenses are relatively fixed in the short term. Depending on the customer, we recognizerevenue at the time of shipment to the customer, or at the time of receipt by the customer, net ofestimated provisions. Consequently, variations in the timing of revenue recognition could causesignificant fluctuations in operating results from period to period and may result in unanticipatedperiodic earnings shortfalls or losses.     We estimate customer demand for our prescription products primarily through use of third partysyndicated data sources which track prescriptions written by health care providers and dispensed bylicensed pharmacies. The data represents extrapolations from information provided only by certainpharmacies and are estimates of historical demand levels. We estimate customer demand for ournon-prescription products primarily through internal data that we compile. We observe trends fromthese data and, coupled with certain proprietary information, prepare demand forecasts that are thebasis for our purchase orders for finished and component inventory from our third partymanufacturers and suppliers. Our forecasts may fail to accurately anticipate ultimate customerdemand for our products. Overestimates of demand may result in excessive inventory production andunderestimates may result in inadequate supply of our products in channels of distribution.     We sell our products primarily to major wholesalers and retail pharmacy chains. Approximately75% of our gross revenues are derived from two major drug wholesale concerns. While we attempt toestimate inventory levels of our products at our major wholesale customers by using historicalprescription information and historical purchase patterns, this process is inherently imprecise.Rarely do wholesale customers provide us complete inventory levels at regional distributioncenters, or within their national distribution systems. We rely wholly upon our wholesale and drugchain customers to effect the distribution allocation of substantially all of our products. Basedupon historically consistent purchasing patterns of our major wholesale customers, we believe ourestimates of trade inventory levels of our products are reasonable. We further believe thatinventories of our products among wholesale customers, taken as a whole, are similar to those ofother specialty pharmaceutical companies, and that our trade practices, which periodically involvevolume discounts and early payment discounts, are typical of the industry.     We periodically offer promotions to wholesale and chain drugstore customers to encouragedispensing of our prescription products, consistent with prescriptions written by licensed healthcare providers. Because many of our prescription products compete in multi-source markets, it isimportant for us to ensure the licensed health care providers’ dispensing instructions arefulfilled with our branded products and are not substituted with a generic product or anothertherapeutic alternative product which may be contrary to the licensed health care providers’recommended and prescribed Medicis brand. We believe that a critical component of our brandprotection program is maintenance of full product availability at drugstore and wholesalecustomers. We believe such availability reduces the probability of local and regional productsubstitutions, shortages and backorders, which could result in lost sales. We expect to continueproviding favorable terms to wholesale and retail drug chain customers as may be necessary toensure the fullest possible distribution of our branded products within the pharmaceutical chain ofcommerce.     We cannot control or significantly influence the purchasing patterns of our wholesale andretail drug chain customers. They are highly sophisticated customers that purchase products in amanner consistent with their industry practices and, presumably, based upon their projected demandlevels. Purchases by any given customer, during any given period, may be above or below actualprescription volumes of any of our products during the same period, resulting in fluctuations ofproduct inventory in the distribution channel.
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     As described in more detail below, the following significant events and transactions occurredduring 2006, and affected our results of operations, our cash flows and our financial condition: - Development and distribution agreement with Ipsen for rights to Ipsen’sbotulinum toxin type A product known as RELOXIN®;  - FDA approval of SOLODYN®;  - Loss contingency for a pending governmental investigation relating to ourmarketing and promotion of LOPROX® products;  - Write-down of long-lived assets due to impairment; and  - FDA approval of ZIANATM.*Development and Distribution Agreement With Ipsen for Rights to Ipsen’s Botulinum Toxin Type AProduct Known as RELOXIN**®*     On March 17, 2006, we entered into a development and distribution agreement with Ipsen Ltd., awholly-owned subsidiary of Ipsen S.A. (“Ipsen”), whereby Ipsen granted Aesthetica Ltd., awholly-owned subsidiary of Medicis, rights to develop, distribute and commercialize Ipsen’sbotulinum toxin type A product in the United States, Canada and Japan for aesthetic use byphysicians. The product is commonly referred to as RELOXIN® in the U.S. aestheticmarket and DYSPORT® in medical and aesthetic markets outside the U.S. The product isnot currently approved for use in the U.S., Canada or Japan. Upon execution of the development anddistribution agreement, we made an initial payment to Ipsen in the amount of $90.1 million.     Additionally, we agreed to negotiate and enter into an agreement relating to the exclusivedistribution and development rights of the product for the aesthetic market in Europe, andsubsequently in certain other markets. Under the terms of the U.S., Canada and Japan agreement, wewere obligated to make an additional $35.1 million payment, as amended, to Ipsen if this agreementwas not entered into by April 15, 2006. On April 13, 2006, we agreed with Ipsen to extend thisdeadline to July 15, 2006. In connection with this extension, we paid Ipsen approximately $12.9million in April 2006, which would be applied against the total obligation, in the event anagreement was not entered into by the extended deadline. On July 17, 2006, we reached a decisionwith Ipsen to not pursue an agreement for the commercialization of the product outside of the U.S.,Canada and Japan. On July 17, 2006, we made the additional $22.2 million payment to Ipsen,representing the remaining portion of the $35.1 million total obligation, resulting from thediscontinuance of negotiations for other territories.     The initial $90.1 million payment was recognized as a charge to research and developmentexpense during the three months ended March 31, 2006, and the $35.1 million obligation wasrecognized as a charge to research and development expense during the three months ended June 30,2006.     We will pay an additional $26.5 million upon successful completion of various clinical andregulatory milestones, $75.0 million upon the product’s approval by the FDA and $2.0 million uponregulatory approval of the product in Japan. Ipsen will manufacture and provide the product to usfor the term of the agreement, which extends to September 2019. Ipsen will receive a royalty basedon sales and a supply price, the total of which is equivalent to approximately 30% of net sales asdefined under the agreement. Under the terms of the agreement, we are responsible for allremaining research and development costs associated with obtaining the product’s approval in theU.S., Canada and Japan. We expect to incur significant additional research and developmentexpenses related to the development of RELOXIN® each quarter throughout the developmentprocess. It is our current expectation that we will file a Biologic License Application (“BLA”)for RELOXIN® with the FDA during calendar 2007.*FDA approval of SOLODYN**®*     On May 8, 2006, the FDA approved our New Drug Application for our SOLODYN®(minocycline HCl, USP) Extended Release Tablets. SOLODYN® is the only oral minocyclineapproved for once daily dosage in the treatment of inflammatory lesions of non-nodular moderate tosevere acne vulgaris in patients 12 years of age andolder. SOLODYN® is also the only approved minocycline in extended release tablet form.The first sales of SOLODYN® to our wholesale customers occurred during June 2006.
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*Loss contingency for a pending governmental investigation relating to our marketing and promotionof LOPROX**® products*     The government notified us on December 14, 2004, that it is investigating claims that weviolated the federal False Claims Act in connection with the alleged off-label marketing andpromotion of LOPROX® and LOPROX® TS products to pediatricians during periodsprior to our May 2004 disposition of our pediatric sales division. In April 2006, we offered $6.0million to resolve the government’s civil claims contingent on the execution of appropriatereleases. The Justice Department countered with a demand of $12.8 million to resolve the civilclaims that the government is prepared to pursue. In May 2006, we countered with an offer of $8.0million that was contingent on resolving other aspects of the government’s investigation to oursatisfaction. In June 2006, the Justice Department countered with a $10.0 million offer forsettlement. On or about October 5, 2006 the parties agreed in principle to resolve all federal andstate civil claims against us for $9.8 million. As ofDecember 31, 2006, we have accrued a loss contingency of $10.2million for this matter in connection with the possibility ofadditional expenses related to the settlement amount. Of this amount, $6.0 million was recordedduring the three months ended March 31, 2006, $2.0 million was recorded during the three monthsended June 30, 2006 and $2.2 million was recorded during the three months ended September 30, 2006.     On or about October 12, 2006, we and the United States Attorney’s Office for the District ofKansas entered into a Nonprosecution Agreement wherein the government agreed not to prosecute usfor any alleged criminal violations relating to the alleged off-label marketing and promotion ofLOPROX®. In exchange for the government’s agreement not to pursue any criminal chargesagainst us, we have agreed to continue cooperating with the government in its ongoing investigationinto whether past and present employees and officers may have violated federal criminal lawregarding alleged off-label marketing and promotion of LOPROX® to pediatricians. Noindividuals have been designated as targets of the investigation. Any such claims, prosecutions orother proceedings, with respect to our past and present employees and officers, the cost of theirdefense and fines and penalties resulting therefrom could have a material impact on our reputation,business and financial condition.     We are also engaged in discussions with the Office of Inspector General of the Department ofHealth and Human Services (“IG”) to resolve any potential administrative claims the IG may havearising out of the government’s investigation into our marketing and promotion ofLOPROX®.*Write-down of Long-lived Assets Due to Impairment*     We assess the potential impairment of long-lived assets on a periodic basis and when events orchanges in circumstances indicate that the carrying value of the assets may not be recoverable.Factors that we consider in deciding when to perform an impairment review include significantunder-performance of a product line in relation to expectations, significant negative industry oreconomic trends, and significant changes or planned changes in our use of the assets.Recoverability of assets that will continue to be used in our operations is measured by comparingthe carrying amount of the asset grouping to our estimate of the related total future net cashflows. If an asset carrying value is not recoverable through the related cash flows, the asset isconsidered to be impaired. The impairment is measured by the difference between the assetgrouping’s carrying amount and its fair value, based on the best information available, includingmarket prices or discounted cash flow analysis.     During the quarter ended September 30, 2006, long-lived assets related to certain of ourproducts were determined to be impaired based on our analysis of the long-lived assets’ carryingvalue and projected future cash flows. As a result of the impairment analysis, we recorded awrite-down of approximately $52.6 million related to these long-lived assets. This write-downincluded the following (in thousands):     Long-lived asset related to LOPROX® products $49,163 Long-lived asset related to ESOTERICA® products  3,267 Other long-lived asset  156       $52,586          Factors affecting the future cash flows of the LOPROX® long-lived asset includedcompetitive pressures in the marketplace and the cancellation of the development plan to supportfuture forms of LOPROX®. Factors
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affecting the future cash flows of theESOTERICA® long-lived asset included a notice of proposed rulemaking by the FDA for anNDA to be required for continued marketing of hydroquinone products, such as ESOTERICA®.ESOTERICA® is currently an over-the-counter product line, and we do not plan to investin obtaining an approved NDA for this product line if this proposed rule is made final withoutchange.     In addition, as a result of the impairment analysis, the remaining amortizable lives of thelong-lived assets related to LOPROX® and ESOTERICA® were reduced to fifteenyears and fifteen months, respectively. The long-lived asset related to LOPROX® willbecome fully amortized on September 30, 2021, and the long-lived asset related toESOTERICA® will become fully amortized on December 31, 2007. The net impact onamortization expense as a result of the write-down of the carrying value of the long-lived assetsand the reduction of their respective amortizable lives is a decrease in quarterly amortizationexpense related to LOPROX® of $354,051 and an increase in quarterly amortization expenserelated to ESOTERICA® of $48,077.*FDA approval of ZIANA**TM*     On November 7, 2006, the FDA approved ZIANATM (clindamycin phosphate 1.2% andtretinoin 0.025%) Gel for once daily use for the topical treatment of acne vulgaris in patients 12years or older. We began selling ZIANATM to wholesale customers during the fourthquarter of 2006. In accordance with the terms of a development and license agreement, as amended,we paid Dow $1.0 million during the fourth quarter of 2006 as a result of the FDA’s approval ofthis product. The $1.0 million payment is classified as a long-lived asset in our consolidatedbalance sheet.
