VIROPHARMA INC – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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Background

ViroPharma Incorporated is a global biotechnology company dedicated to the development and commercialization of products that address serious diseases, with a focus on products used by physician specialists or in hospital settings. We intend to grow through sales of our marketed products, through continued development of our product pipeline, expansion of sales into additional territories outside the United States, through potential acquisition or licensing of products and product candidates and the acquisition of companies. We expect future growth to be driven by sales of Vancocin, sales of Cinryze, both domestically and internationally, sales of Buccolam and Plenadren in Europe, and by our primary development programs, including C1 esterase inhibitor and a non-toxigenic strain of C. difficile (VP20621).  We market and sell Cinryze in the United States for routine prophylaxis against angioedema attacks in adolescent and adult patients with hereditary angioedema (HAE). Cinryze is a C1 esterase inhibitor therapy for routine prophylaxis against HAE, also known as C1 inhibitor (C1-INH) deficiency, a rare, severely debilitating, life-threatening genetic disorder. Cinryze was acquired in October 2008 and in January 2010, we acquired expanded rights to commercialize Cinryze and future C1-INH derived products in certain European countries and other territories throughout the world as well as rights to develop future C1-INH derived products for additional indications. In June 2011, the European Commission granted us Centralized Marketing Authorization for Cinryze® in adults and adolescents with HAE for routine prevention, pre-procedure prevention and acute treatment of angioedema attacks. The approval also includes a self administration option for appropriately trained patients. We have begun to commercialize Cinryze in Europe and continue to evaluate our commercialization plans in countries where we have distribution rights.  We also market and sell Vancocin HCl capsules, the oral capsule formulation of vancomycin hydrochloride, in the U.S. and its territories. Vancocin is indicated for the treatment of C. difficile-associated diarrhea (CDAD). Vancocin capsules are also used for the treatment of enterocolitis caused by Staphylococcus aureus, including methicillin-resistant strains.  On December 14, 2011, we announced the modernization of labeling for Vancocin capsules made effective through the FDA's approval of a supplemental new drug application (sNDA).  On November 15, 2011, we acquired a 100% ownership interest in DuoCort Pharma AB (DuoCort), a private company based in Helsingborg, Sweden focused on improving glucocorticoid replacement therapy for treatment of adrenal insufficiency, or Addison's disease (AD). We paid approximately 213 million Swedish Krona (SEK) or approximately $32.1 million in upfront consideration. We have also agreed to make additional payments ranging from SEK 240 million up to SEK 860 million or approximately $35 million to $124 million, contingent on the achievement of certain milestones. Up to SEK 160 million or approximately $23 million of the contingent payments relate to specific regulatory milestones; and up to SEK 700 million or approximately $101 million of the contingent payments are related to commercial milestones based on the success of the product.  

As part of the closing of this transaction, we also paid approximately SEK 9.3 million or $1.4 million to certain of DuoCort's creditors. We incurred approximately $1.4 million of transaction cost as part of this acquisition.

  The acquisition of Duocort further expands our orphan disease commercial product portfolio. On November 3, 2011, the European Commission (EC) granted European Marketing Authorization for Plenadren ® (hydrocortisone, modified release tablet), an orphan drug for treatment of adrenal insufficiency in adults, which will bring these patients their first pharmaceutical innovation in over 50 years. We anticipate commercial launch of Plenadren in the EU in late 2012 or early 2013. A named patient program is currently available to patients in Europe, which we expect to continue until commercial launch.                                           64

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  In May 2010, we acquired Auralis Limited, a UK based specialty pharmaceutical company. The acquisition of Auralis provides us with the opportunity to accelerate our European commercial systems for potential future product launches and additional business development acquisitions. In connection with the Auralis acquisition, we acquired Buccolam® (Oromucosal Solution, Midazolam [as hydrochloride]). In September of 2011, the European Commission granted a Centralized Pediatric Use Marketing Authorization (PUMA) for Buccolam, for treatment of prolonged, acute, convulsive seizures in infants, toddlers, children and adolescents, from 3 months to less than 18 years of age. We have begun to commercialize Buccolam in Europe.  

Our product development portfolio is primarily focused on three programs, C1 esterase inhibitor [human], VP20621 and VP-20629.

  We are working on developing further therapeutic uses, potential additional indications in other C1 mediated diseases, and alternative modes of administration for C1 esterase inhibitor. We are currently undertaking studies on the viability of subcutaneous administration of Cinryze. We intend to conduct ViroPharma sponsored studies and investigator-initiated studies (IIS) to identify further therapeutic uses and potentially expand the labeled indication for Cinryze to include other C1 mediated diseases. We are also conductiong our own studies of Ciryze in Antibody-Mediated Rejection (AMR) and Delayed Graft Function (DGF). Additionally, in May 2011, Halozyme Therapeutics (Halozyme) granted us an exclusive worldwide license to use Halozyme's proprietary Enhanze™ technology, a proprietary drug delivery platform using Halozyme's recombinant human hyaluronidase enzyme (rHuPH20) technology in combination with a C1 esterase inhibitor. We intend to apply rHuPH20 initially to develop an alternative subcutaneous formulation of Cinryze for routine prophylaxis against attacks of HAE. In September 2011, we initiated a Phase 2 study to evaluate the safety, and pharmacokinetics and pharmacodynamics of subcutaneous administration of Cinryze in combination with rHuPH20.  We are also developing VP20621 for the treatment and prevention of CDAD. In May 2011, we initiated a Phase 2 dose-ranging clinical study to evaluate the safety, tolerability, and efficacy of VP 20621 for prevention of recurrence of CDAD in adults previously treated for CDAD.  On September 30, 2011, we entered into a license agreement for the worldwide rights of Intellect Neurosciences, Inc. (INS) to its clinical stage drug candidate, VP-20629, which we expect to develop for the treatment of Friedreich's Ataxia (FA), a rare, hereditary, progressive neurodegenerative disease. VP-20629, or indole-3-propionic acid, is a naturally occurring, small molecule that has potent anti-oxidant properties that can protect against neurodegenerative disease. In a recent Phase 1 safety and tolerability study conducted in the Netherlands, VP-20629 was demonstrated to be safe and well tolerated at all dose levels tested. We expect to initiate a phase 2 study within 12 to 18 months of the date of this agreement, after completion of longer-term toxicology studies. We intend to file for Orphan Drug Designation upon review of the phase 2 proof of concept data.  Under the terms of the agreement, we have exclusive worldwide rights to develop and commercialize VP-20629 for the treatment, management or prevention of any disease or condition covered by Intellect's patents. We paid INS a $6.5 million up-front licensing fee and may pay additional milestones up to $120 million based upon defined events. We will also pay a tiered royalty of up to a maximum percentage of low teens, based on annual net sales.  In addition to these programs, we have several other assets that we may make additional investments in. These investments will be limited and dependent on our assessment of the potential future commercial success of or benefits from the asset. These assets include maribavir for CMV, recombinant C1-INH and other compounds.  On December 22, 2011, we entered into an exclusive development and option agreement with Meritage Pharma, Inc. (Meritage) , a private company based in San Diego, CA focused on developing oral budesonide suspension (OBS) as a treatment for eosinophilic esophagitis (EoE). EoE is a newly recognized chronic disease that is increasingly being diagnosed in children and adults. It is characterized by inflammation and accumulation of a                                           65

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specific type of immune cell, called an eosinophil, in the esophagus. EoE patients may have persistent or relapsing symptoms, which include dysphagia (difficulty in swallowing), nausea, stomach pain, chest pain, heartburn, loss of weight and food impaction.

  We have an exclusive option to acquire Meritage, at our sole discretion, by providing written notice at any time during the period from December 22, 2011 to and including the date that is the earlier of (a) the date that is 30 business days after the later of (i) the receipt of the final study data for the Phase 2 study and (ii) identification of an acceptable clinical end point definition for a pivotal induction study agreed to by the FDA. As consideration for the option, we paid an initial $7.5 million and have the option to provide Meritage up to an additional $12.5 million for the development of OBS. Meritage will utilize the funding to conduct additional Phase 2 clinical assessment of OBS. If we exercise this option, we have agreed to pay $69.9 million for all of the outstanding capital stock of Meritage. Meritage stockholders could also receive additional payments of up to $175 million, upon the achievement of certain clinical and regulatory milestones.  We intend to continue to evaluate in-licensing or other opportunities to acquire products in development, or those that are currently on the market. We plan to seek products that treat serious or life threatening illnesses with a high unmet medical need, require limited commercial infrastructure to market, and which we believe will provide both revenue and earnings growth over time.  

Executive Summary

Since December 31, 2010, we experienced the following:

  Business Activities  Cinryze:         •   Shipped approximately 64,000 doses of Cinryze to specialty          pharmacy/specialty distributors (SP/SD's);    

• The European Commission granted us Centralized Marketing Authorization for

Cinryze in adults and adolescents with HAE for routine prevention,

pre-procedure prevention and acute treatment of angioedema attacks and we

began commercial sales of Cinryze in Europe in the fourth quarter of 2011;

• Announced a collaboration with Halozyme for combination of Halozyme's

         recombinant human hyaluronidase enzyme (rHuPH20) technology with a C1          esterase inhibitor and initiated a Phase 2 study to evaluate the safety,

and pharmacokinetics and pharmacodynamics of subcutaneous administration

of Cinryze in combination with rHuPH20 from which we receieved positive

         top line data from the trial; and,    

• Initiated a Phase 2 clinical study to evaluate the safety and efficacy of

C1 Esterase Inhibitor [Human] for the treatment of acute antibody-mediated

rejection (AMR) in recipients of donor-specific cross-match positive

         kidney transplants and withdrew Cinryze from the register of orphan          medicinal products of the EMA;  

C. difficile infection (CDAD):

         •   Announced the modernization of labeling for Vancocin capsules made          effective through the FDA's approval of a supplemental new drug          application (sNDA);    

• Initiated a Phase 2 dose-ranging clinical study to evaluate the safety,

tolerability, and efficacy of VP 20621 for prevention of recurrence of

         CDAD in adults previously treated for CDAD; and,       •   Vancocin scripts decreased 5.6% in 2011 as compared to 2010;   Buccolam:    

• Received a PUMA (Pediatric Use Marketing Authorization) for Buccolam from

         the European Commission and we began commercial sales of Buccolam in          Europe in the fourth quarter of 2011;                                            66 

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   Table of Contents  Business Development:      •   Entered into the INS license agreement;       •   Acquired DuoCort; and,       •   Entered into the development and option agreement with Meritage;   Financial Results         •   Net sales of Cinryze increased to $251.2 million for the year ended          December 31, 2011 from $176.8 million for the year ended December 31,          2010;          •   Net sales of Vancocin increased to $288.9 million for the year ended          December 31, 2011 from $259.6 million for the year ended December 31,          2010; and,    

• Reported net income of $140.7 million for the year ended December 31, 2011;

   Liquidity      •   Generated net cash from operations of $170.7 million;          •   Ended 2011 with working capital of $537.3 million which includes cash and

cash equivalents of $331.4 million and investments of $128.5 million;

       •   Entered into $200 million revolving credit facility; and,          •   Repurchased approximately 9.2 million shares of our common stock at a cost

of approximately $169.7 million

During 2012 and going forward, we expect to face a number of challenges, which include the following:

