Cephalon 10Q 2006 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2006

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

For the transition period from to

Commission File Number 000-19119

CEPHALON, INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware		23-2484489
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification Number)

41 Moores Road, Frazer, Pennsylvania		19355
(Address of Principal Executive Offices)		(Zip Code)

(610) 344-0200

(Registrant’s Telephone Number, Including Area Code)

Not Applicable

(Former Name, Former Address and Former Fiscal Year, If Changed Since Last Report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Large accelerated filer x Accelerated filer o Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.

Class		Outstanding as of November 1, 2006
Common Stock, par value $.01		60,965,523 Shares

TABLE OF CONTENTS

Cautionary Note Regarding Forward-Looking Statements			ii

PART I – FINANCIAL INFORMATION

	Item 1.	Consolidated Financial Statements

		Consolidated Balance Sheets - September 30, 2006 and December 31, 2005	1

		Consolidated Statements of Operations - Three and nine months ended September 30, 2006 and 2005	2

		Consolidated Statements of Stockholders’ Equity - September 30, 2006 and December 31, 2005	3

		Consolidated Statements of Cash Flows - Nine months ended September 30, 2006 and 2005	4

		Notes to Consolidated Financial Statements	5

	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18

	Item 3.	Quantitative and Qualitative Disclosure About Market Risk	35

	Item 4.	Controls and Procedures	36

PART II – OTHER INFORMATION

	Item 1.	Legal Proceedings	37

	Item 1A.	Risk Factors	37

	Item 5.	Other Information	48

	Item 6.	Exhibits	49

SIGNATURES			50

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

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

· our dependence on sales of PROVIGIL® (modafinil) [C-IV] in the United States and the market prospects and future marketing efforts for PROVIGIL, FENTORA™ (fentanyl buccal tablet) [C-II] and VIVITROL® (naltrexone for extended-release injectable suspension);

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

· our anticipated scientific progress in our research programs and our development of potential pharmaceutical products including our ongoing or planned clinical trials, the timing and costs of such trials and the likelihood or timing of revenues from these products, if any;

· the timing and unpredictability of regulatory approvals;

· our ability to adequately protect our technology and enforce our intellectual property rights and the future expiration of patent and/or regulatory exclusivity on certain of our products;

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

· other statements regarding matters that are not historical facts or statements of current condition.

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

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

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

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

· unanticipated cash requirements to support current operations, expand our business or incur capital expenditures;

· the inability to adequately protect our key intellectual property rights;

· the loss of key management or scientific personnel;

· the activities of our competitors in the industry, including the impact of generic competition to ACTIQ;

· regulatory or other setbacks with respect to our settlements of the PROVIGIL and ACTIQ patent litigations;

· unanticipated conversion of our convertible notes by our note holders;

· market conditions in the biopharmaceutical industry that make raising capital or consummating acquisitions

difficult, expensive or both; and

· enactment of new government laws, regulations, court decisions, regulatory interpretations or other initiatives that are adverse to us or our interests.

We do not intend to update publicly any forward-looking statement, whether as a result of new information, future events or otherwise, except as required by law. We discuss in more detail the risks that we anticipate in the section above included in Part II, Item 1A of this report. This discussion is permitted by the Private Securities Litigation Reform Act of 1995.

iii

PART I - FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

CEPHALON, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

(Unaudited)

	September 30,			December 31,
	2006			2005
ASSETS

CURRENT ASSETS:
Cash and cash equivalents	$	630,363		$	205,060
Investments	37,619			279,030
Receivables, net	234,675			199,086
Inventory, net	164,664			137,886
Deferred tax assets, net	170,131			187,436
Other current assets	43,937			40,339
Total current assets	1,281,389			1,048,837

PROPERTY AND EQUIPMENT, net	391,846			323,830
GOODWILL	472,152			471,051
INTANGIBLE ASSETS, net	799,756			742,874
DEFERRED TAX ASSETS, net	164,919			200,629
OTHER ASSETS	17,498			31,985
	$	3,127,560		$	2,819,206