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Results of Operations     The following table sets forth certain data as a percentage of net revenues for the periodsindicated.                               **(Unaudited)**     **(Unaudited)**    **Year** **Year**     **Six Months**    **Ended** **Ended**     **Ended**    **Dec. 31,** **Dec. 31,** **Transition** **Dec. 31,** **Fiscal Year Ended**  **2006(a)** **2005(b)** **Period(c)** **2004(d)** **2005(e)** **2004(f)**Net revenues  100.0%  100.0%  100.0%  100.0%  100.0%  100.0%Gross profit (g)  88.0   85.5   85.3   84.9   85.3   84.7 Operating expenses  127.2   62.9   75.7   66.8   59.2   49.9                          Operating (loss) income  (39.2)  22.6   9.6   18.1   26.1   34.8 Other income, net  —   16.6   36.5   —   —   — Interest and investmentincome (expense), net  5.8   1.6   2.9   (0.1)  0.2   (0.2)Loss on earlyextinguishment of debt  —   —   —   —   —   (19.3)                         (Loss) income before incometax benefit (expense)  (33.4)  40.8   49.0   18.0   26.3   15.3 Income tax benefit (expense)  11.7   (14.8)  (18.7)  (6.3)  (9.1)  (5.1)                         Net (loss) income  (21.7)%  26.0%  30.3%  11.7%  17.2%  10.2%                          (a) Included in operating expenses is $125.2 million (35.8% of net revenues) related to ourdevelopment and distribution agreement with Ipsen for the development of RELOXIN®,$52.6 million (15.1% of net revenues) for the write-down of long-lived assets, $26.1 million(7.5% of net revenues) of share-based compensation expense,$10.2 million (2.9% of netrevenues) related to a loss contingency for a legal matter and $1.8 million (0.5% of netrevenues) related to a settlement of a dispute related to our merger with Ascent. (b) Included in operating expenses is $11.9 million (3.3% of net revenues) related to a researchand development collaboration with Dow, $8.3 million (2.3% of net revenues) related to aresearch and development collaboration with AAIPharma, $15.2 million (4.2% of net revenues) ofshare-based compensation expense, $9.2 million (2.5% of net revenues) for the write-down of along-lived asset and $6.0 million (1.7% of net revenues) of business integration planningcosts related to the proposed (and subsequently terminated) merger with Inamed incurred duringthe three months ended June 30, 2005 and three months ended September 30, 2005. Included inother income, net, is $59.8 million (16.6% of net revenue) related to a termination fee of$90.5 million received from Inamed upon the termination of the proposed merger with Inamed,net of a fee paid to an investment banker and the expensing of accumulated transaction costsof $27.0 million, and integration planning costs incurred during the three months endedDecember 31, 2005 of $3.7 million. (c) Included in operating expenses is $14.9 million (9.1%) of net revenues) of share-basedcompensation expense, a charge of approximately $9.2 million (5.6% of net revenues) for thewrite-down of a long-lived asset, and $0.7 million (0.4% of net revenues) related tointegration planning costs incurred during the three months ended September 30, 2005 relatedto the proposed merger with Inamed. Included in other income, net, is $59.8 million (36.5% ofnet revenue) related to a termination fee of $90.5 million received from Inamed upon thetermination of the proposed merger with Inamed, net of a fee paid to an investment banker andthe expensing of accumulated transaction costs of $27.0 million, and integration planningcosts incurred during the three months ended December 31, 2005 of $3.7 million. (d) Included in operating expenses is $5.5 million (3.1% of net revenues) related to ourexclusive development and license agreement withAnsata for proprietary technology and $30.7 million (17.0% of net revenues) related to ourexclusive license agreement with Q-Med forthe development of SubQTM. (e) Included in operating expenses is $5.3 million (1.4% of net revenues) of businessintegration planning costs related to the proposed mergerwith Inamed, $8.3 million (2.2% of net revenues) related to a research and developmentcollaboration with AAIPharma, $5.5 million(1.5% of net revenues) related to our exclusive development and license agreement with Ansatafor proprietary technology and $30.7million (8.2% of net revenues) related to our exclusive license agreement with Q-Med for thedevelopment of SubQTM. (f) Included in operating expenses is a $2.4 million payment (0.8% of net revenues) to Dow fora research and development collaboration. (g) Gross profit does not include amortization of the related intangibles as such expense isincluded in operating expenses.
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*Year Ended December 31, 2006 Compared to the Unaudited Year Ended December 31, 2005**Net Revenues*     The following table sets forth the net revenues for the year ended December 31, 2006 and2005, along with the percentage of net revenues and percentage point change for each of our productcategories (dollar amounts in millions):                   2006  2005  $ Change  % Change Net product revenues $333.6  $313.7  $19.9   6.4%Net contract revenues  15.6   46.0   (30.4)  (66.1)             Net revenues $349.2  $359.7  $(10.5)  (2.9)%                                    Percentage          Point  2006 2005 ChangeAcne and acne-relateddermatological products  45.3%  27.2%  18.1%Non-acne dermatologicalproducts  45.2   53.8   (  8.6)Non-dermatological products  9.5   19.0   (  9.5)             Total net revenues  100.0%  100.0%  —                   Our total net revenues decreased during 2006 primarily due to a decrease in net contractrevenues associated with licensing agreements. Net contract revenues decreased primarily due to adecrease in contract revenues during 2006 related to our outlicensing of the ORAPRED®brand pursuant to the terms of our license agreement with BioMarin. Net revenues associated withour acne and acne-related dermatological products increased as a percentage of net revenues, andincreased in net revenue dollars by 61.8% during 2006 as compared to 2005, primarily due to salesof SOLODYN®, which was approved by the FDA during the second quarter of 2006, and salesof ZIANATM, which was approved by the FDA during the fourth quarter of 2006, partiallyoffset by decreases in sales of DYNACIN®, PLEXION® and TRIAZ®products due to competitive pressures, including generic competition. Net revenues associated withour non-acne dermatological products decreased as a percentage of net revenues, and decreased innet revenue dollars by 18.4% during 2006, primarily due to decrease in sales of VANOSTMand LOPROX® products, which was offset by an increase in sales of RESTYLANE®.Net revenues associated with our non-dermatological products decreased as a percentage of netrevenues, and decreased in net revenue dollars by 51.6% during 2006, primarily due to the decreasein ORAPRED® contract revenues discussed above.*Gross Profit*     Gross profit represents our net revenues less our cost of product revenue. Our cost ofproduct revenue includes our acquisition cost for the products we purchase from our third partymanufacturers and royalty payments made to third parties. Amortization of intangible assetsrelated to products sold is not included in gross profit. Amortization expense related to theseintangibles for 2006 and 2005 was approximately $20.0 million and $21.6 million, respectively.Product mix plays a significant role in our quarterly and annual gross profit as a percentage ofnet revenues. Different products generate different gross profit margins, and the relative mix ofhigher gross profit products and lower gross profit products can affect our total gross profit.
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     The following table sets forth our gross profit for 2006 and 2005, along with the percentageof net revenues represented by such gross profit (dollar amounts in millions):                   2006 2005 $ Change % ChangeGross profit $307.5  $307.4  $0.1   0.0%% of net revenues  88.0%  85.5%             The increase in gross profit as a percentage of net revenues was primarily due to thedifferent mix of high gross margin products sold during 2006 as compared to 2005. The launch ofSOLODYN® during the second quarter of 2006, a higher margin product, was the primarychange in the mix of products sold during the comparable periods that affected gross profit as apercentage of net revenues.*Selling, General and Administrative Expenses*     The following table sets forth our selling, general and administrative expenses for 2006 and2005, along with the percentage of net revenues represented by selling, general and administrativeexpenses (dollar amounts in millions):                   2006 2005 $Change % ChangeSelling, general and administrative $206.8  $149.6  $57.2   38.2%% of net revenues  59.2%  41.6%        Inamed business integration planningcosts included in selling,general and administrative $—  $6.0  $(6.0)  (100.0)%Share-based compensation expenseincluded in selling, general andadministrative $24.5  $14.2  $10.3   72.1%     The increase in selling, general and administrative expenses during 2006 from 2005 wasattributable to approximately $10.3 million of additional share-based compensation expenserecognized in accordance with SFAS No. 123R (twelve months of expense was recognized during 2006 ascompared to six months of expense recognized during 2005 as SFAS No. 123R was adopted as of July 1,2005), $10.2 million related to a loss contingency for a legal matter related to our marketing ofLOPROX® to pediatricians (see Part II, Item 3, Legal Proceedings), approximately $11.2million of increased promotional expense, primarily related to the promotion ofRESTYLANE®, the launches of SOLODYN® and ZIANATM and pre-launchcosts for PERLANE®, $11.2 million of increased personnel costs due to increasedheadcount and the effect of the annual salary increase that occurred during August 2005 and thepartial-year salary increase that occurred during February 2006, $1.8 million related to asettlement of a dispute related to our merger with Ascent, and $18.5 million of other additionalselling, general and administrative expenses incurred during 2006, which was partially offset by$6.0 million of business integration planning costs related to the proposed (and subsequentlyterminated) merger with Inamed incurred during 2005.*Impairment of Long-lived Assets*     During the third quarter of 2006, long-lived assets related to certain of our products weredetermined to be impaired based on our analysis of the long-lived assets’ carrying value andprojected future cash flows. As a result of the impairment analysis, we recorded a write-down ofapproximately $52.6 million related to these long-lived assets. This write-down included thefollowing (in thousands):     Long-lived asset related to LOPROX® products $49,163 Long-lived asset related to ESOTERICA® products  3,267 Other long-lived asset  156       $52,586          Factors affecting the future cash flows of the LOPROX® long-lived asset includedcompetitive pressures in the marketplace and the cancellation of the development plan to supportfuture forms of LOPROX®. Factorsaffecting the future cash flows of the ESOTERICA® long-lived asset included anotice of proposed rulemaking by the FDA for an NDA to be required for continued marketing ofhydroquinone products, such as ESOTERICA®.