  The commercial sale of approved pharmaceutical products is subject to risks and uncertainties. There can be no assurance that future Vancocin sales will meet or exceed the historical rate of sales for the product, for reasons that include, but are not limited to, generic and non-generic competition for Vancocin and/or changes in prescribing habits or disease incidence.  The FDA convened a meeting of its Advisory Committee for Pharmaceutical Science and Clinical Pharmacology to discuss bioequivalence recommendations for oral vancomycin hydrochloride capsule drug products on August 4, 2009. The Advisory Committee was asked if the proposed guidelines are sufficient for establishing bioequivalence for generic vancomycin oral capsules. The Advisory Committee voted unanimously in favor of the component of the proposed OGD recommendation that requires bioequivalence to be demonstrated through comparable dissolution in media of pH 1.2, 4.5 and 6.8 for potential vancomycin HCl capsule generic products that (a) contain the same active and inactive ingredients in the same amounts as Vancocin HCl capsules; (b) meet currently accepted standards for assay, potency, purity, and stability (equivalent to those in place for Vancocin HCl capsules); and (c) are manufactured according to cGMP. We have opposed both the substance of the FDA's bioequivalence method and the manner in which it was developed. There can be no assurance that the FDA will agree with the positions stated in our Vancocin related submissions or that our efforts to oppose the OGD's March 2006 and December 2008 recommendation to determine bioequivalence to Vancocin through in-vitro dissolution testing will be successful.  On December 14, 2011, we announced the modernization of labeling for Vancocin Capsules made effective through the FDA's approval of a supplemental new drug application (sNDA).  Through the sNDA approval, Vancocin's label for the first time includes clinical safety and efficacy data for the use of Vancocin capsules in treating Clostridium difficile. Vancocin's labeling now reflects safety and efficacy data from 260 patients with C. difficile-associated diarrhea (CDAD) treated with Vancocin in two pivotal studies                                           67

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  of Genzyme Corporation's investigational drug, tolevamer. We purchased exclusive rights to the two studies from Genzyme for which we will pay Genzyme royalties of 10 percent, 10 percent and 16 percent on net sales of Vancocin for the three year period following the approval of the sNDA.  As a result of the sNDA approval, we believe Vancocin meets the requirements for three years of exclusivity, and that generic vancomycin capsules will not be approved during this period. Under FDA's regulations, labeling changes based on new clinical investigations that are essential to approval of the sNDA and to which the applicant has exclusive rights may be entitled to three years of exclusivity, and generic drug labeling cannot include information protected by such three-year exclusivity. A generic may seek approval by omitting labeling protected by three-year exclusivity; however, if such omissions render the generic drug less safe or effective, it cannot be approved until the three-year exclusivity expires.  We believe that attempting to omit Vancocin labeling changes protected by exclusivity would render generic versions of Vancocin less safe and effective. However, ultimately, the decision on a grant of three-year exclusivity and its effect on generic vancomycin capsule approvals resides with the FDA.  We cannot predict the timeframe in which the FDA will make a decision regarding either our citizen petition for Vancocin or the approval of generic versions of Vancocin. If FDA's proposed bioequivalence method for Vancocin becomes effective, and either FDA does not agree that our labeling changes made effective through our sNDA warrant exclusivity, or FDA acknowledges such exclusivity but nonetheless determines that generic products would be no less safe or effective in the absence of such labeling changes, then the time period in which a generic competitor could be approved would be reduced and multiple generics may enter the market. The approval of generic copies of Vancocin would materially impact our operating results, cash flows and possibly intangible asset valuations. This could also result in a reduction to the useful life of the Vancocin-related intangible assets. Management currently believes there are no indicators that would require a change in useful life as management believes that Vancocin will continue to be utilized along with generics that may enter the market, and the number of generics and the timing of their market entry is unknown.  Approval of new products, or expanded use of currently available products, to treat CDAD, and particularly severe disease caused by C. difficile infection, could materially and adversely affect our sales of Vancocin. The number of units sold of Vancocin for the treatment of C. difficile-associated diarrhea has increased over the past 12 months but Vancocin's share of the U.S. market for this indication may decrease due to competitive forces and market dynamics. In May 2011, FDA approved Optimer Pharmaceuticals' product, Dificid® (fidaxomicin), for the treatment of CDAD. Metronidazole, a generic product, is regularly prescribed to treat CDAD at costs which are substantially lower than for Vancocin. Products which are currently marketed for other indications by other companies may also be prescribed to treat this indication. Additionally, several other companies, including, Merck & Co., Sanofi-Aventis and Cubist Pharmaceuticals have clinical development programs with therapeutic agents for the treatment of C. difficile infection that could be found to have competitive advantages over Vancocin.  The FDA approved Cinryze for routine prophylaxis against angioedema attacks in adolescent and adult patients with hereditary angioedema on October 10, 2008. Cinryze became commercially available for routine prophylaxis against HAE in December 2008. The commercial success of Cinryze depends on several factors, including: the number of patients with HAE that may be treated with Cinryze; manufacturing or supply interruptions and capacity which could impair our ability to acquire an adequate supply of Cinryze to meet demand for the product; and our ability to achieve expansion of manufacturing capabilities in the capacities and timeframes currently anticipated; acceptance by physicians and patients of Cinryze as a safe and effective treatment; our ability to effectively market and distribute Cinryze in the United States; cost effectiveness of HAE treatment using Cinryze; relative convenience and ease of administration of Cinryze; potential advantages of Cinryze over alternative treatments; the timing of the approval of competitive products including another C1 esterase inhibitor for the acute treatment of HAE; the market acceptance of competing approved products such as Berinert; patients' ability to obtain sufficient coverage or reimbursement by third-party payors; variations in                                           68

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  dosing arising from physician preferences and patient compliance; sufficient supply and reasonable pricing of raw materials necessary to manufacture Cinryze. In addition, our ability to develop life cycle management plans for Cinryze, including designing and commencing clinical studies for additional indications and pursuing regulatory approvals in additional indications or territories will impact our ability to generate future revenues from Cinryze. In Europe, the European Commission has granted us Centralized Marketing Authorization for Cinryze in adults and adolescents with HAE for routine prevention, pre-procedure prevention and acute treatment of angioedema attacks. The approval also includes a self administration option for appropriately trained patients. In addition, the European Commission has granted us a PUMA for Buccolam. We have begun the commercials sales of these products in Europe during the fourth quarter of 2011. The commercial success of each of these products in Europe will depend on a number of factors, including the impact of the loss of orphan designation on Cinryze, market acceptance of each of the products and our ability to manufacture sufficient quantities of product to meet patient needs.  In March 2010, President Obama signed into law the Patient Protection and Affordable Care Act (PPACA), which was amended by the Health Care and Education Reconciliation Act of 2010. PPACA, as amended, is a sweeping measure intended to expand healthcare coverage within the United States, primarily through the imposition of health insurance mandates on employers and individuals and expansion of the Medicaid program. Several provisions of the new law, which have varying effective dates, will affect us. These include new requirements on private insurance companies that prohibit coverage denials because of a pre-existing condition; prohibit the application of annual and lifetime benefits limits on health insurance policies; and prohibit coverage rescissions (except for fraud) and health-based insurance rating. In addition, PPACA, as amended, funds an interim high risk pool that states can draw on; following the expiration of this high risk pool funding, it provides for the creation of state-run "exchanges" that will allow people without employer-provided coverage, or who cannot afford their employer's plan, to buy health insurance; and provides federal subsidies to those who cannot afford premiums. Collectively, these factors may increase the availability of reimbursement for patients seeking the products that ViroPharma commercializes. However, the Act, as amended, will likely increase certain of our costs as well. For example, an increase in the Medicaid rebate rate from 15.1% to 23.1% was effective as of January 1, 2010, and the volume of rebated drugs has been expanded to include beneficiaries in Medicaid managed care organizations, effective as of March 23, 2010. In 2011, PPACA also imposes a manufacturer's fee on the sale of branded Pharmaceuticals (excluding orphan drugs) to specified government programs, expands the 340B drug discount program (excluding orphan drugs), and includes a 50% discount on brand name drugs for Medicare Part D participants in the coverage gap, or "doughnut hole". We have determined that the manufacturing fee is immaterial relative to our anticipated 2011 operating income and cash flow. We have also estimated that our incremental cost associated with the Medicare Part D coverage gap will be approximately $5.4 million during 2011. Our evaluation of PPACA, as amended, will continue to enable us to determine not only the immediate effects on our business, but also the trends and changes that may be encouraged by the legislation that may potentially impact on our business over time.  We will face intense competition in acquiring additional products to further expand our product portfolio. Many of the companies and institutions that we will compete with in acquiring additional products to further expand our product portfolio have substantially greater capital resources, research and development staffs and facilities than we have, and greater resources to conduct business development activities. We may need additional financing in order to acquire new products in connection with our plans as described in this report. Upon completion of business development transactions, we will face risks related to the integration of the acquired asset or business which could result in delays in development timelines, increased expenses or assumption of undisclosed liabilities, and disruption from the transaction making it more difficult to maintain relationships with manufacturers, employees or other suppliers.  The outcome of our clinical development programs is subject to considerable uncertainties. We are currently undertaking studies on the viability of subcutaneous administration of Cinryze, either alone or in combination with Halozyme's recombinant human hyaluronidase enzyme (rHuPH20) technology, and to identify further therapeutic uses and potentially expand the labeled indication for Cinryze to include other C1 mediated diseases,                                           69

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  such as AMR and DGF. In addition, we are also developing VP20621 for the treatment and prevention of CDAD and in May 2011 we initiated a Phase 2 dose-ranging clinical study. We anticipate that we will commence pre-clinical and clinical studies with VP-20629 for the treatment of Friedreich's Ataxia. There can be no assurance that that our clinical programs with Cinryze, VP20621 and VP-20629 will yield positive results or support further development. There can be no assurance that the OBS development efforts at Maritage will yield positive results or support further development.  We cannot be certain that we will be successful in developing and ultimately commercializing any of our product candidates, that the FDA or other regulatory authorities will not require additional or unanticipated studies or clinical trial outcomes before granting regulatory approval, or that we will be successful in obtaining regulatory approval of any of our product candidates in the timeframes that we expect, or at all.  We cannot assure you that our current cash and cash equivalents and investments or cash flows from product sales will be sufficient to fund all of our ongoing development and operational costs, as well as the interest payable on our outstanding senior convertible notes, over the next several years, that planned clinical trials can be initiated, or that planned or ongoing clinical trials can be successfully concluded or concluded in accordance with our anticipated schedule and costs. Moreover, the results of our business development efforts could require considerable investments.  Our actual results could differ materially from those results expressed in, or implied by, our expectations and assumption described in this Annual Report on Form 10-K. The risks described in this report, our Form 10-K for the year ended December 31, 2011 are not the only risks facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results. Please also see our discussion of the "Risk Factors" in Item 1A, which describe other important matters relating our business.  