LIABILITIES AND STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES:
Current portion of long-term debt	$	933,494		$	933,160
Accounts payable	63,492			53,699
Accrued expenses	245,011			291,744
Total current liabilities	1,241,997			1,278,603

LONG-TERM DEBT	762,404			763,097
DEFERRED TAX LIABILITIES, net	87,228			110,703
OTHER LIABILITIES	58,764			54,632
Total liabilities	2,150,393			2,207,035

COMMITMENTS AND CONTINGENCIES	—			—

STOCKHOLDERS’ EQUITY:
Preferred stock, $.01 par value, 5,000,000 shares authorized, 2,500,000 shares issued, and none outstanding	—			—
Common stock, $.01 par value, 200,000,000 shares authorized, 60,846,575 and 58,445,405 shares issued, and 60,468,051 and 58,072,562 shares outstanding	608			584
Additional paid-in capital	1,333,340			1,166,166
Treasury stock, at cost, 378,524 and 372,843 shares outstanding	(17,558		)	(17,125		)
Accumulated deficit	(420,347		)	(570,072		)
Accumulated other comprehensive income	81,124			32,618
Total stockholders’ equity	977,167			612,171
	$	3,127,560		$	2,819,206

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

CEPHALON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
REVENUES:
Sales	$	470,513		$	294,371		$	1,246,825		$	833,588
Other revenues	11,820			15,165			32,562			41,900
	482,333			309,536			1,279,387			875,488

COSTS AND EXPENSES:
Cost of sales	62,356			37,629			189,848			114,093
Research and development	81,012			91,934			279,765			255,591
Selling, general and administrative	157,490			103,253			460,068			302,904
Depreciation and amortization	29,849			22,346			85,989			61,151
Impairment charge	—			—			12,417			—
Acquired in-process research and development	—			5,500			—			295,615
	330,707			260,662			1,028,087			1,029,354

INCOME (LOSS) FROM OPERATIONS	151,626			48,874			251,300			(153,866		)

OTHER INCOME (EXPENSE):
Interest income	7,046			7,247			16,736			19,559
Interest expense	(4,749		)	(7,494		)	(13,523		)	(19,311		)
Write-off of deferred debt issuance costs	—			—			(13,105		)	—
Gain on early extinguishment of debt	—			2,085			—			2,085
Other income (expense), net	895			(38		)	(116		)	1,983
	3,192			1,800			(10,008		)	4,316

INCOME (LOSS) BEFORE INCOME TAXES	154,818			50,674			241,292			(149,550		)

INCOME TAX EXPENSE	59,077			21,331			91,567			43,477

NET INCOME (LOSS)	$	95,741		$	29,343		$	149,725		$	(193,027	)

BASIC INCOME (LOSS) PER COMMON SHARE	$	1.58		$	0.51		$	2.48		$	(3.33	)

DILUTED INCOME (LOSS) PER COMMON SHARE	$	1.43		$	0.50		$	2.17		$	(3.33	)

WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING	60,762			58,064			60,415			58,035

WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING- ASSUMING DILUTION	67,072			59,398			68,921			58,035

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

CEPHALON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(In thousands, except share data)

(Unaudited)