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ESOTERICA® is currently anover-the-counter product line, and we do not plan to invest in obtaining an approved NDA for thisproduct line if this proposed rule is made final without change.     During the fourth quarter of 2005, a long-lived asset related to our DYNACIN**®**capsule products was determined to be impaired based on our analysis of the long-lived asset’scarrying value and projected future cash flows. Factors affecting the long-lived asset’s futurecash flows included our promotional focus on our DYNACIN**®** tablet products, andcompetitive pressures in the marketplace. As a result of the impairment analysis, we recorded awrite-down of approximately $9.2 million related to this long-lived asset.*Research and Development Expenses*     The following table sets forth our research and development expenses for 2006 and 2005 (dollaramounts in millions):                   2006 2005 $ Change % ChangeResearch and development $161.8  $42.9  $118.9   277.2%Charges included in researchand development $125.2  $20.2  $105.0   518.8%Share-based compensationexpense included inresearch and development $1.6  $1.0  $0.6   62.7%     Included in research and development expenses for 2006 was $125.2 million related to thedevelopment and distribution agreement with Ipsen for the development of RELOXIN® andapproximately $1.6 million of share-based compensation expense. Included in research anddevelopment expense for 2005 was approximately $11.9 million related to research and development ofZIANATM, $8.3 million related to a research and development of SOLODYN® andapproximately $1.0 million of share-based compensation expense. In addition to these increases indevelopment milestone charges and share-based compensation expense, research and developmentexpenses increased due to costs related to the development of RELOXIN® incurred during2006. We expect research and development expenses to continue to fluctuate from quarter to quarterbased on the timing of the achievement of development milestones under license and developmentagreements, as well as the timing of other development projects and the funds available to supportthese projects. We expect to incur significant research and development expenses related to thedevelopment of RELOXIN® each quarter throughout the development process.*Depreciation and Amortization Expenses*     Depreciation and amortization expenses during 2006 decreased $1.5 million, or 6.1%, to $23.0million from $24.5 million during 2005. This decrease was primarily due to a decrease in theamount of intangible assets being amortized during 2006 as compared to 2005, due to the write-downof a long-lived asset due to impairment during the three months ended December 31, 2005. Thislong-lived asset had a cost basis of approximately $15.4 million and was being amortized at a rateof approximately $0.3 million per quarter.*Interest and Investment Income*     Interest and investment income during 2006 increased $14.3 million, or 87.1%, to $30.8 millionfrom $16.5 million during 2005, due to an increase in the funds available for investment and anincrease in the interest rates achieved by our invested funds during 2006.*Interest Expense*     Interest expense during 2006 remained consistent with 2005, at $10.6 million. Our interestexpense during 2006 and 2005 consisted of interest expense on our Old Notes, which accrue interestat 2.5% per annum,our New Notes, which accrue interest at 1.5% per annum, and amortization of fees and otherorigination costs related to the issuance of the Old Notes and New Notes. See Note 13 in ouraccompanying consolidated financial statements for further discussion on the Old Notes and NewNotes.
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*Income Tax Expense*     The following table sets forth our income tax expense and the resulting effective tax ratestated as a percentage of pre-tax income for 2006 and 2005 (dollar amounts in millions):                   2006 2005 $ Change % ChangeIncome tax (benefit) expense $(40.8) $53.3  $(94.1)  (176.6)%Effective tax rate  (35.0)%  36.3%             Income taxes are determined using an annual effective tax rate, which generally differs fromthe U.S. Federal statutory rate, primarily because of state and local income taxes, charitablecontribution deductions, tax credits available in the U.S., the treatment of certain share-basedpayments under SFAS 123R that are not designed to normally result in tax deductions, variousexpenses that are non-deductible for tax purposes, and differences in tax rates in certain non-U.S.jurisdictions. Our effective tax rate may be subject to fluctuations during the year as newinformation is obtained which may affect the assumptions we use to estimate our annual effectivetax rate, including factors such as our mix of pre-tax earnings in the various tax jurisdictions inwhich we operate, changes in valuation allowances against deferred tax assets, reserves for taxaudit issues and settlements, utilization of tax credits and changes in tax laws in jurisdictionswhere we conduct operations. We recognize deferred tax assets and liabilities for temporarydifferences between the financial reporting basis and the tax basis of our assets and liabilities,along with net operating losses and credit carryforwards. We record valuation allowances againstour deferred tax assets to reduce the net carrying values to amounts that management believes ismore likely than not to be realized.     Income taxes during 2006 was a benefit of $40.8 million, due to our pre-tax loss recognizedduring 2006, compared to income tax expense of $53.3 million during 2005. The effective tax ratefor 2006 of 35.0% includes a $5.1 million tax benefit recorded during the second quarter of 2006relating to resolutions of income tax examinations through years ended June 30, 2004. Theeffective tax rate for 2006 absent this $5.1 million benefit is (30.8)%.*Six Months Ended December 31, 2005 Compared To Unaudited Six Months Ended December 31, 2004**Net Revenues*     The following table sets forth the net revenues for the Transition Period and December 31,2004 (the “comparable 2004 six months”), along with the percentage of net revenues for each of ourproduct categories (amounts in millions):                       Comparable         Transition  2004         Period  Six Months  $ Change  %Change Net product revenues $155.6  $147.0  $8.6   5.8%Net contract revenues  8.4   34.2   (25.8)  (75.5)%             Net revenues $164.0  $181.2  $(17.2)  (9.5)%                                Comparable Percentage  Transition 2004 Point  Period Six Months ChangeAcne and acne-relateddermatological products  28.1%  32.8%  (4.7)%Non-acne dermatologicalproducts  58.9%  44.4%  14.5%Non-dermatological products  13.0%  22.8%  (9.8)%             Total net revenues  100.0%  100.0%  —                   Our total net revenues decreased during the Transition Period compared to the comparable 2004six months primarily as a result of a decrease in net contract revenues associated with licensingagreements and authorized generic agreements. Net contract revenues decreased primarily due to adecrease in contract revenues during the Transition
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Period related to our outlicensing of theORAPRED® brand pursuant to the terms of our license agreement with BioMarin. Netrevenues associated with our acne and acne-related dermatological products decreased as apercentage of net revenues and decreased in net dollars by 22.6% during the Transition Period ascompared to the comparable 2004 six months, primarily due to generic competition with ourDYNACIN® brand of products. Net revenues associated with our non-acne dermatologicalproducts increased as a percentage of net revenues, and increased in net dollars by 20.0% duringthe Transition Period, primarily due to the launch of VANOSTM in April 2005, and anincrease in sales of RESTYLANE®. Net revenues associated with our non-dermatologicalproducts decreased as a percentage of net revenues and decreased in net dollars by 48.1% during theTransition Period, primarily due to the decrease in ORAPRED® contract revenues discussedabove.*Gross Profit*     Gross profit represents our net revenues less our cost of product revenue. Our cost ofproduct revenue includes our acquisition cost for the products we purchase from our third partymanufacturers and royalty payments made to third parties. Amortization of intangible assetsrelated to products sold is not included in gross profit. Amortization expense related to theseintangibles for the Transition Period and the comparable 2004 six months was approximately $10.9million and $8.9 million, respectively. Product mix plays a significant role in our quarterly andannual gross profit as a percentage of net revenues. Different products generate different grossprofit margins, and the relative mix of higher gross profit products and lower gross profitproducts can affect our total gross profit.     The following table sets forth our gross profit for the Transition Period and comparable 2004six months, along with the percentage of net revenues represented by such gross profit (amounts inmillions):                       Comparable      Transition 2004      Period Six Months $ Change % ChangeGross profit $139.8  $153.9  $(14.1)  (9.1)%% of net revenues  85.3%  84.9%             The decrease in gross profit during the Transition Period as compared to the comparable 2004six months was due to the decrease in our net revenues, while the increase in gross profit as apercentage of net revenues was primarily due to the different mix of products sold during theTransition Period as compared to the comparable 2004 six months.*Selling, General and Administrative Expenses*     The following table sets forth our selling, general and administrative expenses for theTransition Period and comparable 2004 six months, along with the percentage of net revenuesrepresented by selling, general and administrative expenses (amounts in millions):                       Comparable      Transition 2004      Period Six Months $ Change % ChangeSelling, general and administrative $80.2  $65.7  $14.5   22.0%% of net revenues  48.9%  36.3%        Share-based compensation expenseincluded in selling, general andadministrative $13.9  $0.3  $13.6   5,416.1%     The increase in selling, general and administrative expenses during the Transition Period fromthe comparable 2004 six months was attributable to $13.6 million of additional share-basedcompensation expense recognized upon our adoption of SFAS No. 123R, $0.7 million of integrationcosts related to the proposed merger with Inamed incurred during the three months ended September30, 2005, and $1.5 million of additional selling, general and administrative expenses incurredduring the Transition Period, partially offset by approximately $1.3 million of professional feesrelated to a research and development agreements with Q-Med (for the development ofSubQTM) and Ansata incurred during the comparable 2004 six months.