Results of Operations

Years ended December 31, 2011 and 2010

                                                                 For the years ended                                                                   December 31,  (in thousands, except per share data)                         2011         

2010

  Net product sales                                          $  544,374

$ 439,012

  Cost of sales (excluding amortization of product rights)   $   79,976     $  61,288  Operating income                                           $  222,128     $ 211,700  Net income                                                 $  140,659     $ 125,608  Net income per share:  Basic                                                      $     1.89     $    1.61  Diluted                                                    $     1.68     $    1.47   The $222.1 million in operating income for the twelve months ended December 31, 2011 increased $10.4 million compared to the same period in 2010. The primary drivers of this increase are increased net sales of $105.4 million. Partly offsetting the increased sales are: (1) an increase of $18.7 million in cost of sales due to increased Cinryze volume; (2) an increase in research and development expense of $ 26.9 million due to: a $9.0 million upfront fee and an additional $3.0 million payment related to the achievement of a development milestone under our license arrangement with Halozyme; a $6.5 million upfront fee related to our license agreement with Intellect Neurosciences, Inc. (INS); and, (3) an increase of $32.1 million in selling, general and administrative expenses primarily related to our European expansion efforts and our Cinryze marketing programs. Additionally, we recorded the following in other operating expenses: (1) an impairment charge of approximately $8.5 million related to certain assets acquired from Auralis; (2) a charge of approximately $4.6 million related to the changes in the fair value of the Auralis contingent consideration liability; and, (3) a charge                                           70

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of approximately $3.4 million of costs associated with the funding of Cinryze manufacturing enhancements at Sanquin.

  We sell Diamorphine in the UK, primarily to hospitals, through approved wholesalers. We began commercial sales of Cinryze and Buccolam in Europe during the fourth quarter of 2011. The revenues and operating income from these sales are not material to our consolidated revenues and operating income for 2011 or 2010.  Revenues 

Revenues consisted of the following:

                                              For the years ended                                                December 31,                      (in thousands)         2011          2010                      Net product sales                      Vancocin            $  288,893     $ 259,567                      Cinryze                251,201       176,815                      Other                    4,280         2,630                       Total revenues      $  544,374     $ 439,012    Net product sales  Our sales of Vancocin are influenced by wholesaler buying decisions related to their desired inventory levels and patient prescription demand, all of which could be at different levels from period to period.  In the US, we sell Cinryze to specialty pharmacy/specialty distributors (SP/SD's) who then distribute to physicians, hospitals and patients, among others. In Europe, we sell Cinryze to wholesalers who then distribute the product principally to pharmacies and hospitals. We continue to work to expand our manufacturing capacity to ensure the availability of Cinryze to meet growing patient needs and believe our efforts will allow us to continue to meet this growing patient demand for the foreseeable future. In order to meet anticipated longer term demand, we submitted to the FDA a Prior Approval Supplement (PAS) in the second quarter of 2010. The PAS involves a larger scale manufacturing project to significantly increase the Cinryze production capabilities at Sanquin. In October 2010, the FDA issued a complete response letter regarding the Cinryze industrial scale manufacturing expansion activities. In the complete response letter the FDA has requested additional information related to observations from the pre-approval inspection and review of the technical processes. In February 2012, the FDA issued a second complete response letter which included three comments related to a portion of the cleaning validation for industrial scale manufacturing. We believe that only one of the comments requires additional unplanned activity which can be completed in a relatively short time frame. The FDA also noted that it has not yet completed the review of our January 2012 updated responses to observations on Form 483 specific to the September 2011 inspection of the Amsterdam facility. In order to manufacture Cinryze at the industrial scale we must respond to all FDA questions and satisfactorily complete the FDA review, including providing responses to all open observations on Form 483.  During the year ended December 31, 2011, net sales of Vancocin increased 11.3% compared to 2010. The increase is primarily due to net realized price growth period over period. The net increase in Vancocin sales includes the negative impact on sales during 2011 of approximately $5.4 million in sales deductions related to the Medicare Part D coverage gap discount enacted under PPACA which did not impact net sales in 2010. Based upon data reported by IMS Health Incorporated, prescriptions during the year ended December 31, 2011 decreased from the same period in 2010 by 5.6%, which we believe is due to a decrease in the incidence of severe disease, improved aseptic technique and an increase in compounding, both in the hospital and long-term care marketplace. Our net sales of Cinryze during the year ended December 31, 2011 increased $74.4 million                                           71

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  compared to the same period in 2010 due to an increase in the number of patients receiving Cinryze. Approximately $73.4 million of the Cinryze revenue increase was generated in the US.  Vancocin product sales are driven by demand fluctuations in trade inventories which could be at different levels from period to period. Cinryze product sales are influenced by prescriptions and the rate at which new patients are placed on Cinryze, as well as fluctuations in trade and patient inventory levels. We receive inventory data from our three largest wholesalers through our fee for service agreements and our two SP/SD's through service agreements. We do not independently verify this data. Based on this inventory data and our estimates, we believe that as of December 31, 2011, the wholesalers and SP/SD's did not have excess channel inventory of either product.  

Cost of sales (excluding amortization of product rights)

Cost of sales increased for the year ended December 31, 2011 by $18.7 million as compared to the same period in 2010 primarily due to increased Cinryze volume.

Vancocin and Cinryze cost of sales includes the cost of materials and distribution costs and excludes amortization of product rights.

Research and development expenses

  For each of our research and development programs, we incur both direct and indirect expenses. Direct expenses include third party costs related to these programs such as contract research, consulting, cost sharing payments or receipts and clinical and development costs. Indirect expenses include personnel, facility, stock compensation and other overhead costs. Due to advancements in our VP20621 clinical program, our Cinryze life cycle management program, the acquisition of DuoCort and the Meritage development agreement, as well as cost associated with our efforts to advance additional initiatives intended to increase our Cinryze capacity and the cost to develop VP-20629 and other compounds, we expect future costs in these programs to increase from historical levels.  

Research and development expenses were divided between our research and development programs in the following manner:

                                                            For the years ended                                                              December 31,       (in thousands)                                      2011           2010       Direct-Core programs

Non-toxigenic strains of C. difficle (VP20621) $ 7,653$ 7,643

      Cinryze & C1 esterase inhibitor                       23,383       

7,113       Vancocin                                                 335        1,151       VP-20629                                               6,500           -       Direct-Other assets       CMV                                                    1,028          866       New Initiatives                                        2,773        2,279       Other assets                                             478        1,604       Indirect       Development                                           24,327       18,957        Total                                            $    66,477     $ 39,613   

Direct Expenses-Core Development Programs

  The increase in costs of VP20621 for the year ended December 31, 2011 compared to the same period in 2010 relates to timing of costs associated with our Phase 1 clinical trial and the initiation of our Phase 2 clinical trial during the second quarter of 2011.                                           72 

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  Our costs associated with our Cinryze program increased during 2011 compared to 2010 as we incurred costs related to the continuation of our Phase 4 clinical trial and development of our life cycle program, including initiation of a Phase 2 study of subcutaneous administration of Cinryze in combination with rHuPH20. In the same period in the prior year, we incurred costs related to the preparation of our Phase 4 clinical trial. During 2011, we made a $9.0 million upfront payment related to our entering into a license with Halozyme for the development of a subcutaneous formulation of Cinryze for routine prophylaxis against attacks of HAE, and we made a $3 million payment related to the achievement of a development milestone under our this license arrangement.  Also during 2011, we incurred a $6.5 million upfront fee related to our license agreement with INS for the clinical stage drug candidate, VP-20629, which is being developed for the treatment of Friedreich's Ataxia (FA), a rare, hereditary, progressive neurodegenerative disease.  

Direct Expenses-Other Assets

  Our direct expenses related to our CMV program decreased in 2011 compared to 2010 as we wound down our stem cell and liver transplant studies during 2010. During 2011, we continue to evaluate potential alternative development strategies for maribavir.  

Our costs related to New Initiatives represent expenses associated with our evaluation of a recombinant C1-INH technology and spending under our collaboration agreement with Sanquin supporting their Early Stage Research Programs.

Anticipated fluctuations in future direct expenses are discussed under "Liquidity-Development Programs."

Indirect Expenses

These costs primarily relate to the compensation of and overhead attributable to our development team.

Selling, general and administrative expenses (SG&A)

In 2011 compared to 2010, SG&A increased $32.1 million. This increase was primarily driven by higher compensation expense and employee cost of $14.5 million, increased marketing expenses of $9.4 million and increased corporate cost of $3.6 million.

  Our European infrastructure and commercialization efforts and new Cinryze marketing programs in the US are predominant reasons for the overall increase in SG&A in both periods. We anticipate that our SG&A spending will continue to increase in future periods as we continue our commercialization and expansion efforts outside the United States.  

Intangible amortization and acquisition of technology rights

  Intangible amortization for the year ended December 31, 2011 was $31.0 million, as compared to $29.4 million in 2010. The year over year increases are primarily due to the amortization of the Auralis intangible assets acquired in May of 2010.  

Impairment losses

  Due to the approval and launch of Buccolam, coupled with the launch of Cinryze in Europe, we have decided to alter our development and commercialization plans for the remaining Auralis IPR&D asset. The decision resulted in the impairment of the IPR&D asset and the Auralis Contract rights. Accordingly, we recorded a charge of approximately £5.4 million (approximately $8.5 million) during 2011.                                           73 

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Other operating expenses

  The re-measurement of the fair value of the contingent consideration given for the acquisition of Auralis resulted in a charge to income of approximately $4.6 million during 2011. We incurred expense of approximately $1.4 million for the re-measurement of the fair value of the contingent consideration during 2010. Also included in other operating expenses for 2011 is approximately $3.4 million of costs associated with the funding of Cinryze manufacturing enhancements at Sanquin.  Other Income (Expense)  Interest Income  Interest income for year ended December 31, 2011 was $0.7 million and $0.4 million in 2010.  Interest Expense                                                     For the years ended                                                      December 31,                (in thousands)                     2011           2010                Interest expense                $     4,372     $  4,100                Amortization of debt discount         7,711        7,129                Amortization of finance costs           557          387                 Total interest expense          $    12,640     $ 11,616    Interest expense and amortization of debt discount and finance costs in 2011 and 2010 relates primarily to the senior convertible notes issued on March 26, 2007. Also include in the 2011 amounts is the amortization of the debt issue cost associated with the $200 million credit facility entered into during the third quarter of 2011 as well as commitment fees on the unused facility.  

Other income, net

Our other income, net includes net foreign exchange gains and losses.