																				Accumulated
										Additional										Other
	Comprehensive						Common Stock			Paid-in			Treasury Stock				Accumulated			Comprehensive
	Income (Loss)			Total			Shares	Amount		Capital			Shares	Amount			Deficit			Income
BALANCE, JANUARY 1, 2005				$	830,044		57,973,050	$	580	$	1,172,499		332,784	$	(14,860	)	$	(395,118	)	$	66,943
Net loss	$	(174,954	)	(174,954		)											(174,954		)
Foreign currency translation loss	(33,317		)
Unrealized investment losses	(1,008		)
Other comprehensive loss	(34,325		)	(34,325		)														(34,325		)
Comprehensive loss	$	(209,279	)
Sale of warrants associated with convertible subordinated notes				217,071						217,071
Purchase of convertible note hedge associated with convertible subordinated notes				(382,261		)				(382,261		)
Tax benefit from the purchase of convertible note hedge				133,791						133,791
Stock options exercised				11,460			346,730	3		11,457
Tax benefit from the exercise of stock options, net of adjustment				2,826						2,826
Restricted stock award plan				10,784			125,625	1		10,783
Treasury stock acquired				(2,265		)							40,059	(2,265		)
BALANCE, DECEMBER 31, 2005				612,171			58,445,405	584		1,166,166			372,843	(17,125		)	(570,072		)	32,618
Net income	$	149,725		149,725													149,725
Foreign currency translation gain	47,635
Unrealized investment gains	871
Other comprehensive gain	48,506			48,506																48,506
Comprehensive income	$	198,231
Issuance of common stock upon conversion of convertible notes				56			943			56
Stock options exercised				112,794			2,400,227	24		112,770
Tax benefit from equity compensation				21,912						21,912
Stock-based compensation expense				32,436						32,436
Treasury stock acquired				(433		)							5,681	(433		)
BALANCE, SEPTEMBER 30, 2006				$	977,167		60,846,575	$	608	$	1,333,340		378,524	$	(17,558	)	$	(420,347	)	$	81,124

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

CEPHALON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Nine Months Ended
	September 30,
	2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)	$	149,725		$	(193,027	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Deferred income tax expense	64,112			27,931
Tax benefit from stock-based compensation	—			3,956
Depreciation and amortization	94,828			70,966
Amortization of debt issuance costs	387			6,521
Write-off of debt issuance costs associated with Zero Coupon convertible subordinated notes	13,105			—
Stock-based compensation expense	32,436			7,631
Non-cash gain on early extinguishment of debt	—			(4,549		)
Loss on disposals of property and equipment	2,368			949
Impairment charge	12,417			—
Acquired in-process research and development	—			130,615
Changes in operating assets and liabilities, net of effect from acquisitions:
Receivables	(30,818		)	43,347
Inventory	(22,837		)	(37,084		)
Other assets	(5,133		)	910
Accounts payable, accrued expenses and deferred revenues	(45,820		)	21,671
Other liabilities	(13,580		)	(11,428		)
Net cash provided by operating activities	251,190			68,409

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment	(97,122		)	(63,951		)
Acquisition of Salmedix, net of cash acquired	—			(130,733		)
Acquisition of TRISENOX	—			(69,722		)
Acquisition of intangible assets	(115,000		)	(2,652		)
Sales and maturities of investments	244,165			90,361
Purchases of investments	(1,505		)	(104,474		)
Net cash provided by (used for) investing activities	30,538			(281,171		)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercises of common stock options	112,794			2,247
Windfall tax benefits from stock-based compensation	21,912			—
Acquisition of treasury stock	(433		)	(32		)
Payments on and retirements of long-term debt	(2,528		)	(501,958		)
Net proceeds from issuance of convertible subordinated notes	—			891,949
Proceeds from sale of warrants	—			217,071
Purchase of convertible note hedge	—			(382,261		)
Net cash provided by financing activities	131,745			227,016

EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS	11,830			(3,222		)

NET INCREASE IN CASH AND CASH EQUIVALENTS	425,303			11,032

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD	205,060			574,244

CASH AND CASH EQUIVALENTS, END OF PERIOD	$	630,363		$	585,276

Non-cash financing activities:
Tax benefit from the purchase of convertible note hedge	$	—		$	133,791

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

CEPHALON, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except per share data)

(Unaudited)

1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnote disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission, which includes audited financial statements as of December 31, 2005 and 2004 and for each of the three years in the period ended December 31, 2005. The results of our operations for any interim period are not necessarily indicative of the results of our operations for any other interim period or for a full year.

Reclassifications

Reclassifications of certain prior year amounts have been made to conform with the current year presentation.

Recent Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in the tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the effect FIN 48 will have on the company’s financial position, liquidity and statement of operations. The cumulative effect of applying the provisions of FIN 48 will be reported as an adjustment to the opening balance of retained earnings upon adoption.

In September 2006, the FASB issued FASB Statement No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 clarifies the definition of fair value, establishes a framework for measuring fair value and expands the disclosures on fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of SFAS 157 adoption on our consolidated financial statements.