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*Impairment of Long-lived Assets*     During the three months ended December 31, 2005, a long-lived asset related to ourDYNACIN**®** capsule products was determined to be impaired based on our analysis of thelong-lived asset’s carrying value and projected future cash flows. Factors affecting thelong-lived asset’s future cash flows included our promotional focus on our DYNACIN**®**tablet products, and competitive pressures in the marketplace. As a result of the impairmentanalysis, we recorded a write-down of approximately $9.2 million related to this long-lived asset.*Research and Development Expenses*     The following table sets forth our research and development expenses for the Transition Periodand comparable 2004 six months (amounts in millions):                       Comparable      Transition 2004      Period Six Months $ Change % ChangeResearch and development $22.4  $45.1  $(22.7)  (50.4)%Charges included in research and development  11.9   35.0   (23.1)  (65.9)%Share-based compensationexpense included inresearch and development  1.0   —   1.0   100.0%     Included in research and development expenses for the Transition Period was approximately$11.9 million of milestone payments related to the license and development agreement with Dow forZIANATM and approximately $1.0 million of share-based compensation expense stockrecognized upon our adoption of SFAS No. 123R. Included in research and development expenses forthe comparable 2004 six months was approximately $30.0 million related to the SubQTMlicense agreement and $5.0 million related to the Ansata development and license agreement.*Depreciation and Amortization Expenses*     Depreciation and amortization expenses during the Transition Period increased $2.2 million, or21.5%, to $12.4 million from $10.2 million during the comparable 2004 six months. This increasewas primarily due to increased amortization that began during the third quarter of fiscal 2005related to certain intangible assets whose useful lives were determined to be shorter thanoriginally estimated.*Other Income, net*     Other income, net, during the Transition Period represented a termination fee received fromInamed as a result of the termination of the proposed merger, net of the expensing of accumulatedtransaction costs related to the transaction and integration planning costs incurred during thethree months ended December 31, 2005. The net amount of these items is summarized as follows (inmillions):     Termination fee received from Inamed, includingexpense reimbursement fees $90.5 Less:    Transaction costs expensed, including legal andadvisory fees  27.0 Integration planning costs incurred during thethree months ended December 31, 2005  3.7       $59.8     
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*Interest and Investment Income*     Interest and investment income during the Transition Period increased $5.0 million, or 98.2%,to $10.1 million from $5.1 million during the comparable 2004 six months, primarily due to anincrease in funds available for investment and an increase in the interest rates achieved by ourinvested funds during the Transition Period. The increase in interest rates achieved was partiallydue to a shift from non-taxable to taxable investments, which yield higher rates.*Interest Expense*     Interest expense during the Transition Period remained consistent with the comparable 2004 sixmonths, at $5.3 million. Our interest expense during the Transition Period and the comparable 2004six months consisted of interest expense on our Old Notes, which accrue interest at 2.5% per annum,our New Notes, which accrue interest at 1.5% per annum, and amortization of fees and otherorigination costs related to the issuance of the Old Notes and New Notes. See Note 13 in ouraccompanying consolidated financial statements for further discussion on the Old Notes and NewNotes. *Income Tax Expense*     The following table sets forth our income tax expense and the resulting effective tax ratestated as a percentage of pre-tax income for the Transition Period and comparable 2004 six months(dollar amounts in millions):                       Comparable      Transition 2004      Period Six Months $ Change % ChangeIncome tax expense $30.5  $11.3  $19.2   169.3%Effective tax rate  38.0%  34.8%             Income taxes are determined using an annual effective tax rate, which generally differs fromthe U.S. Federal statutory rate, primarily because of state and local income taxes, charitablecontribution deductions, tax deductions available in the U.S., the treatment of certain share-basedpayments under SFAS 123R that are not designed to normally result in tax deductions, tax-exemptinterest in applicable periods, various expenses that are non-deductible for tax purposes, anddifference in tax rates in certain non-U.S. jurisdictions. Our effective tax rate may be subjectto fluctuations during the fiscal year as new information is obtained which may affect theassumptions we use to estimate our annual effective tax rate, including factors such as our mix ofpre-tax earnings in the various tax jurisdictions in which we operate, changes in valuationallowances against deferred tax assets, reserves for tax audit issues and settlements, utilizationof research and development tax credits and changes in tax laws in jurisdictions where we conductoperations. We recognize deferred tax assets and liabilities for temporary differences between thefinancial reporting basis and the tax basis of our assets and liabilities. We record valuationallowances against our deferred tax assets to reduce the net carrying values to amounts thatmanagement believes is more likely than not to be realized.     Income tax expense during the Transition Period increased 169.3%, or $19.2 million, to $30.5million, from $11.3 million in the comparable 2004 six months. The increase in income tax expensewas primarily due to the increase in our pre-tax income for the same period. The increase in ourTransition Period effective tax rate from the comparable 2004 six months effective tax rate wasprimarily due to: (i) an increase in the relative weighting of interest income in our mix oftaxable and tax-exempt investments and (ii) the adoption of SFAS No. 123R which precludes therecognition of tax benefits relating to the expensing of share-based awards that are not ordinarilydesigned to result in a tax deduction.
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*Fiscal Year Ended June 30, 2005 Compared To Fiscal Year Ended June 30, 2004**Net Revenues*     The following table sets forth the net revenues for the fiscal years ended June 30, 2005 andJune 30, 2004, along with the percentage of net revenues for each of our product categories (dollaramounts in millions):                   Fiscal 2005  Fiscal 2004  $ Change  % Change Net product revenues $305.1  $291.6  $13.5   4.6%Net contract revenues  71.8   12.1   59.7   492.5%             Net revenues $376.9  $303.7  $73.2   24.1%                                    Percentage          Point  Fiscal 2005 Fiscal 2004 ChangeAcne and acne-relateddermatological products  29.5%  30.5%  (1.0)%Non-acne dermatologicalproducts  47.1%  50.9%  (3.8)%Non-dermatological products  23.4%  18.6%  4.8%             Total net revenues  100.0%  100.0%  —                   Our total net revenues increased during fiscal 2005 primarily as a result of growth in salesof the PLEXION®, RESTYLANE® and VANOSTM products and an increasein contract revenue. Net revenues associated with our Acne and acne-related dermatologicalproducts decreased as a percentage of net revenues, but increased in net dollars by 20.0% primarilydue to an increase in PLEXION® net revenues due to the launch of PLEXION®Cleansing Cloths during the first quarter of fiscal 2005. Net revenues associated with ourNon-acne dermatological products decreased as a percentage of net revenues, but increased in netdollars by 14.8% during fiscal 2005, primarily due to the launch of RESTYLANE® in theUnited States in January 2004 and the launch of VANOSTM in April 2005, partially offsetby a decrease in LOPROX® net revenues due to increased competition from generic productslaunched during fiscal 2005. Net revenues associated with our Non-dermatological products increasedas a percentage of net revenues primarily due to the increase in contract revenues associated withthe outlicensing of the ORAPRED® and LUSTRA® brands, which was greater thanthe revenues generated by those products for the comparable period during fiscal 2004. Contractrevenue during fiscal 2005 included fees derived from authorized generics launched on our behalf.*Gross Profit*     Gross profit represents our net revenues less our cost of product revenue. Our cost ofproduct revenue includes our acquisition cost for the products we purchase from our third partymanufacturers and royalty payments made to third parties. Amortization of intangible assetsrelated to acquired products is not included in gross profit. Amortization expense related tothese intangibles for fiscal 2005 and fiscal 2004 was approximately $19.6 million and $14.9million, respectively. Product mix plays a significant role in our quarterly and annual grossprofit as a percentage of net revenues. Different products generate different gross profitmargins, and the relative mix of higher gross profit products and lower gross profit products canaffect our total gross profit.
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     The following table sets forth our gross profit for fiscal 2005 and fiscal 2004, along withthe percentage of net revenues represented by such gross profit (dollar amounts in millions):                   Fiscal 2005 Fiscal 2004 $ Change % ChangeGross profit $321.5  $257.1  $64.4   25.0%% of net revenues  85.3%  84.7%             The increase in gross profit during fiscal 2005 as compared to fiscal 2004 was due to theincrease in our net revenues, while the increase in gross profit as a percentage of net revenueswas primarily due to the different mix of products sold during fiscal 2005 as compared to duringfiscal 2004, and an increase in contract revenue during fiscal 2005 as compared to fiscal 2004.*Selling, General and Administrative Expenses*     The following table sets forth our selling, general and administrative expenses for fiscal2005 and fiscal 2004, along with the percentage of net revenues represented by selling, general andadministrative expenses (dollar amounts in millions):                   Fiscal 2005 Fiscal 2004 $ Change % ChangeSelling, general and administrative $135.2  $118.3  $16.9   14.3%% of net revenues  35.9%  38.9%             The increase in selling, general and administrative expenses from fiscal 2004 as compared tofiscal 2005 was primarily attributable to incremental costs associated with RESTYLANE®,$5.3 million of business integration planning costs related to the proposed merger with Inamed andapproximately $1.3 million of professional fees related to research and development collaborations.The decrease in selling, general and administrative expenses as a percentage of net revenues fromfiscal 2004 to fiscal 2005 was due to net revenues during fiscal 2005, which exceeded the increasein selling, general and administrative spending. A pre-market approval application forRESTYLANE®was approved by the FDA on December 12, 2003, followed by the product launchand first U.S. commercial sales of RESTYLANE® on January 6, 2004. During fiscal 2004,we incurred incremental costs associated with the establishment of a sales and marketing strategyfor RESTYLANE®, prior to the commercial launch of the product.*Research and Development Expenses*     The following table sets forth our research and development expenses for fiscal 2005 andfiscal 2004 (dollar amounts in millions):                   Fiscal 2005 Fiscal 2004 $ Change % ChangeResearch and development $65.7  $16.5  $49.2   298.2%Charges included in researchand development associatedwith research and developmenttransactions  43.3   2.4   40.9   1,686.2%     Included in research and development expenses for fiscal 2005 was approximately $8.3 millionrelated to the AAIPharma research and development collaboration, $30.0 million related to theSubQTM license agreement and $5.0 million related to the Ansata development and licenseagreement. Included in research and development expenses for fiscal 2004 was a $2.4 millionmilestone payment under a license and development agreement with Dow for ZIANATM.
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*Depreciation and Amortization Expenses*     Depreciation and amortization expenses during fiscal 2005 increased $5.5 million, or 33.1%, to$22.3 million from $16.8 million during fiscal 2004. This increase was primarily due to theamortization of expenses related to the $53.3 million and $19.4 million milestone payments made toQ-Med in December 2003 and May 2004, respectively, which are being amortized over the period fromthe date of payment through January 2018 and increased amortization related to certain intangibleassets whose useful lives were determined to be shorter than originally estimated.*Interest and Investment Income*     Interest and investment income during fiscal 2005 increased $1.5 million, or 14.1%, to $11.5million from $10.0 million during fiscal 2004, primarily due to an increase in the rates achievedby our invested funds during fiscal 2005.*Interest Expense*     Interest expense during fiscal 2005 decreased $0.2 million, or 1.6%, to $10.6 million from$10.8 million during fiscal 2004. This decrease was due to the August 2003 exchange of a portionof our Old Notes, which accrue interest at 2.5% per annum, for our New Notes, which accrue interestat 1.5% per annum.*Income Tax Expense*     The following table sets forth our income tax expense and the resulting effective tax ratestated as a percentage of pre-tax income for fiscal 2005 and fiscal 2004 (dollar amounts inmillions):                   Fiscal 2005 Fiscal 2004 $ Change % ChangeIncome tax expense $34.1  $15.3  $18.8   122.7%Effective tax rate  34.4%  33.2%             The increase in income tax expense from fiscal 2004 to fiscal 2005 was primarily due to theincrease in pretax earnings over the same period. Excluding the loss on early extinguishment ofdebt in fiscal 2004, our adjusted effective tax rate for fiscal 2004 was 35%. The effective rateis lower than the expected combined federal and state income tax rates due primarily to tax-exemptinterest income and contributions to charitable programs that receive favorable tax treatment. Ourfull year effective tax rate may increase in fiscal 2006 compared to our effective tax rate infiscal 2005 due to expected changes in the mix of earnings, the adoption of Financial AccountingStandards Board (“FASB”) Statement No. 123R, “Share-Based Payment” (“SFAS No. 123R”), and theexpiration of the U.S. research and development tax credit, the latter of which is currentlyexpected to sunset on December 31, 2005.