Income Tax Expense

  Our income tax expense was $67.3 million and $75.3 million for 2011 and 2010, respectively. Our income tax expense includes federal, state and foreign income taxes at statutory rates and the effects of various permanent differences.  Our effective tax rates for 2011 and 2010 were 32.4% and 37.5%, respectively. Our effective tax rate in 2011 is lower than the statutory U.S. tax rate due to domestic manufacturing tax deductions and a reduction in the valuation allowance for state net operating losses partly offset by state income taxes, and by certain share-based compensation and an increase in the fair value of contingent consideration, neither of which is deductible for tax purposes. Our effective tax rate in 2010 was higher than the statutory U.S. tax rate primarily due to state income taxes and certain share-based compensation that is not tax deductible.  The examination of our 2008 U.S. income tax return concluded during the quarter ended March 31, 2011 with no material adjustments. We are currently under examination in a foreign jurisdiction and by various states. At this time, we do not believe that the results of these examinations will have a material impact on our financial statements.                                           74 

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Results of Operations

Years ended December 31, 2010 and 2009

                                                                 For the years ended                                                                   December 31,  (in thousands, except per share data)                         2010         

2009

  Net product sales                                          $  439,012

$ 310,449

  Cost of sales (excluding amortization of product rights)   $   61,288     $  40,214  Operating income                                           $  211,700     $  32,130  Net (loss) income                                          $  125,608     $ (11,077 )  Net (loss) income per share:  Basic                                                      $     1.61     $   (0.14 )  Diluted                                                    $     1.47     $   (0.14 )   The $211.7 million in operating income for the twelve months ended December 31, 2010 increased $179.6 million as compared to the same period in 2009. The primary drivers of this increase are increased net sales of $128.6 million, the $65.1 million goodwill impairment charge in the first quarter of 2009 for which no impairment occurred in 2010, and, a decrease in our research and development expense of $12.5 million primarily due to the wind-down of our CMV program. These were partly offset from increased cost of sales $21.1 million due to the increase in Cinryze sales volume and a $6.3 million increase in selling, general and administrative expense.  Revenues 

Revenues consisted of the following:

                                              For the years ended                                                December 31,                      (in thousands)         2010          2009                      Net product sales                      Vancocin            $  259,567       213,138                      Cinryze                176,815        97,311                      Other                    2,630            -                       Total Revenues      $  439,012     $ 310,449   

Revenue-Vancocin and Cinryze product sales

  During the year ended December 31, 2010, net sales of Vancocin increased 21.8% compared to 2009. The increase is primarily due to price increases during 2010, offset by lower sales volumes. Based upon data reported by IMS Health Incorporated, prescriptions during the year ended December 31, 2010 decreased from the same period in 2009 by 5.8%, which we believe is due to a decrease in the severity of the disease state, improved aseptic techniques and a suspected increase in compounding seen both in the hospital and long-term care marketplace. The units sold for the year ended December 31, 2010 decreased by 1.4% compared to the same period in 2009. Our net sales of Cinryze during the year ended December 31, 2010 increased $79.5 million compared to the same period in 2009 due to an increase in the number of patients receiving Cinryze.  Vancocin product sales are driven by demand fluctuations in trade inventories which could be at different levels from period to period. Cinryze product sales are influenced by prescriptions and the rate at which new patients are placed on Cinryze. We receive inventory data from our three largest wholesalers through our fee for service agreements and our two SP/SD's through service agreements. We do not independently verify this data. Based on this inventory data and our estimates, we believe that as of December 31, 2010, the wholesalers and SP/SD's did not have excess channel inventory of either product.                                           75

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Cost of sales (excluding amortization of product rights)

  Cost of sales increased for the year ended December 31, 2010 by $21.1 million as compared to the same period in 2009 due to increased Cinryze volume, partially offset by the impact of the step-up on 2009 cost of sales related to the acquisition of Lev ($6.9 million). We utilized the entire inventory that was recorded at fair value as part of the Lev purchase during 2009. Additionally, included in the cost of sales for the year ended December 31, 2010 are expenses of $1.5 million related to non-refundable start up costs paid to a new plasma supplier and a $2.8 million write-off of inventory, produced as part of our effort to receive FDA approval for a larger scale manufacturing line.  Vancocin and Cinryze cost of sales includes the cost of materials and distribution costs and excludes amortization of product rights. Since units are shipped based upon earliest expiration date, we would expect the cost of product sales of both Vancocin and Cinryze to fluctuate from quarter to quarter as we may experience fluctuations in quarterly manufacturing yields.  

Research and development expenses

For each of our research and development programs, we incur both direct and indirect expenses. Direct expenses include third party costs related to these programs such as contract research, consulting, cost sharing payments or receipts and clinical and development costs. Indirect expenses include personnel, facility, stock compensation and other overhead costs. Due to advancements in our VP20621 preclinical program, and our Cinryze Phase 4 commitment and Phase 2 study in children, we expect future costs in these programs to exceed historical costs.

Research and development expenses were divided between our research and development programs in the following manner:

                                                            For the years ended                                                              December 31,       (in thousands)                                      2010           2009       Direct-Core programs       Non-toxigenic strains of C. difficle (VP20621)   $     7,643     $  9,801       Cinryze                                                7,113        7,067       Vancocin                                               1,151          675       Direct-Other assets       CMV                                                      866       15,715       New Initiatives                                        2,279           -       Other assest                                           1,604            8       Indirect       Development                                           18,957       18,817        Total                                            $    39,613     $ 52,083   

Direct Expenses-Core Development Programs

  The decrease in costs of VP20621 for the year ended December 31, 2010 compared to the same period in 2009 relates to timing associated with costs of our Phase 1 clinical trial.  Our costs associated with our Cinryze program during 2010 are flat compared to 2009, as we incurred costs related to our Phase 4 clinical trial and the development of our life cycle program during 2010, while during 2009, we incurred costs related to our open label trials which closed on March 31, 2009 and preparation of our Phase 4 clinical trial.                                           76

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Vancocin costs in 2010 and 2009 related to additional research activities.

Direct Expenses-Other Assets

  Our direct expenses related to our CMV program decreased in 2010 compared to 2009 as we wound down our stem cell and liver transplant studies in 2009. In February 2009, based upon preliminary analysis of the data, we announced that our Phase 3 trial evaluating maribavir used as prophylaxis in allogeneic stem cell, or bone marrow, transplant patients did not achieve its primary endpoints. In addition, the study failed to meet its key secondary endpoints. Additionally, we announced that our Phase 3 trial evaluating maribavir in liver transplant patients was discontinued and that all patients on study drug were moved to current standard of care. During 2009 we continued enrollment in our solid organ (liver) study through February 2009, conducted follow-up visits necessary to complete both our Phase 3 studies following receipt of the results of our stem cell transplant study and continued to evaluate the results of our Phase 3 programs. We continue to evaluate any potential alternative development strategies for maribavir.  

Our costs related to New Initiatives represent expenses associated with our evaluation of a recombinant C1-INH technology and spending under our collaboration agreement with Sanquin supporting their Early Stage Research Programs. Included in the 2010 Other assets is a one-time charge of approximately $1.1 million associated with a re-negotiation of a royalty arrangement on a product in late stage development.

Anticipated fluctuations in future direct expenses are discussed under "Liquidity-Development Programs."

Indirect Expenses

These costs primarily relate to the compensation of and overhead attributable to our development team. During the second half of 2009 and through 2010, our development team shifted its focus from our CMV program to our Cinryze and VP20621 programs.

Selling, general and administrative expenses

  Selling, general and administrative expenses (SG&A) increased $6.3 million during 2010 compared to 2009. The increase was driven by increased marketing expenses ($2.9 million), legal costs ($2.2 million), compensation expense ($1.7 million) and increased costs associated with our activities in Europe, partly offset by decreased medical education expenses ($2.6 million).  Included in SG&A are legal and consulting costs incurred related to our opposition to the attempt by the OGD regarding the conditions that must be met in order for a generic drug application to request a waiver of in-vivo bioequivalence testing for copies of Vancocin, which were $6.4 million and $5.5 million for the years 2010 and 2009, respectively. We anticipate that these additional legal and consulting costs will continue at the current level, or possibly higher, in future periods as we continue this opposition. We anticipate continued increased spending in selling, general and administrative expenses in future periods as we continue to implement additional commercial programs related to Cinryze and continue our European initiatives.  

Intangible amortization and acquisition of technology rights

Intangible amortization for the year ended December 31, 2010 was $29.4 million, as compared to $28.2 million in 2009.

  On an ongoing periodic basis, we evaluate the useful life of our intangible assets and determine if any economic, governmental or regulatory event has modified their estimated useful lives. This evaluation did not result in a change in the life of the intangible assets during the year ended December 31, 2010. We will continue to monitor the actions of the FDA and OGD surrounding the bioequivalence recommendation for Vancocin and consider the                                           77

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  effects of our opposition efforts, any announcements by generic competitors or other adverse events for additional impairment indicators. We will reevaluate the expected cash flows and fair value of our Vancocin-related assets, as well as estimated useful lives, at such time.  

Impairment losses

  During the first quarter of 2009, the market capitalization of ViroPharma fell below the carrying value of ViroPharma's net assets due to the announcements surrounding our maribavir development program. This situation required us to test for impairment of our goodwill and other intangible assets which lead to a goodwill impairment charge of $65.1 million in 2009. There was no impairment of goodwill during 2010.  

During 2009 we incurred an impairment charge related to our previous corporate headquarters of $3.4 million due to the down turn in the real estate market.

Other operating expenses

  The re-measurement of the fair value of the contingent consideration given relating to the acquisition of Auralis resulted in a charge to income during the period ended December 31, 2010 of $1.4 million. There was no such charge during 2009.  Other Income (Expense)  Interest Income 

Interest income for year ended December 31, 2010 was $0.4 million is flat compared to $0.4 million in 2009.

 Interest Expense                                                            For the years ended                                                             December 31,        (in thousands)                                    2010           2009

Interest expense on senior convertible notes $ 4,100$ 4,343

       Amortization of debt discount                        7,129       

6,854

       Amortization of finance costs                          387         

412

         Total interest expense                         $    11,616     $ 

11,609

Interest expense and amortization of debt discount and finance costs in 2010 and 2009 relates entirely to the senior convertible notes issued on March 26, 2007.

Other income, net

Our other income, net includes net foreign exchange gains and the rental income attributable to our previous corporate headquarters.

Income Tax Expense

  Our income tax expense was $75.3 million and $41.0 million for the year ended December 31, 2010 and 2009, respectively. The effective tax rate in 2010 was 37.5% compared to 137.0% in 2009. The effective tax rate in 2010 exceeded the federal statutory tax rate due to state income taxes and certain share-based compensation that is not tax deductible. The effective tax rate in 2009 exceeded the statutory tax rate because of a goodwill impairment charge which is not deductible for tax purposes and state income taxes, partially offset by an orphan drug credit.                                           78 

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Liquidity

  In the near term, we expect that our sources of revenue will continue to arise from Cinryze and Vancocin product sales. We began the commercial sales of Buccolam and Cinryze in Europe during the fourth quarter of 2011. However, future sales of Vancocin will vary based on the number of generic competitors that could enter the market if the three-year exclusivity period is not granted by the FDA as a result of the FDA's approval of a supplemental new drug application (sNDA) for Vancocin (or if FDA decides that any protected labeling can be omitted from the labels of generic products), and if generics are permitted to demonstrate bioequivalence through an in vitro dissolution method, the timing of entry into the market of those generic competitors and/or the sales we may generate from an authorized generic version of Vancocin. In addition, there are no assurances that demand for Cinryze will continue to grow or that demand for Vancocin will continue at historical or current levels.  Although we began commercial sales of Cinryze and Buccolam in Europe during the fourth quarter of 2011, the revenues and operating income from these sales are not material to our consolidated revenues and operating income for 2011 and there are no assurances that there will be growing demand for products in Europe or we will be successful in our commercialization efforts in Europe or any other territories we have the rights to sell these drug products.  Our ability to generate positive cash flow is also impacted by the timing of anticipated events in our Cinryze, VP20621, VP-20629, Plenadren and other development programs, including the timing of our expansions into other territories and the costs of our anticipated commercial activities, the scope of the clinical trials required by regulatory authorities, results from clinical trials, the results of our product development efforts, including the OBS development efforts at Meritage and variations from our estimate of future direct and indirect expenses.  The cash flows we have used in operations historically have been applied to research and development activities, marketing and commercial efforts, business development activities, general and administrative expenses, debt service, and income tax payments. Bringing drugs from the preclinical research and development stage through phase 1, phase 2, and phase 3 clinical trials and FDA and/or EMA or regulatory approval is a time consuming and expensive process. Because we have product candidates that are currently in the clinical stage of development, there are a variety of events that could occur during the development process that will dictate the course we must take with our drug development efforts and the cost of these efforts. As a result, we cannot reasonably estimate the costs that we will incur through the commercialization of any product candidate. However, our future costs may exceed current costs as we anticipate we will continue to invest in our pipeline, including our initiative to develop VP20621 (non-toxigenic strains of C. difficile), VP-20629, any additional studies to identify further therapeutic uses and expand the labeled indication for Cinryze to potentially include other C1 mediated diseases as well as new modes of administration for Cinryze. Also, we will incur additional costs as we intend to seek to commercialize Cinryze, Buccolam and Plenadren in Europe in countries where we have distribution rights and certain other countries beginning in 2011 as well as conduct studies to identify additional C1 mediated diseases, such as AMR and DGF, which may be of interest for further clinical development, and to evaluate new forms of administration for Cinryze.  In May 2011, Halozyme Therapeutics (Halozyme) granted us an exclusive worldwide license to use Halozyme's proprietary Enhanze™ technology, a proprietary drug delivery platform using Halozyme's recombinant human hyaluronidase enzyme (rHuPH20) technology in combination with a C1 esterase inhibitor. We intend to apply rHuPH20 initially to develop a novel subcutaneous formulation of Cinryze for routine prophylaxis against attacks. Under the terms of the license agreement, we paid Halozyme an initial upfront payment of $9 million. In the fourth quarter of 2011, we made a milestone payment of $3 million related to the initiation of a Phase 2 study begun in September 2011 to evaluate the safety, and pharmacokinetics and pharmacodynamics of subcutaneous administration of Cinryze in combination with rHuPH20. Pending successful completion of an additional series of clinical and regulatory milestones, anticipated to begin during 2012, we may make further milestone payments to Halozyme which could reach up to an additional $41 million related to HAE and up to $30 million of                                           79 