In September 2006, the FASB issued FASB Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS 158”). SFAS 158 requires the recognition of the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position, the measurement of a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year and the recognition of changes in that funded status in the year in which the changes occur through comprehensive income. SFAS 158 is effective for us as of December 31, 2006. We are currently evaluating the impact of SFAS 158 and we do not expect the adoption of this statement to have a material impact on our financial statements.

Revenue Recognition

The following is in addition to, and should be read in conjunction with, the revenue recognition significant accounting policy included in Part II, Item 8, footnote 1 of our Annual Report on Form 10-K for the year ended December 31, 2005.

We recognize revenue on new product launches when sales returns can be reasonably estimated and all other revenue recognition requirements have been met. When determining if returns can be estimated, we consider actual returns of similar products as well as sales returns with similar customers. In cases in which a new product is not an extension of an existing line of product or where the company has no history of experience with products in a similar therapeutic category such that we can not estimate expected returns of the new product, we defer recognition of revenue until the right of return no longer exists or until we have developed sufficient historical experience to estimate sales returns. In developing estimates for sales returns, we consider inventory levels in the distribution channel, shelf life of the product and expected demand based on market data and prescriptions.

On September 27, 2006, Barr began selling a generic version of oral transmucosal fentanyl citrate (“generic OTFC”) in the U.S. market. On that same date, we also entered the market with a generic OTFC, utilizing Watson Pharma, Inc. as our sales agent in this effort. As of the end of the third quarter of 2006, inventory held at the wholesalers of ACTIQ totaled approximately 0.4 million units and inventory held at the wholesalers and retailers of our generic OTFC totaled approximately 1.3 million units. According to prescription data provided by IMS Health, the average demand for ACTIQ during the 12-month period between August 2005 and July 2006 was approximately 2.4 million units per month.

The terms of sale of Cephalon’s generic OTFC product to wholesalers and retailers provide for both the right of return of expired product and retroactive price reductions under certain conditions. Given the limited sales data history for the generic OTFC products and the estimated level of inventory at the wholesalers and retailers, it is not possible at this time to assess the relative future market shares for each of the generic OTFC products and the branded ACTIQ product or the potential for further generic entrants into the market. In light of these uncertainties, we do not believe that the price charged to wholesalers and retailers for the majority of our generic OTFC sold during the quarter was fixed or determinable. As such, we have not recognized revenue during the quarter. We will continue to assess the development in the market and our ability to estimate returns and the final sales price.

2. ACQUISITIONS AND TRANSACTIONS

VIVITROL LICENSE AND COLLABORATION

In June 2005, we entered into a license and collaboration agreement with Alkermes, Inc. to develop and commercialize VIVITROL® (naltrexone for extended-release injectable suspension) in the United States. In April 2006, the U.S. Food and Drug Administration (“FDA”) approved VIVITROL for the treatment of alcohol dependent patients who are able to abstain from drinking in an outpatient setting and are not actively drinking when initiating treatment and, in June 2006, we launched the product.

Concurrent with the execution of this agreement, we entered into a supply agreement under which Alkermes provides to us finished commercial supplies of VIVITROL. We made an initial payment of $160 million cash to Alkermes upon execution of this agreement, all of which was recorded as an in-process research and development charge (“IPR&D”) as the product had not yet received FDA approval. In April 2006, we made an additional cash payment of $110 million to Alkermes upon FDA approval of the product. This payment has been capitalized and is being amortized over the life of the agreement. Alkermes also could receive up to an additional $220 million in milestone payments from us upon attainment of certain agreed-upon sales levels of VIVITROL.

Cephalon and Alkermes have formed a joint steering committee that shares responsibility for the commercialization, development and supply strategy for VIVITROL. We have primary responsibility for the commercialization of VIVITROL, while Alkermes is responsible for manufacturing the product. Until December 31, 2007, Alkermes is responsible for any cumulative losses up to $120 million and we are responsible for any cumulative losses in excess of $120 million. Pre-tax profit, as adjusted for certain items, and losses incurred after December 31, 2007 will be split equally between the parties. We began recognizing revenue for VIVITROL effective in the third quarter of 2006.