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Liquidity and Capital Resources*Overview*     The following table highlights selected cash flow components for the year ended December 31,2006 and the unaudited year ended December 31, 2005, and selected balance sheet components as ofDecember 31, 2006 and 2005 (dollar amounts in millions):                   2006 2005 $ Change % ChangeCash (used in) provided by:                Operating activities $(41.0) $232.5  $(273.5)  (117.6)%Investing activities  (216.9)  188.0   (404.9)  (215.4)%Financing activities  14.3   (5.1)  19.4   (377.9)%                   Dec. 31, 2006 Dec. 31, 2005 $ Change % ChangeCash, cash equivalents andshort-term investments $554.3  $742.5  $(188.2)  (25.4)%Working capital  550.0   692.5   (142.5)  (20.6)%Long-term investments  130.3   —   130.3   100.0%2.5% contingent convertible seniornotes due 2032  169.2   169.2   —   — 1.5% contingent convertible seniornotes due 2033  283.9   283.9   —   —      The following table highlights selected cash flow components for the Transition Period and theunaudited comparable 2004 six months, and selected balance sheet components as of December 31, 2005and June 30, 2005 (dollar amounts in millions):                       Comparable      Transition 2004      Period Six Months $ Change % ChangeCash provided by (used in):                Operating activities $148.0  $45.5  $102.5   225.5%Investing activities  123.7   76.2   47.5   62.4%Financing activities  (2.8)  (137.4)  134.6   (98.0)%                       Dec. 31, 2005 June 30, 2005 $ Change % Change    Cash, cash equivalents andshort-term investments $742.5  $603.6  $138.9   23.0%    Working capital  692.5   600.1   92.4   15.4%    2.5% contingent convertible seniornotes due 2032  169.2   169.2   —   —     1.5% contingent convertible seniornotes due 2033  283.9   283.9   —   —     
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     The following table highlights selected cash flow components for fiscal 2005 and fiscal 2004,and selected balance sheet components as of June 30, 2005 and 2004 (dollar amounts in millions):                   Fiscal 2005 Fiscal 2004 $ Change % ChangeCash provided by (used in):                Operating activities $130.0  $128.0  $2.0   1.6%Investing activities  140.5   (166.3)  306.8   184.5%Financing activities  (139.8)  40.6   (180.4)  (444.1)%                   June 30, 2005 June 30, 2004 $ Change % ChangeCash, cash equivalents andshort-term investments $603.6  $634.0  $(30.4)  (4.8)%Working capital  600.1   666.7   (66.6)  (10.0)%2.5% contingent convertible seniornotes due 2032  169.2   169.2   —   — 1.5% contingent convertible seniornotes due 2033  283.9   283.9   —   — *Working Capital*     Working capital as of December 31, 2006 and 2005 consisted of the following (dollar amounts inmillions):                   Dec. 31, 2006  Dec. 31, 2005  $ Change  % Change Cash, cash equivalents andshort-term investments $554.3  $742.5  $(188.2)  (25.4)%Accounts receivable, net  36.4   46.7   (10.3)  (22.1)%Inventories, net  27.0   19.1   7.9   41.6%Deferred tax assets, net  23.0   12.7   10.3   80.9%Other current assets  16.0   12.3   3.7   30.6%             Total current assets  656.7   833.3   (176.6)  (21.1)% Accounts payable  47.5   57.7   (10.2)  (17.7)%Short-term contract obligation  —   27.4   (27.4)  (100.0)%Income taxes payable  11.3   31.5   (20.2)  (64.0)%Other current liabilities  47.9   24.2   23.7   (97.6)%              Total current liabilities  106.7   140.8   (34.1)  (24.3)%              Working capital $550.0  $692.5  $(142.5)  (20.6)%                  We had cash, cash equivalents and short-term investments of $554.3 million and working capitalof $550.0 million at December 31, 2006, as compared to $742.5 million and $692.5 million,respectively, at December 31, 2005. The decreases were primarily due to payments totaling $125.2million made to Ipsen related to a development and distribution agreement related toRELOXIN®, payment of the $27.4 million contingent payment related to the merger withAscent, and payments totaling $35.7 million for income taxes during 2006. In addition, $130.3million of our available-for-sale investments have been treated as long-term assets as of December31, 2006, based on their expected maturities.
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     Working capital as of December 31, 2005 and June 30, 2005 consisted of the following (dollaramounts in millions):                   Dec. 31, 2005  June 30, 2005  $ Change  % Change Cash, cash equivalents andshort-term investments $742.5  $603.6  $138.9   23.0%Accounts receivable, net  46.7   47.2   (0.5)  (1.1)%Inventories, net  19.1   20.7   (1.6)  (7.9)%Deferred tax assets, net  12.7   11.0   1.7   15.8%Other current assets  12.3   16.4   (4.1)  (25.5)%             Total current assets  833.3   698.9   134.4   19.2% Accounts payable  57.7   30.8   26.9   87.2%Short-term contract obligation  27.4   27.4   —   —%Income taxes payable  31.5   10.2   21.3   207.9%Other current liabilities  24.2   30.4   (6.2)  (20.4)%             Total current liabilities  140.8   98.8   42.0   42.5%              Working capital $692.5  $600.1  $92.4   15.4%                  We had cash, cash equivalents and short-term investments of $742.5 million and working capitalof $692.5 million at December 31, 2005, as compared to $603.6 million and $600.1 million,respectively, at June 30, 2005. The increases were primarily due to the $90.5 million terminationfee received from Inamed due to the termination of the proposed merger (before expenses), and otheroperating cash flows generated during the Transition Period.     Working capital as of June 30, 2005 and 2004 consisted of the following (dollar amounts inmillions):                   June 30, 2005  June 30, 2004  $ Change  % Change Cash, cash equivalents andshort-term investments $603.6  $634.0  $(30.4)  (4.8)%Accounts receivable, net  47.2   47.9   (0.7)  (1.3)%Inventories, net  20.7   19.5   1.2   5.9%Deferred tax assets, net  11.0   14.1   (3.1)  (22.0)%Other current assets  16.4   18.3   (1.9)  (10.3)%             Total current assets  698.9   733.8   (34.9)  (4.8)% Accounts payable  30.8   13.9   16.9   121.6%Short-term contract obligation  27.4   17.9   9.5   53.2%Income taxes payable  10.2   0.7   9.5   1,337.3%Other current liabilities  30.4   34.6   (4.2)  (12.2)%             Total current liabilities  98.8   67.1   31.7   47.3%              Working capital $600.1  $666.7  $(66.6)  (10.0)%                  We had cash, cash equivalents and short-term investments of $603.6 million and working capitalof $600.1 million at June 30, 2005, as compared to $634.0 million and $666.7 million, respectively,at June 30, 2004. The decreases were primarily due to $150.0 million of repurchases of our Class Acommon stock, $30.7 million paid in respect of the SubQTM license agreement during thefirst quarter of fiscal 2005 (including $0.7 million of related professional fees), $5.5 millionpaid in respect of the Ansata development and license agreement during the second quarter of fiscal2005 (including $0.5 million of related professional fees) and $8.3 million paid in respect of theresearch and development collaboration with AAIPharma during the third quarter of fiscal 2005,partially offset by operating cash flow generated during fiscal 2005 and proceeds from the exerciseof stock options received during fiscal 2005.     Management believes existing cash and short-term investments, together with funds generatedfrom operations, should be sufficient to meet operating requirements for the foreseeable future.Our cash and short-term
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investments are available for strategic investments, mergers andacquisitions, and other potential large-scale needs. In addition, we may consider incurringadditional indebtedness and issuing additional debt or equity securities in the future to fundpotential acquisitions or investments, to refinance existing debt or for general corporatepurposes. If a material acquisition or investment is completed, our operating results andfinancial condition could change materially in future periods. However, no assurance can be giventhat additional funds will be available on satisfactory terms, or at all, to fund such activities.     During July 2006, we executed a lease agreement for new headquarter office space toaccommodate our expected long-term growth. The first phase is for approximately 150,000 squarefeet with the right to expand. Occupancy of the new headquarter office space, which is locatedapproximately one mile from our current headquarter office space in Scottsdale, Arizona, isexpected to occur in 2008.     During October 2006, we executed a lease agreement for additional headquarter office space toaccommodate our current needs and future growth. Approximately 21,000 square feet of office spaceis being leased for a period of three years. Occupancy of the additional headquarter office space,which is located approximately one mile from our current headquarter office space in Scottsdale,Arizona, is expected to occur in 2007.     During 2007 and 2008, we will be designing and implementing a new ERP system to integrate andimprove the financial and operational aspects of our business. We are committed to having theinformation technology system in place that will allow us to better operate and manage all aspectsof our operations. We have dedicated approximately 50 of our employees to various aspects of theproject, along with third party consultants. We expect this project will require an aggregateinvestment of approximately $10 — $12 million during 2007 and 2008.*Operating Activities*     Net cash used in operating activities during the year ended December 31, 2006 wasapproximately $41.0 million, compared to cash provided by operating activities of approximately$232.5 million during the unaudited year ended December 31, 2005. The following is a summary ofthe primary components of cash (used in) provided by operating activities during the year endedDecember 31, 2006 and 2005 (in millions):               (Unaudited)   2006  2005 Payments made to Ipsen related to development of RELOXIN® $(125.2) $— Termination fee received from Inamed related to terminationof proposed merger  —   90.5 Payment made to AAIPharma related to a research anddevelopment collaboration  —   (8.3)Payments made to Dow related to a research anddevelopment collaboration  (3.9)  (8.0)Payment of professional fees related to termination of proposedmerger with Inamed  (16.7)  — Income taxes paid  (35.7)  (22.4)Other cash provided by operating activities  140.5   180.7        Cash (used in) provided by operating activities $(41.0) $232.5             Net cash provided by operating activities during the Transition Period increased 225.5%, or$102.5 million, to $148.0 million from $45.5 million during the comparable 2004 six months. Ouroperating cash flow for the Transition Period was generated principally by our net earnings,(including the $90.5 million terminationfee received from Inamed related to the termination of the proposed merger, before expenses),adjusted for non-cash charges including depreciation and amortization.     Net cash provided by operating activities during fiscal 2005 increased 1.6%, or $2.0 million,to $130.0 million from $128.0 million during fiscal 2004. Our operating cash flow for fiscal 2005was generated principally by our net earnings, adjusted for non-cash charges including depreciationand amortization.