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  additional milestone payments for three additional indications. Additionally, we will pay an annual maintenance fee of $1 million to Halozyme until specified events have occurred. Upon regulatory approval, Halozyme will receive up to a 10% royalty on net sales of the combination product utilizing Cinryze and rHuPH20, depending on the existence of a valid patent claim in the country of sale.  On September 30, 2011, we entered into a license agreement for the worldwide rights of Intellect Neurosciences, Inc. (INS) to its clinical stage drug candidate, VP-20629, being developed for the treatment of Friedreich's Ataxia (FA), a rare, hereditary, progressive neurodegenerative disease. We expect to initiate a phase 2 study within 12 to 18 months of the date of this agreement, after completion of longer-term toxicology studies. We intend to file for Orphan Drug Designation upon review of the phase 2 proof of concept data. Under the terms of the agreement, we have exclusive worldwide rights to develop and commercialize VP-20629 for the treatment, management or prevention of any disease or condition covered by Intellect's patents. We paid INS a $6.5 million up-front licensing fee and may pay additional milestones up to $120 million based upon defined events. We will also pay a tiered royalty of up to a maximum percentage of low teens, based on annual net sales.  On October 21, 2008, we completed our acquisition under which ViroPharma acquired Lev Pharmaceuticals, Inc. (Lev). Lev is a biopharmaceutical company focused on developing and commercializing therapeutic products for the treatment of inflammatory diseases. The terms of the merger agreement provided for the conversion of each share of Lev common stock into upfront consideration of $453.1 million, or $2.75 per Lev share, comprised of $2.25 per share in cash and $0.50 per share in ViroPharma common stock, and contingent consideration of up to $1.00 per share which may be paid on achievement of certain regulatory and commercial milestones. The target for the first CVR payment of $0.50 per share (or $87.5 million) will not be paid as a third party's human C1 inhibitor product was approved for the acute treatment of HAE and granted orphan exclusivity. The second CVR payment of $0.50 per share ($87.5 million) becomes payable if Cinryze reaches at least $600 million in cumulative net product sales by October 2018. As of December 31, 2011, we have recognized approximately $525.3 million of cumulative sales of Cinryze and we anticipate achieving this milestone in 2012.  On November 15, 2011, we acquired a 100% ownership interest in DuoCort Pharma AB (DuoCort), a private company based in Helsingborg, Sweden focused on improving glucocorticoid replacement therapy for treatment of adrenal insufficiency, or Addison's disease (AD). We paid approximately 213 million Swedish Krona (SEK) or approximately $32.1 million in upfront consideration. We have also agreed to make additional payments ranging from SEK 240 million up to SEK 860 million or approximately $35 million to $124 million, contingent on the achievement of certain milestones. Up to SEK 160 million or approximately $23 million of the contingent payments relate to specific regulatory milestones; and up to SEK 700 million or approximately $101 million of the contingent payments are related to commercial milestones based on the success of the product.  On December 22, 2011, we entered into an exclusive development and option agreement with Meritage Pharma, Inc. (Meritage) , a private company based in San Diego, CA focused on developing oral budesonide suspension (OBS) as a treatment for eosinophilic esophagitis (EoE). As consideration for the agreement, we paid an initial $7.5 million and have the option to provide Meritage up to an additional $12.5 million for the development of OBS. Meritage will utilize the funding to conduct additional Phase 2 clinical assessment of OBS. We have an exclusive option to acquire Meritage, at our sole discretion, by providing written notice at any time during the period from December 22, 2011 to and including the date that is the earlier of (a) the date that is 30 business days after the later of (i) the receipt of the final study data for the Phase 2 study and (ii) identification of an acceptable clinical end point definition for a pivotal induction study agreed to by the FDA. If we exercise this option, we have agreed to pay $69.9 million for all of the outstanding capital stock of Meritage. Meritage stockholders could also receive additional payments of up to $175 million, upon the achievement of certain clinical and regulatory milestones.  

The most significant of our near-term operating development cash outflows are as described under "Development Programs" as set forth below.

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  In March 2010, President Obama signed into law the Patient Protection and Affordable Care Act (PPACA). The PPACA, as amended, will likely increase certain of our costs as well. For example, an increase in the Medicaid rebate rate from 15.1% to 23.1% was effective as of January 1, 2010, and the volume of rebated drugs has been expanded to include beneficiaries in Medicaid managed care organizations, effective as of March 23, 2010. Beginning in 2011, the PPACA also imposes a manufacturer's fee on the sale of branded Pharmaceuticals (excluding orphan drugs) to specified government programs, expands the 340B drug discount program (excluding orphan drugs), and includes a 50% discount on brand name drugs for Medicare Part D participants in the coverage gap, or "donut hole". We have determined that the manufacturing fee is immaterial relative to our anticipated 2011 operating income and cash flow. We have also estimated that our incremental cost associated with the Medicare Part D coverage gap will be approximately $5.4 million during 2011. Our evaluation of PPACA, as amended, will continue to enable us to determine not only the immediate effects on our business, but also the trends and changes that may be encouraged by the legislation that may potentially impact on our business over time.  

Capital Resources

  While we anticipate that cash flows from Cinryze and Vancocin, our current cash, cash equivalents and short-term investments (together, "our cash") and revolving credit facility should allow us to fund our ongoing development and operating costs, as well our interest payments and future milestone payments or acquisition costs, we may need additional financing in order to expand our product portfolio. At December 31, 2011, we had cash, cash equivalents and short-term investments of $459.8 million. Short-term investments consist of high quality fixed income securities with remaining maturities of greater than three months at the date of purchase and high quality debt securities or obligation of departments or agencies of the United States. At December 31, 2011, the annualized weighted average nominal interest rate on our short-term investments was 0.38% and the weighted average length to maturity was 7.0 months. At December 31, 2011, we also had $200 million available under our revolving credit agreement. At December 31, 2011, approximately $194.5 million of our cash and availability under the credit agreement is subject to the minimum liquidity covenant, as defined in our credit agreement.  

Financing

  Should we need financing, we would seek to access the public or private equity or debt markets, enter into additional arrangements with corporate collaborators to whom we may issue equity or debt securities or enter into other alternative financing arrangements that may become available to us.  

If we raise additional capital by issuing equity securities, the terms and prices for these financings may be much more favorable to the new investors than the terms obtained by our existing stockholders. These financings also may significantly dilute the ownership of existing stockholders.

  If we raise additional capital by accessing debt markets, the terms and pricing for these financings may be much more favorable to the new lenders than the terms obtained from our prior lenders. These financings also may require liens on certain of our assets that may limit our flexibility.  Additional equity or debt financing, however, may not be available on acceptable terms from any source as a result of, among other factors, our operating results, our inability to achieve regulatory approval of any of our product candidates, and our inability to file, prosecute, defend and enforce patent claims and or other intellectual property rights. If sufficient additional financing is not available, we may need to delay, reduce or eliminate current development programs, or reduce or eliminate other aspects of our business.  From time to time, we may seek approval from our board of directors to evaluate additional opportunities to repurchase our common stock or convertible notes, including through open market purchases or individually negotiated transactions.                                           81 

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Overall Cash Flows

  During the twelve months ended December 31, 2011, we generated $170.7 million of net cash from operating activities, primarily from our net income after adjustments for non-cash items, including the charge for the intangible assets impairment, partly offset by our net increase in working capital and our payment of the Auralis contingent consideration. The decrease from 2010 is primarily related to higher cash payments for taxes during 2011. We used $101.0 million of cash from investing activities mainly in the purchase of short-term investments, net of investment maturities and the acquisition of DuoCort. Our net cash used in financing activities for the twelve months ended December 31, 2011 was $163.2 million is primarily attributable to the repurchases of our common stock and our payment of the Auralis contingent consideration. During the year ended December 31, 2010, we generated $193.5 million of net cash from operating activities, primarily from our net income after adjustments for non-cash items. We used $101.9 million of cash from investing activities mainly in the purchase of short-term investments, as well as in the purchase of Auralis and the additional purchase price consideration for Vancocin. Our net cash provided by financing activities was $3.6 million which relates to stock option exercises.  

Development Programs

  For each of our development programs, we incur both direct and indirect expenses. Direct expenses include third party costs related to these programs such as contract research, consulting, cost sharing payments or receipts, and preclinical and clinical development costs. Indirect expenses include personnel, facility and other overhead costs. Additionally, for some of our development programs, we have cash inflows and outflows upon achieving certain milestones.  