In October 2006, Cephalon and Alkermes amended the existing license and collaboration agreement to provide that Cephalon would be responsible for its own VIVITROL-related costs during the period August 1, 2006 through December 31, 2006 and, for that period, such costs will not be chargeable to the collaboration and against the $120 million cumulative loss cap. The parties also agreed to amend the existing supply agreement to provide that Cephalon will purchase from Alkermes two VIVITROL manufacturing lines (and related equipment). As of the filing date of this report, Alkermes has spent approximately $19 million on construction of these two manufacturing lines and will be reimbursed by Cephalon for these expenditures and for certain future capital improvements related to these two manufacturing lines. Cephalon also has granted Alkermes an option, exercisable after two years, to purchase these manufacturing lines at the then-current net book value of the assets.

ZENEUS HOLDINGS LIMITED

On December 22, 2005, we completed our acquisition of all of the issued share capital of Zeneus Holdings Limited (“Zeneus”). Total consideration paid in connection with the acquisition was $365.8 million. Total purchase price after transaction costs and other working capital adjustments was $385.6 million, which included payment for $19.8 million of cash acquired. Zeneus, a European specialty pharmaceutical company headquartered in the United Kingdom, has three key products that are currently marketed in key European countries: Myocet, used in the treatment of metastatic breast cancer; Abelcet, used as an antifungal treatment; and Targretin, used to treat the skin manifestations of cutaneous T-cell lymphoma. Key customer targets are oncologists, hematologists and dermatologists.

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

The following table summarizes the estimated fair values of assets acquired and liabilities assumed at the date of acquisition:

	At December 22,
	2005
Cash and cash equivalents	$	19,792
Receivables	29,577
Inventory	12,085
Other current assets	6,316
Property, plant and equipment	1,319
Intangible assets	224,100
Acquired in-process research and development	71,200
Goodwill	106,706
Total assets acquired	471,095
Other liabilities	(34,303		)
Deferred tax liability	(51,214		)
Total liabilities assumed	(85,517		)
Net assets acquired	$	385,578

The purchase price allocation was finalized during the third quarter of 2006. We did not make any significant adjustments to the purchase price allocation during the third quarter of 2006. During the second quarter of 2006, we finalized the Zeneus integration plan as it relates to employee severance costs and recorded a reserve for employee termination benefits of $3.4 million. This reserve is for employee severance costs related to 31 employees throughout the organization including finance, legal, clinical and regulatory, sales and marketing and general administration. The termination of these employees is substantially complete as of September 30, 2006. Severance payments are expected to be completed by the end of 2007.

As part of our purchase price allocation, during the second quarter of 2006, we finalized our valuation of the Zeneus intellectual property and, as a result of this review, we have reduced the net book value of the Myocet intellectual property by $12.2 million. Also during the second quarter of 2006, we reduced the net deferred tax liability by $19.7 million. This adjustment was to record the deferred tax effect on deferred revenue and intellectual property adjustments described above as well as the finalization of our assessment of the deductibility of previously acquired intangible assets.

The following unaudited pro forma information shows the results of our operations for the three and nine months ended September 30, 2005 as though the acquisition had occurred as of the beginning of the period presented:

	For the three		For the nine
	months ended		months ended
	September 30, 2005		September 30, 2005
Total revenues	$	332,319	$	946,280
Net income (loss)	$	27,637	$	(199,411	)
Basic and diluted net income (loss) per common share:
Basic income (loss) per common share	$	0.48	$	(3.44	)
Diluted income (loss) per common share	$	0.47	$	(3.44	)

The pro forma results have been prepared for comparative purposes only and are not necessarily indicative of the actual results of operations had the acquisition taken place as of the beginning of the periods presented, or the results that may occur in the future. Furthermore, the pro forma results do not give effect to all cost savings or incremental costs that may occur as a result of the integration and consolidation of the acquisition.

CO-PROMOTION AGREEMENT WITH TAKEDA

On June 12, 2006, we entered into a co-promotion agreement with a three-year term effective July 1, 2006 with Takeda Pharmaceuticals North America, Inc. (“Takeda”) with respect to PROVIGIL in the United States.