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*Investing Activities*     Net cash used in investing activities during the year ended December 31, 2006 wasapproximately $216.9 million, compared to net cash provided by investing activities during theunaudited year ended December 31, 2005 of $188.0 million. The change was primarily due to the netpurchases or sales of our short-term and long-term investments during the respective periods. Inaddition, approximately $27.4 million was paid during the first quarter of 2006 for ContingentPayments related to our 2001 merger with Ascent.     Net cash provided by investing activities during the Transition Period was $123.7 million, ascompared to $76.2 million during the comparable 2004 six months. Net cash provided by investingactivities during the Transition Period included net dispositions and maturities ofavailable-for-sale investments of approximately $130.7 million, as compared to approximately $81.2million during the comparable 2004 six months.     Net cash provided by investing activities during fiscal 2005 was $140.5 million, as comparedto net cash used in investing activities during fiscal 2004 of $166.3 million. Net cash providedby investing activities during fiscal 2005 included net sales of available-for-sale investments ofapproximately $154.1 million, as compared to net purchases of available-for-sale investments ofapproximately $143.1 million during fiscal 2004. Net cash used in investing activities duringfiscal 2004 included $84.1 million in payments for the purchase of product rights, including $72.7million in milestone payments to Q-Med, as compared to $3.3 million in payments for the purchase ofproduct rights during fiscal 2005.     On December 12, 2003, the FDA approved RESTYLANE® for use in the United States, anda payment of $53.3 million was made to Q-Med upon the occurrence of this milestone. In May 2004,we paid $19.4 million to Q-Med as a result of certain cumulative commercial milestones beingachieved. We will pay Q-Med approximately $29.1 million upon FDA approval of PERLANE®.*Financing Activities*     Net cash provided by financing activities during the year ended December 31, 2006 was $14.3million, compared to net cash used in financing activities of $5.1 million during the unauditedyear ended December 31, 2005. Proceeds from the exercise of stock options were $18.7 millionduring 2006 compared to $1.3 million during 2005. Dividends paid during 2006 was $6.6 millioncompared to $6.5 million during 2005.     Net cash used in financing activities during the Transition Period was $2.8 million comparedto $137.4 million during the comparable 2004 six months. The change is primarily attributable tothe purchase of $150.0 million of our common stock during the comparable 2004 six months while nocash was used to purchase our common stock during the Transition Period, as well as $15.7 millionof proceeds from the exercise of stock options received during the comparable 2004 six months, ascompared to $0.4 million received during the Transition Period.     Net cash used in financing activities during fiscal 2005 was $139.8 million compared to netcash provided by financing activities of $40.6 million during fiscal 2004. The change is primarilyattributable to the purchase of $150.0 million of our common stock during fiscal 2005 while no cashwas used to purchase our common stock during fiscal 2004, as well as $16.6 million of proceeds fromthe exercise of stock options received during fiscal 2005, as compared to $51.4 million receivedduring fiscal 2004.*Contingent Convertible Senior Notes and Other Long-Term Commitments*     On August 14, 2003, we exchanged $230.8 million in principal amount of our Old Notes for$283.9 million in principal amount of our New Notes. Holders of Old Notes that accepted theCompany’s exchange offer received $1,230 in principal amount of New Notes for each $1,000 inprincipal amount of Old Notes. The terms of the New Notes are similar to the terms of the OldNotes, but have a different interest rate, conversion rate andmaturity date. Holders of Old Notes that did not exchange will continue to be subject to the termsof the Old Notes. See Note 13 of Notes to Consolidated Financial Statements for furtherdiscussion.
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     The New Notes and the Old Notes are unsecured and do not contain any restrictions on theincurrence of additional indebtedness or the repurchase of our securities, and do not contain anyfinancial covenants. The Old Notes do not contain any restrictions on the payment of dividends.The New Notes require an adjustment to the conversion price if the cumulative aggregate of allcurrent and prior dividend increases above $0.025 per share would result in at least a one percent(1%) increase in the conversion price. This threshold has not been reached and no adjustment tothe conversion price has been made.     Except for the Old Notes, the New Notes and deferred tax liabilities, we have no long-termliabilities and had only $106.7 million of current liabilities at December 31, 2006. Our othercommitments and planned expenditures consist principally of payments we will make in connectionwith strategic collaborations and research and development expenditures, and we will continue toinvest in sales and marketing infrastructure. In addition, we will be implementing a new ERPsystem during 2007 and 2008, which will require financial expenditures to complete.     We have made available to BioMarin the ability to draw down on a Convertible Note up to $25.0million beginning July 1, 2005 (the “Convertible Note”). The Convertible Note is convertible basedon certain terms and conditions including a change of control provision. Money advanced under theConvertible Note is convertible into BioMarin shares at a strike price equal to the BioMarinaverage closing price for the 20 trading days prior to such advance. The Convertible Note matureson the option purchase date in 2009 as defined in the Securities Purchase Agreement entered into onMay 18, 2004 (the “Securities Purchase Agreement”) but may be repaid by BioMarin at any time priorto the option purchase date. As of February 28, 2007, BioMarin has not requested any monies to beadvanced under the Convertible Note, and no amounts are outstanding.*Repurchases of Common Stock*     In May 2003, our Board of Directors approved a new repurchase program that authorized therepurchase of up to $75.0 million of our common stock. This program provided for the repurchase ofClass A common stock at such times as management determined. As of June 30, 2004, we had notrepurchased any shares of our Class A common stock under this program. In August 2004, our Boardof Directors approved a new program that replaced the May 2003 program, which authorized therepurchase of up to $150.0 million of our Class A common stock. During the first two quarters offiscal 2005, we purchased a total of 3,921,086 shares of our Class A common stock in the openmarket at an average price of $38.25 per share, for an aggregate purchase price of approximately$150.0 million. As the purchase limit had been reached, the plan was terminated during the secondquarter of fiscal 2005.*Dividends*     We do not have a dividend policy. Since July 2003, we have paid quarterly cash dividendsaggregating approximately $21.8 million on our common stock. In addition, on December 14, 2006, wedeclared a cash dividend of $0.03 per issued and outstanding share of common stock payable onJanuary 31, 2007 to our stockholders of record at the close of business on January 2, 2007. Priorto these dividends, we had not paid a cash dividend on our common stock. Any future determinationsto pay cash dividends will be at the discretion of our Board of Directors and will be dependentupon our financial condition, operating results, capital requirements and other factors that ourBoard of Directors deems relevant.*Off-Balance Sheet Arrangements*     As of December 31, 2006, we are not involved in any off-balance sheet arrangements, as definedin Item 3(a)(4)(ii) of SEC Regulation S-K.