Core Development Programs

  Cinryze-We acquired Cinryze in October 2008 and through December 31, 2011 have spent approximately $42.8 million in direct research and development costs related to Cinryze since acquisition. During 2012, we continue to expect research and development costs related to Cinryze to increase as we complete our Phase 4 commitment and initiate our Phase 2 study to evaluate Cinryze for treatment of acute HAE in children. Additionally, we will incur costs related to evaluating additional indications, formulations and territories as we develop our life cycle program related to Cinryze such as our efforts on the C1 esterase inhibitor/rHuPH20 combination sub-subcutaneous formulation, AMR and DGF. We are solely responsible for the costs of Cinryze development. In September 2011, we initiated a Phase 2 study to evaluate the safety, and pharmacokinetics and pharmacodynamics of subcutaneous administration of Cinryze in combination with rHuPH20.  VP20621-We acquired VP20621 in February 2006 and through December 31, 2011 have spent approximately $31.5 million in direct research and development costs. For the remainder of 2011, we expect our research and development activities related to VP20621 to increase as we continue our development program and in May 2011, we initiated a Phase 2 dose-ranging clinical study to evaluate the safety, tolerability, and efficacy of VP 20621 for prevention of recurrence of CDAD in adults previously treated for CDAD. We are solely responsible for the costs of VP20621 development.  Vancocin-We acquired Vancocin in November 2004 and through December 31, 2011 have spent approximately $3.1 million in direct research and development costs related to Vancocin activities since acquisition.  VP-20629-On September 30, 2011, we entered into a license agreement for the worldwide rights of Intellect Neurosciences, Inc. (INS) to its clinical stage drug candidate, VP-20629, being developed for the treatment of Friedreich's Ataxia (FA), a rare, hereditary, progressive neurodegenerative disease. We expect to initiate a phase 2 study within 12 to 18 months of the date of this agreement, after completion of longer-term toxicology studies. We intend to file for Orphan Drug Designation upon review of the phase 2 proof of concept data. Under the terms of the agreement, we have exclusive worldwide rights to develop and commercialize VP-20629 for the treatment, management or prevention of any disease or condition covered by Intellect's patents. We paid INS a                                           82

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$6.5 million up-front licensing fee and may pay additional milestones up to $120 million based upon defined events. We will also pay a tiered royalty of up to a maximum percentage of low teens, based on annual net sales. We are solely responsible for the costs of VP-20629 development.  

Other Assets

  In addition to the programs described above, we have several other assets that we may make additional investments in. These investments will be dependent on our assessment of the potential future commercial success of or benefits from the asset. These assets include maribavir for CMV, and other compounds. We will continue to incur costs associated with our other development assets for direct research and development costs for medicinal products which will address unmet medical needs such as our current evaluation of a recombinant C1-INH technology which may be included in future clinical studies.  

Business Development Activities

  On December 22, 2011, we entered into an exclusive development and option agreement with Meritage Pharma, Inc. (Meritage) , a private company based in San Diego, CA focused on developing oral budesonide suspension (OBS) as a treatment for eosinophilic esophagitis (EoE). We have an exclusive option to acquire Meritage, at our sole discretion, by providing written notice at any time during the period from December 22, 2011 to and including the date that is the earlier of (a) the date that is 30 business days after the later of (i) the receipt of the final study data for the Phase 2 study and (ii) identification of an acceptable clinical end point definition for a pivotal induction study agreed to by the FDA. As consideration for the option, we paid an initial $7.5 million and have the option to provide Meritage up to an additional $12.5 million for the development of OBS. Meritage will utilize the funding to conduct additional Phase 2 clinical assessment of OBS. If we exercise this option, we have agreed to pay $69.9 million for all of the outstanding capital stock of Meritage. Meritage stockholders could also receive additional payments of up to $175 million, upon the achievement of certain clinical and regulatory milestones.  On November 15, 2011, we acquired a 100% ownership interest in DuoCort Pharma AB (DuoCort), a private company based in Helsingborg, Sweden focused on improving glucocorticoid replacement therapy for treatment of adrenal insufficiency, or Addison's disease (AD). We paid approximately 213 million Swedish Krona (SEK) or approximately $32.1 million in upfront consideration. We have also agreed to make additional payments ranging from SEK 240 million up to SEK 860 million or approximately $35 million to $124 million, contingent on the achievement of certain milestones. Up to SEK 160 million or approximately $23 million of the contingent payments relate to specific regulatory milestones; and up to SEK 700 million or approximately $101 million of the contingent payments are related to commercial milestones based on the success of the product.  On September 30, 2011, we entered into a license agreement for the worldwide rights of Intellect Neurosciences, Inc. (INS) to its clinical stage drug candidate, VP-20629, being developed for the treatment of Friedreich's Ataxia (FA), a rare, hereditary, progressive neurodegenerative disease. We paid INS a $6.5 million up-front licensing fee and may pay additional milestones up to $120 million based upon defined events. We will also pay a tiered royalty of up to a maximum percentage of low teens, based on annual net sales. We are solely responsible for the costs of VP-20629 development.  On May 28, 2010, we acquired a 100% ownership interest in Auralis Limited, a UK based specialty pharmaceutical company for approximately $14.5 million in upfront consideration for the acquisition of the company and its existing pharmaceutical licenses and products. During the third quarter of 2011, we made additional payment of £10 million Pounds Sterling (approximately $15.8 million) upon the European Commission grant of a Centralized Pediatric Use Marketing Authorization (PUMA) for Buccolam during the quarter.  

We intend to continue to seek to acquire additional products or product candidates. The costs associated with evaluating or acquiring any additional product or product candidate can vary substantially based upon market

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size of the product, the commercial effort required for the product, the product's current stage of development, and actual and potential generic and non-generic competition for the product, among other factors. Due to the variability of the cost of evaluating or acquiring business development candidates, it is not feasible to predict what our actual evaluation or acquisition costs would be, if any, however, the costs could be substantial.

Share Repurchase Program

  On March 9, 2011 our Board of Directors authorized the use of up to $150.0 million to repurchase shares of our common stock and/or our 2% Senior Convertible Notes due 2017. Purchases may be made by means of open market transactions, block transactions, privately negotiated purchase transactions or other techniques from time to time. The sources of cash for this repurchase program were a combination of our available liquid assets and/or our cash flows from operations.  On March 14, 2011, we entered into a three month accelerated share repurchase (ASR) agreement with a large financial institution to repurchase $50.0 million of our common stock on an accelerated basis. We paid $50.0 million to the financial institution and received approximately 2.7 million shares under this arrangement at an average purchase price of $18.74 per share.  During the third quarter of 2011, we reacquired approximately 5.5 million shares of our common stock at a cost of approximately $98.9 million or an average price of $18.04 per share. These purchases effectively completed our repurchase program authorized by our board on March 9, 2011.  On September 14, 2011, our Board of Directors authorized the use of up to an additional $200 million to repurchase shares of our common stock and/or our 2% Senior Convertible Notes due 2017. Purchases may be made by means of open market transactions, block transactions, privately negotiated purchase transactions or other techniques from time to time. To the extent repurchases are made, the sources of cash for this program are expected to be a combination of our available liquid assets and/or cash flows from operations.  

During the fourth quarter of 2011, we reacquired approximately 1.0 million shares through open market transactions at a cost of approximately $20.8 million or an average price of $20.62 per share.

  From time to time, we may seek approval from our board of directors to evaluate additional opportunities to repurchase our common stock or convertible notes, including through open market purchases or individually negotiated transactions.  

Senior Convertible Notes

  On March 26, 2007, we issued $250.0 million of 2% senior convertible notes due March 2017 (the "senior convertible notes") in a public offering. Net proceeds from the issuance of the senior convertible notes were $241.8 million. The senior convertible notes are unsecured unsubordinated obligations and rank equally with any other unsecured and unsubordinated indebtedness. The senior convertible notes bear interest at a rate of 2% per annum, payable semi-annually in arrears on March 15 and September 15 of each year commencing on September 15, 2007.  The debt and equity components of our senior convertible debt securities are bifurcated and accounted for separately based on the value and related interest rate of a non-convertible debt security with the same terms. The fair value of a non-convertible debt instrument at the original issuance date was determined to be $148.1 million. The equity (conversion options) component of our convertible debt securities is included in Additional paid-in capital on our Consolidated Balance Sheet and, accordingly, the initial carrying value of the debt securities was reduced by $101.9 million. Our net income for financial reporting purposes is reduced by recognizing the accretion of the reduced carrying values of our convertible debt securities to their face amount of $250.0 million as additional non-cash interest expense. Accordingly, the senior convertible debt securities will recognize interest expense at effective rates of 8.0% as they are accreted to par value.                                           84 

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  As of December 31, 2011 senior convertible notes representing $205.0 million of principal debt are outstanding with a carrying value of $153.5 million and a fair value of approximately $318.6 million, based on the level 2 valuation hierarchy of the fair value measurements standard.  The senior convertible notes are convertible into shares of our common stock at an initial conversion price of $18.87 per share. The senior convertible notes may only be converted: (i) anytime after December 15, 2016; (ii) during the five business-day period after any five consecutive trading day period (the "measurement period") in which the price per note for each trading day of that measurement period was less than 98% of the product of the last reported sale price of our common stock and the conversion rate on each such day; (iii) during any calendar quarter (and only during such quarter) after the calendar quarter ending June 30, 2007, if the last reported sale price of our common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; or (iv) upon the occurrence of specified corporate events. Upon conversion, holders of the senior convertible notes will receive shares of common stock, subject to ViroPharma's option to irrevocably elect to settle all future conversions in cash up to the principal amount of the senior convertible notes, and shares for any excess. We can irrevocably elect this option at any time on or prior to the 35th scheduled trading day prior to the maturity date of the senior convertible notes. The senior convertible notes may be required to be repaid on the occurrence of certain fundamental changes, as defined in the senior convertible notes.  Concurrent with the issuance of the senior convertible notes, we entered into privately-negotiated transactions, comprised of purchased call options and warrants sold, to reduce the potential dilution of our common stock upon conversion of the senior convertible notes. The transactions, taken together, have the effect of increasing the initial conversion price to $24.92 per share. The net cost of the transactions was $23.3 million.  The call options allowed ViroPharma to receive up to approximately 13.25 million shares of its common stock at $18.87 per share from the call option holders, equal to the number of shares of common stock that ViroPharma would issue to the holders of the senior convertible notes upon conversion. These call options will terminate upon the earlier of the maturity dates of the related senior convertible notes or the first day all of the related senior convertible notes are no longer outstanding due to conversion or otherwise. Concurrently, we sold warrants to the warrant holders to receive shares of its common stock at an exercise price of $24.92 per share. These warrants expire ratably over a 60-day trading period beginning on June 13, 2017 and will be net-share settled.  The purchased call options are expected to reduce the potential dilution upon conversion of the senior convertible notes in the event that the market value per share of ViroPharma common stock at the time of exercise is greater than $18.87, which corresponds to the initial conversion price of the senior convertible notes, but less than $24.92 (the warrant exercise price). The warrant exercise price is 75.0% higher than the price per share of $14.24 of our common stock on the pricing date. If the market price per share of ViroPharma common stock at the time of conversion of any senior convertible notes is above the strike price of the purchased call options ($18.87), the purchased call options will entitle us to receive from the counterparties in the aggregate the same number of shares of our common stock as we would be required to issue to the holder of the converted senior convertible notes. Additionally, if the market price of ViroPharma common stock at the time of exercise of the sold warrants exceeds the strike price of the sold warrants ($24.92), we will owe the counterparties an aggregate of approximately 13.25 million shares of ViroPharma common stock. If we have insufficient shares of common stock available for settlement of the warrants, we may issue shares of a newly created series of preferred stock in lieu of our obligation to deliver common stock. Any such preferred stock would be convertible into 10% more shares of our common stock than the amount of common stock we would otherwise have been obligated to deliver under the warrants.  Initially, the purchased call options and warrants sold with the terms described above were based upon the $250.0 million offering, and the number of shares we would purchase under the call option and the number of shares we would sell under the warrants was 13.25, to correlate to the $250.0 million principal amount. On March 24, 2009                                           85 

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  we repurchased, in a privately negotiated transaction, $45.0 million in principal amount of our senior convertible notes due March 2017 for total consideration of approximately $21.2 million. The repurchase represented 18% of our then outstanding debt and was executed at a price equal to 47% of par value. Additionally, in negotiated transactions, we sold approximately 2.38 million call options for approximately $1.8 million and repurchased approximately 2.38 million warrants for approximately $1.5 million which terminated the call options and warrants that were previously entered into by us in March 2007. We recognized a $9.1 million gain in the first quarter of 2009 as a result of this debt extinguishment. For tax purposes, the gain qualifies for deferral until 2014 in accordance with the provisions of the American Recovery and Reinvestment Act.  As a result of the above negotiated sale and purchase transactions we are now entitled to receive approximately 10.87 million shares of our common stock at $18.87 from the call option holders and if the market price of ViroPharma common stock at the time of exercise of the sold warrants exceeds the strike price of the sold warrants ($24.92), will owe the counterparties an aggregate of approximately 10.87 million shares of ViroPharma common stock, which correlates to $205 million of convertible notes outstanding.  The purchased call options and sold warrants are separate transactions entered into by us with the counterparties, are not part of the terms of the senior convertible notes, and will not affect the holders' rights under the senior convertible notes. Holders of the senior convertible notes will not have any rights with respect to the purchased call options or the sold warrants. The purchased call options and sold warrants meet the definition of derivatives. These instruments have been determined to be indexed to our own stock and have been recorded in stockholders' equity in our Consolidated Balance Sheet. As long as the instruments are classified in stockholders' equity they are not subject to the mark to market provisions.  