Under the co-promotion agreement, Takeda agreed to have at least 500 of its sales representatives promote PROVIGIL to primary care physicians and other appropriate health care professionals in the United States. Effective on January 1, 2007, Takeda will have 750 sales representatives promoting PROVIGIL. Together with our sales representatives, there will be nearly 1,200 sales representatives promoting PROVIGIL as of January 1, 2007. We also have an option to utilize the Takeda sales force for the promotion of NUVIGIL, assuming FDA approval of this product candidate. The parties have formed a joint commercialization committee to manage the promotion of PROVIGIL. We have retained all responsibility for the development, manufacture, distribution and sale of the product.

We will pay Takeda a royalty based on certain sales criteria for PROVIGIL and NUVIGIL during the three-year term and, if specified sales levels are reached, during the three calendar years following the expiration of the co-promotion agreement.

3. STOCK-BASED COMPENSATION

Equity Compensation Plans

We have established equity compensation plans for our employees, directors and certain other individuals. All grants and terms are authorized by the Stock Option and Compensation Committee of our Board of Directors. We may grant non-qualified stock options under the Cephalon, Inc. 2004 Equity Compensation Plan (the “2004 Plan”) and the Cephalon, Inc. 2000 Equity Compensation Plan (the “2000 Plan”), and also may grant incentive stock options and restricted stock awards under the 2004 Plan. Options and restricted stock awards generally become exercisable or vest ratably over four years from the grant date, and options must be exercised within ten years of the grant date. There are currently 11.5 million and 4.3 million shares authorized for issuance under the 2004 Plan and the 2000 Plan, respectively. At September 30, 2006, the shares available for future grants of stock options or restricted stock awards were 1,961,944, of which up to 607,409 may be issued as restricted stock awards.

Prior to the January 1, 2006 adoption of the FASB Statement No. 123(R), “Share Based Payment” (“SFAS 123(R)”), we accounted for stock option plans and restricted stock award plans in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees.” Accordingly, no compensation expense has been recognized for stock options since all options granted had an exercise price equal to the market value of the underlying stock on the grant date. Restricted stock awards have been recorded as compensation cost over the requisite vesting periods based on the market value on the date of grant. As permitted by SFAS No. 123, “Accounting for Stock-Based Compensation (“SFAS 123”), stock-based compensation was presented as a pro forma disclosure in the notes to the consolidated financial statements.

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123(R), using the modified-prospective transition method. Under this transition method, stock-based compensation is recognized in the consolidated financial statements for stock granted. Compensation expense recognized in the financial statements includes estimated expense for stock options granted after December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R), and the estimated expense for the options granted prior to, but not vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. SFAS 123(R) also requires us to estimate forfeitures in calculating the expense relating to stock-based compensation as opposed to only recognizing forfeitures and the corresponding reduction in expense as they occur. We recorded an adjustment for this cumulative effect for restricted stock awards and recognized a reduction in stock-based compensation in the first quarter of 2006 consolidated statements of operations allocated evenly between research and development and selling, general and administrative expenses based on the employees’ compensation allocation between these line items. The adjustment was not significant to the consolidated statement of operations.

Total stock-based compensation expense recognized in the consolidated statement of operations for the three months ended September 30, 2006 was $9.7 million before income taxes or $6.2 million after-tax. The impact of stock-based compensation expense on basic income per common share and diluted income per common share was $0.10 and $0.09, respectively. Stock-based compensation expense consisted of stock option and restricted stock expense of $6.7 million and $3.0 million, respectively. Total stock-based compensation expense recognized in the consolidated statement of operations for the nine months ended September 30, 2006 was $32.4 million before income taxes or $20.5 million after-tax. The impact of stock-based compensation expense on basic income per common share and diluted income per common share was $0.34 and $0.30, respectively. Stock-based compensation expense consisted of stock option and restricted stock expense of $23.9 million and $8.5 million, respectively. This expense was recognized evenly between research and development and selling, general and administrative expenses based on the employees’ compensation allocation between these line items. Compensation expense is recognized in the period the employee performs the service in accordance with FASB Interpretation Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans (“FIN 28”). The impact of capitalizing stock-based compensation was not significant at September 30, 2006.