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*Contractual Obligations*     The following table summarizes our significant contractual obligations at December 31, 2006,and the effect such obligations are expected to have on our liquidity and cash flows in futureperiods. This table excludes amounts already recorded on our balance sheet as current liabilitiesat December 31, 2006 or certain other purchase obligations as discussed below (in thousands):                       **Payments Due By Period**           **More Than**  **More Than**              **1 Year and**  **3 Years and**          **Less Than**  **Less Than**  **Less Than**  **More Than**   **Total**  **1 Year**  **3 Years**  **5 Years**  **5 Years** Long-term debt $453,065  $—  $—  $—  $453,065 Interest on long-term debt  220,691   8,488   16,975   16,975   178,253 Operating leases  55,860   2,371   6,866   10,507   36,116 Other purchase obligationsand commitments  867   173   347   347   —                                      Total contractual obligations $730,483  $11,032  $24,188  $27,829  $667,434                      The long-term debt consists of the Company’s Old Notes and New Notes. The table abovereflects the maturity date of debt. However, the Company may redeem some or all of the Old Notesand New Notes at any time on or after June 11, 2007 and June 11, 2008, respectively, at aredemption price, payable in cash, of 100% of the principal amount, plus accrued and unpaidinterest, including contingent interest, if any. Holders of the Old Notes and New Notes mayrequire the Company to repurchase all or a portion of their Old Notes on June 4, 2007, 2012 and2017 and New Notes on June 4, 2008, 2013 and 2018, or upon a change in control, as defined in theindenture agreements governing the Old Notes and New Notes, at 100% of the principal amount of theOld Notes and New Notes, plus accrued and unpaid interest to the date of the repurchase, payable incash.     Interest on long-term debt includes interest payable on our Old Notes and New Notes, assumingthe Old Notes and New Notes will not have any redemptions or conversions into shares of our Class Acommon stock until their respective maturities in 2032 and 2033, but does not include anycontingent interest. The amount of interest ultimately paid in future years could change if any ofthe Old Notes or New Notes are converted or redeemed and/or if contingent interest becomes payableif certain future criteria are met.     Other purchase obligations and commitments include payments due under research and developmentand consulting contracts.     We have committed to make potential future “milestone” payments to third-parties as part ofcertain product development and license agreements. Payments under these agreements generallybecome due and payable only upon achievement of certain developmental, regulatory and/or commercialmilestones. Because the achievement and timing of these milestones are not fixed or reasonablydeterminable, such contingencies have not been recorded on our consolidated balance sheets and arenot included in the above table. The total amount of potential future milestone payments relatedto development and license agreements is approximately $213.7 million.     Purchase orders for raw materials, finished goods and other goods and services are notincluded in the above table. We are not able to determine the aggregate amount of such purchaseorders that represent contractual obligations, as purchase orders may represent authorizations topurchase rather than binding agreements. For the purpose of this table, contractual obligationsfor purchase of goods or services are defined as agreements that are enforceable and legallybinding on us and that specify all significant terms, including: fixed or minimum quantities to bepurchased; fixed, minimum or variable price provisions; and the approximate timing of thetransaction. Ourpurchase orders are based on our current manufacturing needs and are fulfilled by our vendorswith relatively short timetables. We do not have significant agreements for the purchase of rawmaterials or finished goods specifying
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minimum quantities or set prices that exceed our short-termexpected requirements. We also enter into contracts for outsourced services; however, theobligations under these contracts were not significant and the contracts generally contain clausesallowing for cancellation without significant penalty.     The expected timing of payment of the obligations discussed above is estimated based oncurrent information. Timing of payments and actual amounts paid may be different depending on thetime of receipt of goods or services or changes to agreed-upon amounts for some obligations.**Critical Accounting Policies and Estimates**     The discussion and analysis of our financial condition and results of operations are basedupon our consolidated financial statements, which have been prepared in conformity with U.S.generally accepted accounting principles. The preparation of the consolidated financial statementsrequires us to make estimates and assumptions that affect the amounts reported in the consolidatedfinancial statements and accompanying notes. On an ongoing basis, we evaluate our estimatesrelated to sales allowances, chargebacks, rebates, returns and other pricing adjustments,depreciation and amortization and other contingencies and litigation. We base our estimates onhistorical experience and various other factors related to each circumstance. Actual results coulddiffer from those estimates based upon future events, which could include, among other risks,changes in the regulations governing the manner in which we sell our products, changes in thehealth care environment and managed care consumption patterns. Our significant accounting policiesare described in Note 2 to the consolidated financial statements included in this report. Webelieve the following critical accounting policies affect our most significant estimates andassumptions used in the preparation of our consolidated financial statements and are important inunderstanding our financial condition and results of operations.*Revenue Recognition*     Revenue from our product sales is recognized pursuant to Staff Accounting Bulletin No. 104(SAB 104), “Revenue Recognition in Financial Statements.” Accordingly, revenue is recognized whenall four of the following criteria are met: (i) persuasive evidence that an arrangement exists;(ii) delivery of the products has occurred; (iii) the selling price is both fixed and determinable;and (iv) collectibility is reasonably assured. Our customers consist primarily of largepharmaceutical wholesalers who sell directly into the retail channel.     We do not provide any material forms of price protection to our wholesale customers and permitproduct returns if the product is damaged, or, depending on the customer, if it is returned withinsix months prior to expiration or up to 12 months after expiration. Our customers consistprincipally of financially viable wholesalers, and depending on the customer, revenue is recognizedbased upon shipment (“FOB shipping point”) or receipt (“FOB destination”), net of estimatedprovisions. As a general practice, we do not ship product that has less than 15 months until itsexpiration date. We also authorize returns for damaged products and credits for expired productsin accordance with our returned goods policy and procedures. The shelf life associated with ourproducts is up to 36 months depending on the product. The majority of our products havea shelf life of approximately 18-24 months.     We enter into licensing arrangements with other parties whereby we receive contract revenuebased on the terms of the agreement. The timing of revenue recognition is dependent on the levelof our continuing involvement in the manufacture and delivery of licensed products. If we havecontinuing involvement, the revenue is deferred and recognized on a straight-line basis over theperiod of continuing involvement. In addition, if our licensing arrangements require no continuinginvolvement and payments are merely based on the passage of time, we assess such payments forrevenue recognition under the collectibility criteria of SAB 104.*Items Deducted From Gross Revenue*     Provisions for estimates for product returns and exchanges, sales discounts, chargebacks,managed care and Medicaid rebates and other adjustments are established as a reduction of productsales revenues at the time such revenues are recognized. These deductions from gross revenue areestablished by us as our best estimate at the time of sale based on historical experience adjustedto reflect known changes in the factors that impact such reserves.
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These deductions from grossrevenue are generally reflected either as a direct reduction to accounts receivable through anallowance, or as an addition to accrued expenses if the payment is due to a party other than thewholesale or retail customer.     Our accounting policies for revenue recognition have a significant impact on our reportedresults and rely on certain estimates that require complex and subjective judgment on the part ofour management. If the levels of product returns and exchanges, cash discounts, chargebacks,managed care and Medicaid rebates and other adjustments fluctuate significantly and/or if ourestimates do not adequately reserve for these reductions of gross product revenues, our reportednet product revenues could be negatively affected.*Product Returns*     We account for returns of product by establishing an allowance based on our estimate ofrevenues recorded for which the related products are expected to be returned in the future. Weestimate the rate of future product returns based on our historical experience, the relative riskof return based on expiration date, and other qualitative factors that could impact the level offuture product returns, such as competitive developments, product discontinuations and ourintroduction of new products. Historical experience and the other qualitative factors are assessedon a product-specific basis as part of our compilation of our estimate of future product returns.We also monitor inventories held by our distributors, as well as prescription trends to help usassess the rate of return. Changes due to our competitors’ price movements have not adverselyaffected us. We do not provide incentives to our distributors to assume additional inventorylevels beyond what is customary in their ordinary course of business.     Returnsfor new products are more difficult to estimate than returns forestablished products. We determine our estimates of the sales return accrual for new productsprimarily based on our historical product returns experience of similar products, products thathave similar characteristics at various stages of their life cycle, and other available informationpertinent to the intended use and marketing of the new product.     Our actual experience and the qualitative factors that we use to determine the necessaryaccrual for future product returns are susceptible to change based on unforeseen events anduncertainties. We assess the trends that could affect our estimates and make changes to theaccrual quarterly.*Sales Discounts*     We offer cash discounts to our customers as an incentive for prompt payment, generallyapproximately 2% of the sales price. We account for cash discounts by establishing an allowancereducing accounts receivable by the full amount of the discounts expected to be taken by thecustomers. We consider payment performance and adjust the allowance to reflect actual experienceand our current expectations about future activity.*Contract Chargebacks*     We have agreements for contract pricing with several entities, whereby pricing on products isextended below wholesaler list price. These parties purchase products through wholesalers at thelower contract price, and the wholesalers charge the difference between their acquisition cost andthe lower contract price back to us. We account for chargebacks by establishing an allowancereducing accounts receivable based on our estimate of chargeback claims attributable to a sale. Wedetermine our estimate of chargebacks based on historical experience and changes to currentcontract prices. We also consider our claim processing lag time, and adjust the allowanceperiodically throughout each quarter to reflect actual experience. Although we record an allowancefor estimatedchargebacks at the time we record the sale (typically when we ship the product), the actualchargeback related to that sale is not processed until the entities purchase the product from thewholesaler. We estimate the rate of chargebacks based on our historical experience and changes tocurrent contract prices.
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*Managed Care and Medicaid Rebates*     Rebates are contractual discounts offered to government programs and private health plans thatare eligible for such discounts at the time prescriptions are dispensed, subject to variousconditions. We record provisions for rebates by estimating these liabilities as products are sold,based on factors such as timing and terms of plans under contract, time to process rebates, productpricing, sales volumes, amount of inventory in the distribution channel, and prescription trends.*Other*     In addition to the significant items deducted from gross revenue described above, we deductother items from gross revenue. For example, we offer consumer rebates on many of our products anda consumer loyalty program for our RESTYLANE® dermal filler product. We generallyaccount for these other items deducted from gross revenue by establishing an accrual based on ourestimate of the adjustments attributable to a sale. We generally base our estimates for theaccrual of these items deducted from gross sales on historical experience and other relevantfactors. We adjust our accruals periodically throughout each quarter based on actual experienceand changes in other factors, if any.*Use of Information from External Sources*     We use information from external sources to estimate our significant items deducted from grossrevenues. Our estimates of inventory in the distribution channel are based on historical shipmentand return information from our accounting records and data on prescriptions filled, which wepurchase from IMS Health, Inc., one of the leading providers of prescription-based information. Wealso utilize projected prescription demand for our products, as well as, written and oralinformation obtained from certain wholesalers with respect to their inventory levels and ourinternal information. We use the information from IMS Health, Inc. to project the prescriptiondemand for our products. Our estimates are subject to inherent limitations pertaining to relianceon third-party information, as certain third-party information is itself in the form of estimates.*Use of Estimates in Reserves*     We believe that our allowances and accruals for items that are deducted from gross revenuesare reasonable and appropriate based on current facts and circumstances. It is possible, however,that other parties applying reasonable judgment to the same facts and circumstances could developdifferent allowance and accrual amounts for items that are deducted from gross revenues.Additionally, changes in actual experience or changes in other qualitative factors could cause ourallowances and accruals to fluctuate, particularly with newly launched products. We review therates and amounts in our allowance and accrual estimates on a quarterly basis. If future estimatedrates and amounts are significantly greater than those reflected in our recorded reserves, theresulting adjustments to those reserves would decrease our reported net revenues; conversely, ifactual returns, rebates and chargebacks are significantly less than those reflected in our recordedreserves, the resulting adjustments to those reserves would increase our reported net revenues. Ifwe changed our assumptions and estimates, our related reserves would change, which would impact thenet revenues we report. For example, if the 2006 prescription dataused to estimate inventory in the distribution channel changed by1.0 percent and our historical returns reserve percent were tochange by 1.0 percentage point our sales returns reserve could beimpactedby approximately $1.1 million and corresponding revenue could beimpacted by the same amount.     During the three months ended December 31, 2006, we experienced a decline in demand forcertain of our products, primarily VANOS**TM**. As a result, we increased the sales returnsreserves by approximately $8.9 million during the three monthsended December 31, 2006, specifically related toVANOS**TM**. We will continue to monitor demand for this product and will adjust our salesreserves accordingly in the future. The effect of this change on the net loss for 2006 was toincrease the net loss by approximately $5.8 million or $0.11 per common share.