Credit Facility

  In September, 2011, we entered into a $200 million, three-year senior secured revolving credit facility (the "Credit Facility"), the terms of which are set forth in a Credit Agreement dated as of September 9, 2011 (the "Credit Agreement") with JPMorgan Chase Bank, N.A., as administrative agent, BMO Harris Financing Inc., TD Bank, N.A. and Morgan Stanley Bank, NA as co-syndication agents and certain other lenders.  

The Credit Facility is available for working capital and general corporate purposes, including acquisitions which comply with the terms of the Credit Agreement. The Credit Agreement provides separate sub-limits for letters of credit up to $20 million and swing line loans up to $10 million.

  The Credit Agreement requires us to maintain (i) a maximum senior secured leverage ratio of less than 2.00 to 1.00, (ii) a maximum total leverage ratio of less than 3.50 to 1.00, (iii) a minimum interest coverage ratio of greater than 3.50 to 1.00 and (iv) minimum liquidity equal to or greater than the sum of $100 million plus the aggregate amount of certain contingent consideration payments resulting from business acquisitions payable by us within a specified time period. The Credit Agreement also contains certain other usual and customary affirmative and negative covenants, including but not limited to, limitations on capital expenditures, asset sales, mergers and acquisitions, indebtedness, liens, dividends, investments and transactions with affiliates.  Our obligations under the Credit Facility are guaranteed by certain of our domestic subsidiaries (the "Subsidiary Guarantors") and are secured by substantially all of our assets and the assets of the Subsidiary Guarantors. Borrowings under the Credit Facility will bear interest at an amount equal to a rate calculated based on the type of borrowing and our senior secured leverage ratio (as defined in the Credit Agreement) from time to time. For loans (other than swing line loans), we may elect to pay interest based on adjusted LIBOR plus between 2.25% and 2.75% or an Alternate Base Rate (as defined in the Credit Agreement) plus between 1.25% and 1.75%. We will also pay a commitment fee of between 35 to 45 basis points, payable quarterly, on the average daily unused amount of the Credit Facility based on our senior secured leverage ratio from time to time. As of the date of this filing, we have not drawn any amounts under the Credit Facility.                                           86 

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Contractual Obligations

  Future contractual obligations and commercial commitments at December 31, 2011 are as follows:  (in thousands)                                                            1 year or                                        More than Contractual Obligations (1)(2)            Total           less          2-3 years       4-5 years         5 years Operating leases (3)                    $   9,867      $     1,881      $    3,935      $    2,927      $     1,124 Senior convertible notes (4)               22,550            4,100           8,200           8,200            2,050 Collaboration agreements (5)                3,876            1,292           2,584              -                - Purchase obligations (6)                  310,404           68,950         140,412         101,042               -  Total                                   $ 346,697      $    76,223      $  155,131      $  112,169      $     3,174     

(1) This table does not include any contingent consideration related to our

business combinations. We account for this contingent consideration as a

liability and recognize changes in its fair value in operating income. We

will continue to recognize such fair value changes in income until the

ultimate disposition or settlement of this liability. Nor does this table

include any milestone payments under our licensing arrangements. We have

several license agreements where we may pay up to $191 million in milestone

payments based on the occurrence of defined events.

(2) This table does not include various agreements that we have entered into for

services with third party vendors, including agreements to conduct clinical

trials, to manufacture product candidates, and for consulting and other

contracted services due to the cancelable nature of the services. We accrue

the costs of these agreements based on estimates of work completed to date.

We estimate that approximately ($20.0) million will be payable in future

periods under arrangements in place at December 31, 2011. Of this amount,

approximately $19.3 million has been accrued for work estimated to have been

completed as of December 31, 2011 and approximately ($39.4) million relates

to future performance under these arrangement.

(3) Operating leases represent building and equipment leases.

(4) These payments represent interest and principal related to our 2% senior

convertible notes due March 2017.

(5) Pursuant to the terms of the ROW Agreement, Sanquin may conduct certain early

stage research programs for which we will provide to Sanquin

€1,000,000 (approximately $1.3 million) per year for a period of five years.

(6) We have committed to purchase up to 240,000 liters of plasma in 2012 and up

to 210,000 liters of plasma per year in 2012 through 2015 from our suppliers.

Additionally, we are required to purchase a minimum number of units from our

third party toll manufacturer. Excluded from these amounts is the

manufacturing fee for Cinryze produced under the EU and ROW agreement as the

minimum purchase shall be determined by the Joint Steering Committee in 2013.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements as of December 31, 2011.

Critical Accounting Policies

  Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. Preparing consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and contingent assets and liabilities. Actual results could differ from such estimates. These estimates and assumptions are affected by the application of our accounting policies. Critical policies and practices are both most important to the portrayal of a company's financial condition and results of operations, and require management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.                                           87

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  Our summary of significant accounting policies is described in Note 2 to our Consolidated Financial Statements contained in our Annual Report on Form 10-K for the year ended December 31, 2010. However, we consider the following policies and estimates to be the most critical in understanding the more complex judgments that are involved in preparing our consolidated financial statements and that could impact our results of operations, financial position, and cash flows:         •   Product Sales-Our net sales consist of revenue from sales of our products,

Vancocin, Cinryze, Buccolam and Diamorphine, less estimates for

chargebacks, rebates, distribution service fees, returns and losses. We

recognize revenue for product sales when title and risk of loss has passed

to the customer, which is typically upon delivery to the customer, when

estimated provisions for chargebacks, rebates, distribution service fees,

returns and losses are reasonably determinable, and when collectability is

reasonably assured. Revenue from the launch of a new or significantly

unique product may be deferred until estimates can be made for

chargebacks, rebates and losses and all of the above conditions are met

and when the product has achieved market acceptance, which is typically

based on dispensed prescription data and other information obtained during

the period following launch.

   At the end of each reporting period we analyze our estimated channel inventory and we would defer recognition of revenue on product that has been delivered if we believe that channel inventory at a period end is in excess of ordinary business needs. Further, if we believe channel inventory levels are increasing without a reasonably correlating increase in prescription demand, we proactively delay the processing of wholesaler orders until these levels are reduced.  We establish accruals for chargebacks and rebates, sales discounts and product returns. These accruals are primarily based upon the history of Vancocin and for Cinryze they are based on information on payee's obtained from our SP/SD's and CinryzeSolutions. We also consider the volume and price of our products in the channel, trends in wholesaler inventory, conditions that might impact patient demand for our product (such as incidence of disease and the threat of generics) and other factors.  In addition to internal information, such as unit sales, we use information from external resources, which we do not verify, to estimate the Vancocin channel inventory. Our external resources include prescription data reported by IMS Health Incorporated and written and verbal information obtained from our three largest wholesaler customers with respect to their inventory levels. Based upon this information, we believe that inventory held at these warehouses are within normal levels.  Chargebacks and rebates are the most subjective sales related accruals. While we currently have no contracts with private third party payors, such as HMO's, we do have contractual arrangements with governmental agencies, including Medicaid. We establish accruals for chargebacks and rebates related to these contracts in the period in which we record the sale as revenue. These accruals are based upon historical experience of government agencies' market share, governmental contractual prices, our current pricing and then-current laws, regulations and interpretations. We analyze the accrual at least quarterly and adjust the balance as needed. These analyses have been adjusted to reflect the U.S. healthcare reform acts and their affect on governmental contractual prices and rebates. We believe that a 10% change in our estimate of the actual rate of sales subject to governmental rebates would affect our operating income and accruals by approximately $2.5 million in the period of adjustment.  

Annually, as part of our process, we performed an analysis on the share of Vancocin and Cinryze sales that ultimately go to Medicaid recipients and result in a Medicaid rebate. As part of that analysis, we considered our actual Medicaid historical rebates processed, total units sold and fluctuations in channel inventory. We also consider our payee mix for Cinryze based on information obtained at the time of prescription.

  Under the PPACA we are required to fund 50% of the Medicare Part D insurance coverage gap for prescription drugs sold to eligible patients staring on January 1, 2011. For Vancocin sales subject to this discount we recognize this cost using an effective rebate percentage for all sales to Medicare patients throughout the year. For applicable Cinryze sales we recognize this cost at the time of sale for                                           88 

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product expected to be purchased by a Medicare Part D insured patient when we estimate they are within the coverage gap.

  Product return accruals are estimated based on Vancocin's history of damage and product expiration returns and are recorded in the period in which we record the sale of revenue. Cinryze has a no returns policy.    

• Impairment of Long-lived Assets-We test our long-lived fixed and

intangible assets for recoverability whenever events occur or changes in

circumstances indicate that the carrying amount of an asset or asset group

may not be recoverable. The impairment test is a two-step test. Under step

         one we assess the recoverability of an asset (or asset group). The          carrying amount of an asset (or asset group) is not recoverable if it          exceeds the sum of the undiscounted cash flows expected from the use and          eventual disposition of the asset (or asset group). The impairment loss is          measured in step two as the difference between the carrying value of the

asset (or asset group) and its fair value. Assumptions and estimates used

in the evaluation of impairment may affect the carrying value of

long-lived assets, which could result in impairment charges in future

periods. Such assumptions include, for example, projections of future cash

flows and the timing and number of generic/competitive entries into the

market, in determining the undiscounted cash flows, and if necessary, the

fair value of the asset and whether impairment exists. These assumptions

         are subjective and could result in a material impact on operating results          in the period of impairment.   On an ongoing periodic basis, we evaluate the useful life of intangible assets and determine if any economic, governmental or regulatory event has modified their estimated useful lives.  On August 4, 2009 the FDA'sPharmaceutical Science and Clinical Pharmacology Advisory Committee voted in favor of the component of the OGD's 2008 draft guidelines on bioequivalence for Vancocin that permits bioequivalence to be demonstrated through comparable in vitro dissolution for potential vancomycin HCl capsule generic products that contain the same active and inactive ingredients in the same amounts as Vancocin, among other requirements. If FDA's proposed bioequivalence method for Vancocin becomes effective, the time period in which a generic competitor could be approved would be reduced and multiple generics may enter the market, which would materially impact our operating results, cash flows and possibly intangible asset valuations. This could also result in a reduction to the useful life of the Vancocin-related intangible assets. Management currently believes there are no indicators that would require a change in useful life as management believes that Vancocin will continue to be utilized along with generics that may enter the market, and the number of generics and the timing of their market entry is unknown.  A reduction in the useful life, as well as the timing and number of generics, will impact our cash flow assumptions and estimate of fair value, perhaps to a level that could result in an impairment charge. We will continue to monitor the actions of the OGD and consider the effects of our opposition actions and any announcements by generic competitors or other adverse events for additional impairment indicators. We will reevaluate the expected cash flows and fair value of our Vancocin-related assets at such time a triggering event occurs.    