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*Share-Based Compensation*     As part of our adoption of SFAS No. 123R as of July 1, 2005, we were required to recognize thefair value of share-based compensation awards as an expense. Determining the appropriatefair-value model and calculating the fair value of share-based awards at the date of grant requiresjudgment. We use the Black-Scholes option pricing model to estimate the fair value of employeestock options. Option pricing models, including the Black-Scholes model, also require the use ofinput assumptions, including expected volatility, expected life, expected dividend rate, andexpected risk-free rate of return. We use a blend of historical and implied volatility based onoptions freely traded in the open market as we believe this is more reflective of market conditionsand a better indicator of expected volatility than using purely historical volatility. Increasingthe weighted average volatility by 2.5 percent (from 0.36 percent to 0.385 percent) would haveincreased the fair value of stock options granted in 2006 to $15.08 per share. Conversely,decreasing the weighted average volatility by 2.5 percent (from 0.36 percent to 0.335 percent)would have decreased the fair value of stock options granted in 2006 to $13.85 per share. Theexpected life of the awards is based on historical and other economic data trended into the future.Stock option awards granted during 2006 have a stated term of 7 years, and the weighted averageexpected life of the awards was determined to be 7 years. Decreasing the weighted average expectedlife by 0.5 years (from 7.0 years to 6.5 years) would have decreased the fair value of stockoptions granted in 2006 to $13.96 per share. The risk-free interest rate assumption is based onobserved interest rates appropriate for the terms of our awards. The dividend yield assumption isbased on our history and expectation of future dividend payouts.     The fair value of our restricted stock grants is based on the fair market value of our commonstock on the date of grant discounted for expected future dividends.     SFAS No. 123R requires us to develop an estimate of the number of share-based awards whichwill be forfeited due to employee turnover. Quarterly changes in the estimated forfeiture rate mayhave a significant effect on share-based compensation, as the effect of adjusting the rate for allexpense amortization after July 1, 2005 is recognized in the period the forfeiture estimate ischanged. If the actual forfeiture rate is higher than the estimated forfeiture rate, then anadjustment is made to increase the estimated forfeiture rate, which will result in a decrease tothe expense recognized in the financial statements. If the actual forfeiture rate is lower thanthe estimated forfeiture rate, then an adjustment is made to decrease the estimated forfeiturerate, which will result in an increase to the expense recognized in the financial statements. Theeffect of forfeiture adjustments in the first quarter of fiscal 2007 was immaterial.     We evaluate the assumptions used to value our awards on a quarterly basis. If factors changeand we employ different assumptions, stock-based compensation expense may differ significantly fromwhat was recorded in the past. If there are any modifications or cancellations of the underlyingunvested securities, we may be required to accelerate, increase or cancel any remaining unearnedstock-based compensation expense. Future stock-based compensation expense and unearned stock-basedcompensation will increase to the extent that we grant additional equity awards to employees or weassume unvested equity awards in connection with acquisitions.     Our estimates of these important assumptions are based on historical data and judgmentregarding market trends and factors. If actual results are not consistent with our assumptions andjudgments used in estimating these factors, we may be required to record additional stock-basedcompensation expense or income tax expense, which could be material to our results of operations.*Inventory*     Inventory costs associated with products that have not yet received regulatory approval arecapitalized if we believe there is probable future commercial use and future economic benefit. Iffuture commercial use and future economic benefit are not considered probable, then costsassociated with pre-launch inventory that has not yet received regulatory approval are expensed asresearch and development expense during the period the costs are incurred. We could be required toexpense previously capitalized costs related to pre-approval inventory if the probability of futurecommercial use and future economic benefit changes due to denial or delay of regulatoryapproval, a delay in commercialization, or other factors. Conversely, our gross margins could befavorably impacted
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if previously expensed pre-approval inventory becomes available and is used forcommercial sale. As of December 31, 2006, there no costs capitalized into inventory for productsthat have not yet received regulatory approval.*Long-lived Assets*     We assess the impairment of long-lived assets when events or changes in circumstances indicatethat the carrying value of the assets may not be recoverable. Factors that we consider in decidingwhen to perform an impairment review include significant under-performance of a product line inrelation to expectations, significant negative industry or economic trends, and significant changesor planned changes in our use of the assets. Recoverability of assets that will continue to be usedin our operations is measured by comparing the carrying amount of the asset grouping to ourestimate of the related total future net cash flows. If an asset carrying value is not recoverablethrough the related cash flows, the asset is considered to be impaired. The impairment is measuredby the difference between the asset grouping’s carrying amount and its fair value, based on thebest information available, including market prices or discounted cash flow analysis.     When we determine that the useful lives of assets are shorter than we had originallyestimated, and there are sufficient cash flows to support the carrying value of the assets, weaccelerate the rate of amortization charges in order to fully amortize the assets over their newshorter useful lives.     During 2006 and the Transition Period, an impairment charge of $52.6 million and $9.2 million,respectively, was recognized related to our review of long-lived assets. During 2006, theremaining useful lives of two of the long-lived assets that were deemed to be impaired werereduced, while no acceleration of amortization was recorded during the Transition Period. Thisprocess requires the use of estimates and assumptions, which are subject to a high degree ofjudgment. If these assumptions change in the future, we may be required to record additionalimpairment charges for, and/or accelerate amortization of, long-lived assets.*Income Taxes*     Income taxes are determined using an annual effective tax rate, which generally differs fromthe U.S. Federal statutory rate because of state and local income taxes, tax-exempt interest,charitable contribution deductions, nondeductible expenses and research and development tax creditsavailable in the U.S. Our effective tax rate may be subject to fluctuations during the year asnew information is obtained which may affect the assumptions we use to estimate our annualeffective tax rate, including factors such as our mix of pre-tax earnings in the various taxjurisdictions in which we operate, valuation allowances against deferred tax assets, reserves fortax audit issues and settlements, utilization of research and development tax credits and changesin tax laws in jurisdictions where we conduct operations. We recognize deferred tax assets andliabilities for temporary differences between the financial reporting basis and the tax basis ofour assets and liabilities. We record valuation allowances against our deferred tax assets toreduce the net carrying value to an amount that management believes is more likely than not to berealized.     Based on the Company’s historical pre-tax earnings, management believes it is more likely thannot that the Company will realize the benefit of the existing net deferred tax assets at December31, 2006. Management believes the existing net deductible temporary differences will reverseduring periods in which the Company generates net taxable income; however, there can be noassurance that the Company will generate any earnings or any specific level of continuing earningsin future years. Certain tax planning or other strategies could be implemented, if necessary, tosupplement income from operations to fully realize recorded tax benefits.*Research and Development Costs and Accounting for Strategic Collaborations*     All research and development costs, including payments related to products under developmentand research consulting agreements, are expensed as incurred. We may continue to makenon-refundable payments tothird parties for new technologies and for research and development work that has been completed.These payments may be expensed at the time of payment depending on the nature of the payment made.
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     Our policy on accounting for costs of strategic collaborations determines the timing of ourrecognition of certain development costs. In addition, this policy determines whether the cost isclassified as development expense or capitalized as an asset. We are required to form judgmentswith respect to the commercial status of such products in determining whether development costsmeet the criteria for immediate expense or capitalization. For example, when we acquire certainproducts for which there is already an ANDA or NDA approval related directly to the product, andthere is net realizable value based on projected sales for these products, we capitalize the amountpaid as an intangible asset. In addition, if we acquire product rights which are in thedevelopment phase and as to which we have no assurance that the third party will successfullycomplete its development milestones or that the product will gain regulatory approval, we expensesuch payments.*Legal Contingencies*     We record contingent liabilities resulting from asserted and unasserted claims againstus, when it is probable that a liability has been incurred and the amount of the loss is reasonablyestimable. We disclose material contingent liabilities, when there is a reasonable possibility,that the ultimate loss will exceed the recorded liability. Estimating probable losses requiresanalysis of multiple factors, in some cases including judgments about the potential actions ofthird-party claimants and courts. Therefore, actual losses in any future period are inherentlyuncertain. We currently are involved in certain legal proceedings and we have accrued a losscontingency of $10.2 million as of December 31, 2006, related to one matter. This loss contingencyis included in other current liabilities as of December 31, 2006 in the accompanying consolidatedbalance sheets, and is included in selling, general and administrative expenses for the year endedDecember 31, 2006 in the accompanying consolidated statements ofincome. In addition to the matters disclosed in "Item 3. LegalProceedings," we are party to ordinary and routine litigationincidental to ourbusiness. We do not expect the outcome of any pending litigation,other than those specified in "Item 3. Legal Proceedings," tohave a material adverse effect on our consolidated financial positionor results of operations. It is possible, however, that future results of operationsfor any particular quarterly or annual period could be materially affected by changes in ourassumptions or the effectiveness of our strategies related to these proceedings.*Recent Accounting Pronouncements*     In June 2006, the FASB issued Interpretation No. 48 (“FIN 48”) *Accounting for Uncertainty inIncome Taxes*, which clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with FASB Statement No. 109, *Accounting for IncomeTaxes*. FIN 48 prescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to be taken in a taxreturn. FIN 48 also provides guidance on derecognition, classification, interest and penalties,accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006. We are currently evaluating FIN 48 but do not expect it to havea material impact on our consolidated results of operations and financial condition.     In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements*, which clarifies thedefinition of fair value, establishes a framework for measuring fair value, and expands thedisclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginningafter November 15, 2007. We are currently evaluating SFAS No. 157 and its impact, if any, on ourconsolidated results of operations and financial condition.     In February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Statementsand Financial Liabilities*, which provides companies with an option to report selected financialassets and liabilities at fair value. SFAS No. 159 requires companies to provide additionalinformation that will help investors and other users of financial statements to more easilyunderstand the effect of the company’s choice to use fair value on its earnings. It also requiresentities to display the fair value of those assets and liabilities for which the company has chosento use fair value on the face of the balance sheet. The new Statement does not eliminatedisclosure requirements included in other accounting standards, including requirements fordisclosures about fair value measurements included in FASB Statements No. 157, *Fair ValueMeasurements,*and No. 107, *Disclosures aboutFair Value of Financial Instruments.*We are currently evaluating SFAS No. 159 and its impact,if any, on our consolidated results of operations and financial condition.
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Item 7A. Quantitative and Qualitative Disclosure About Market Risk     At December 31, 2006, $198.1 million of our cash equivalent investments are in money marketsecurities that are reflected as cash equivalents, because all maturities are within 90 days.Included in money market securities are commercial paper, Federal agency discount notes and moneymarket funds. Our interest rate risk with respect to these investments is limited due to theshort-term duration of these arrangements and the yields earned, which approximate current interestrates.     Our investment portfolio, consisting of fixed income securities that we hold on anavailable-for-sale basis, was approximately $481.2 million as of December 31, 2006, $295.5 millionas of December 31, 2005, $425.8 million as of June 30, 2005, and $587.4 million as of June 30,2004. These securities, like all fixed income instruments, are subject to interest rate risk andwill decline in value if market interest rates increase. We have the ability to hold our fixedincome investments until maturity and, therefore, we would not expect to recognize any materialadverse impact in income or cash flows if market interest rates increase. The following tableprovides information about our available-for-sale securities that are sensitive to changes ininterest rates. We have aggregated our available-for-sale securities for presentation purposessince they are all very similar in nature (dollar amounts in thousands):**Interest Rate Sensitivity**