• Impairment of Goodwill and Indefinite-lived Intangible Assets-We review

the carrying value of goodwill and indefinite-lived intangible assets, to

         determine whether impairment may exist. The goodwill impairment test          consists of two steps. The first step compares a reporting unit's fair

value to its carrying amount to identify potential goodwill impairment. If

the carrying amount of a reporting unit exceeds the reporting unit's fair

value, the second step of the impairment test must be completed to measure

the amount of the reporting unit's goodwill impairment loss, if any. Step

         two requires an assignment of the reporting unit's fair value to the          reporting unit's assets and liabilities to determine the implied fair          value of the reporting unit's goodwill. The implied fair value of the

reporting unit's goodwill is then compared with the carrying amount of the

reporting unit's goodwill to determine the goodwill impairment loss to be

recognized, if any. The impairment test for indefinite-lived intangible

assets is a one-step test, which compares the fair value of the intangible

         asset to its carrying value. If                                            89 

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the carrying value exceeds its fair value, an impairment loss is

recognized in an amount equal to the excess. Based on accounting

standards, it is required that these assets be assessed at least annually

for impairment unless a triggering event occurs between annual assessments

which would then require an assessment in the period which a triggering

        event occurred.          •   Share-Based Payments-We record the estimated grant date fair value of

awards granted as stock-based compensation expense in our consolidated

         statements of operations over the requisite service period, which is          generally the vesting period.    

• Income Taxes-Our annual effective tax rate is based on pre-tax earnings,

enacted tax laws and statutory tax rates, determination of manufacturing

income and related deduction limits, limitations on the use of tax credits

and net operating loss carryforwards, evaluation of qualified expenses

related to the orphan drug credit and tax planning opportunities available

in the jurisdictions in which we operate. Significant judgment is required

in determining our effective tax rate.

   On a periodic basis, we evaluate the realizability of our deferred tax assets and adjust such amounts in light of changing facts and circumstances, including but not limited to projections of future taxable income, the reversal of deferred tax liabilities, tax legislation, rulings by relevant tax authorities, tax planning strategies and the progress of ongoing tax examinations. As part of this evaluation, we consider whether it is more likely than not that all or some portion of the deferred tax asset will not be realized. The ultimate realization of a deferred tax asset is dependent upon the generation of future taxable income during the period in which the related temporary difference becomes deductible or the NOL and credit carryforwards can be utilized. With respect to the reversal of valuation allowances, we consider the level of past and future taxable income, the existence and nature of reversing deferred tax liabilities, the utilization of carryforwards and other factors. Revisions to the estimated net realizable value of the deferred tax asset could cause our provision for income taxes to vary significantly from period to period.  We recognize the benefit of tax positions that we have taken or expect to take on the income tax returns we file if such tax position is more likely than not of being sustained. Settlement of filing positions that may be challenged by tax authorities could impact our income tax expense in the year of resolution.    

• Acquisition Accounting-The application of the purchase accounting requires

certain estimates and assumptions especially concerning the determination

         of the fair values of the acquired intangible assets and property, plant          and equipment as well as the liabilities assumed at the date of the          acquisition. Moreover, the useful lives of the acquired intangible assets,          property, plant and equipment have to be determined.   The total purchase price of businesses acquired will be allocated to the net tangible assets and identifiable intangible assets based on their fair values as of the date of the acquisition and the fair value of any contingent consideration. Changes in the fair value of contingent consideration will be expensed in the period in which the change in fair value occurs. Additionally, acquired IPR&D projects will initially be capitalized and considered indefinite-lived assets subject to annual impairment reviews or more often upon the occurrence of certain events. For those compounds that reach commercialization, the assets are amortized over the expected useful lives.  Measurement of fair value and useful lives are based to a large extent on anticipated cash flows. If actual cash flows vary from those used in calculating fair values, this may significantly affect our future results of operations. In particular, the estimation of discounted cash flows of intangible assets of newly developed products is subject to assumptions closely related to the nature of the acquired products. Factors that may affect the assumptions regarding future cash flows:      •   long-term sales forecasts,             •    anticipation of selling price erosion after the end of orphan              exclusivity due to follow-on biologic competition in the market,             •    behavior of competitors (launch of competing products, marketing              initiatives etc.).                                            90 

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  For significant acquisitions, the purchase price allocation is carried out with assistance from independent third-party valuation specialists. The valuations are based on information available at the acquisition date.  

As our business evolves, we may face additional issues that will require increased levels of management estimation and complex judgments.

Recently Issued Accounting Pronouncements

  In September 2009, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. This ASU amends certain disclosure requirements of Topic 820 to provide for additional disclosures for transfers in and out of Levels 1 and 2 and for activity in Level 3. The ASU also clarifies certain other disclosure requirements including level of disaggregation and disclosures around inputs and valuation techniques. We adopted this ASU on January 1, 2010. The new disclosures about the purchases, sales, issuances and settlements in the roll forward activity for Level 3 fair value measurements are effective for fiscal years beginning after December 15, 2010 and we adopted this provision on January 1, 2011. The adoption of this disclosure provision did not have a material impact on our results of operations, cash flows, and financial position.  In October 2009, the FASB issued ASU No. 2009-13, Multiple-Deliverable Revenue Arrangements, or ASU 2009-13, formerly EITF Issue No. 08-1. ASU 2009-13, which amends existing revenue recognition accounting pronouncements that are currently within the scope of FASB ASC Topic 605 and provides accounting principles and application guidance on how the arrangement should be separated, and the consideration allocated. This guidance changes how to determine the fair value of undelivered products and services for separate revenue recognition. Allocation of consideration is now based on management's estimate of the selling price for an undelivered item where there is no other means to determine the fair value of that undelivered item. This new approach is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. We adopted this ASU January 1, 2011. The adoption of the provisions of this guidance did not have a material impact on our results of operations, cash flows, and financial position.  In March 2010, the FASB ratified EITF Issue No. 08-9, Milestone Method of Revenue Recognition, and as a result of this ratification the FASB issued ASU 2010-17 in April 2010, which states that the milestone method is a valid application of the proportional performance model for revenue recognition if the milestones are substantive and there is substantive uncertainty about whether the milestones will be achieved. The Task Force agreed that whether a milestone is substantive is a judgment that should be made at the inception of the arrangement. To meet the definition of a substantive milestone, the consideration earned by achieving the milestone (1) would have to be commensurate with either the level of effort required to achieve the milestone or the enhancement in the value of the item delivered, (2) would have to relate solely to past performance, and (3) should be reasonable relative to all deliverables and payment terms in the arrangement. No bifurcation of an individual milestone is allowed and there can be more than one milestone in an arrangement. The new guidance is effective for interim and annual periods beginning on or after June 15, 2010. We adopted this ASU January 1, 2011. The adoption of this guidance did not have a material impact on our results of operations, cash flows, and financial position.  In December 2010, the FASB issued ASU 2010-27, Fees Paid to the Federal Government by Pharmaceutical Manufactures (EITF Issue 10-D; ASC 720), which addresses how pharmaceutical manufacturers should recognize and classify in the income statement fees mandated by the Patient Protection and Affordable Care Act as amended by the Health Care Education Reconciliation Act. The ASU specifies that the liability for the fee be estimated and recorded in full upon the first qualifying sale with a corresponding deferred cost that is amortized to operating expense using a straight-line method of allocation unless another method better allocates the fee over the calendar year. The new guidance is effective for calendar years beginning after December 31, 2010. We adopted this ASU January 1, 2011. The adoption of this guidance does not have a material impact on our results of operations, cash flows, and financial position.                                           91

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  In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, and the IASB issued IFRS 13, Fair Value Measurement. The new guidance results in a consistent definition of fair value and common requirements for measurement of and disclosure about fair value between U.S. GAAP and IFRS. The ASU is effective for interim and annual periods beginning on or after December 15, 2011, with early adoption prohibited. The new guidance changes certain fair value measurement principles and disclosure requirements. We do not expect the amendment to U.S. GAAP to have a material impact on our results of operations, cash flows, and financial position.  In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income (Topic 220). This standard eliminates the current option to report other comprehensive income and its components in the statement of changes in equity. The standard is intended to enhance comparability between entities that report under U.S. GAAP and those that report under IFRS, and to provide a more consistent method of presenting non-owner transactions that affect an entity's equity. Under the ASU, an entity can elect to present items of net income and other comprehensive income in one continuous statement, referred to as the statement of comprehensive income, or in two separate, but consecutive, statements. Each component of net income and each component of other comprehensive income, together with totals for comprehensive income and its two parts, net income and other comprehensive income, would need to be displayed under either alternative. The statement(s) would need to be presented with equal prominence as the other primary financial statements. This ASU does not change items that constitute net income and other comprehensive income, when an item of other comprehensive income must be reclassified to net income or the earnings-per-share computation (which will continue to be based on net income). The new U.S. GAAP requirements are effective for public entities as of the beginning of a fiscal year that begins after December 15, 2011 and interim and annual periods thereafter. Early adoption is permitted, but full retrospective application is required under the accounting standard. We do not expect the amendment to U.S. GAAP to have a material impact on our results of operations, cash flows, and financial position.  In December 2011, the FASB issued ASU 2011-12, Deferral of the Effective Date for Amendments to Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update 2011-05. This ASU defers certain provisions of ASU 2011-05, which required entities to present reclassification adjustments out of accumulated other comprehensive income by component in the statement in which net income is presented and the statement in which comprehensive income is presented for both interim and annual periods. This requirement is indefinitely deferred by this ASU and will be further deliberated by the FASB at a future date. The new ASU is effective for public entities as of the beginning of a fiscal year that begins after December 15, 2011 and interim and annual periods thereafter, the same as that for the unaffected provisions of ASU 2011-05. We do not expect the amendments in this ASU to have a material impact on our results of operations, cash flows, and financial position.  In September 2011, the FASB issued ASU 2011-08, Testing Goodwill for Impairment (the revised standard) (Topic 350). The objective of this Update is to simplify how entities test goodwill for impairment. The amendments in the Update provide the option to first assess qualitative factors to determine whether it is necessary to perform the current two-step test. If an entity believes, as a result of its qualitative assessment, that it is more-likely-than-not (a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. The revised standard includes examples of events and circumstances that might indicate that a reporting unit's fair value is less than its carrying amount. These include macro-economic conditions such as deterioration in the entity's operating environment, entity-specific events such as declining financial performance, and other events such as an expectation that a reporting unit will be sold. An entity should also consider in its qualitative assessment the "cushion" between a reporting unit's fair value and carrying amount if determined in a recent fair value calculation. The revised standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, if a company has not yet issued financial statements for the most recent annual or interim period, provided that the entity has not yet performed its 2011 annual impairment test. We do not expect the adoption of this guidance to have a material impact on our results of operations, cash flows, and financial position.                                           92 

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