During the second quarter of 2006, we elected to adopt the short-cut method of FASB Staff Position (“FSP”) No. FAS 123(R)-3 “The Transition Election Related to Accounting for the Tax Effects of Share Based Payment Awards” to determine our pool of windfall tax benefits under FAS 123(R). Under the short-cut method, our historical pool of windfall tax benefits was calculated as cumulative net increases to additional paid in capital related to tax benefits from stock-based compensation after the election date of FAS 123 less the product of cumulative FAS 123 compensation cost, as adjusted, multiplied by the blended statutory tax rate at adoption of FAS 123(R). Using this calculation, we determined our historical windfall tax pool was zero as of January 1, 2006. Following the guidance within FSP FAS 123(R)-3, we retrospectively applied the short-cut method to our consolidated financial statements for the three months ended March 31, 2006. Under the transition provisions of the short-cut method, for awards fully vested at the adoption date of FAS 123(R) and subsequently settled, the pool of windfall tax benefits is equal to the total tax benefit recognized in additional paid in capital upon settlement. Prior to the election of the short-cut method, we accounted for the on-going income tax effects for partially or

fully vested awards as of the date of FAS 123(R) adoption using the “as if” method of accounting required by the long-form method under FAS 123(R). The retrospective application adjustments to our consolidated financial statements for the three months ended March 31, 2006 had no impact on our financial position or results of operations. For the three months ended March 31, 2006, there was no change to our total net cash flows; however, our net cash used for operating activities increased by $21.5 million to $33.6 million and our net cash provided by financing activities increased by $21.5 million to $127.9 million. Upon adoption during the second quarter of 2006, the impact of the election was not significant to our consolidated financial statements. The cumulative pool of windfall tax benefits was $21.9 million as of September 30, 2006

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

Our expected term of options granted was derived from the average midpoint between vesting and the contractual term, as described in SEC’s Staff Accounting Bulletin No. 107, “Share-Based Payment.” For 2006, expected volatilities are based on a combination of implied volatilities from traded options on our stock and the historical volatility of our stock for the related vesting period. The risk-free interest rate is based on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent remaining term. We have not paid dividends in the past and do not plan to pay any dividends in the foreseeable future.

The following table illustrates the effect on pro forma net income (loss) and earnings per share if we had applied the fair value recognition provisions of SFAS 123:

	For the three months ended September 30, 2005			For the nine months ended September 30, 2005
Net income (loss), as reported	$	29,343		$	(193,027	)
Add: Stock-based compensation expense included in net income (loss), net of related tax effects	1,473			5,099
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects	(6,514		)	(22,664		)
Pro forma net income (loss)	$	24,302		$	(210,592	)

Earnings per share:
Basic income (loss) per share, as reported	$	0.51		$	(3.33	)
Basic income (loss) per share, pro forma	$	0.42		$	(3.63	)

Diluted income (loss) per share, as reported	$	0.50		$	(3.33	)
Diluted income (loss) per share, pro forma	$	0.42		$	(3.63	)

The fair value of each option grant at the grant date is calculated using the Black-Scholes option-pricing model with the following weighted average assumptions:

	For the three months ended						For the nine months ended
	September 30,						September 30,
	2006			2005			2006			2005
				(Pro forma)						(Pro forma)
Risk free interest rate	4.90		%	4.19		%	4.98		%	3.81		%
Expected term (years)	6.25			6.50			5.74			6.50
Expected volatility	48.7		%	45.0		%	51.3		%	52.1		%
Expected dividend yield	—		%	—		%	—		%	—		%

Estimated fair value per option granted	$	35.51		$	21.67		$	33.22		$	24.52

Stock Options

The following tables summarize the aggregate option activity under the plans for the nine months ended September 30, 2006:

	Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (years)	Aggregate Intrinsic Value
Outstanding, January 1, 2006	9,955,904		$	50.84
Granted	148,300		61.90
Exercised	(2,400,227	)	46.88
Forfeited	(246,125	)	50.01
Expired	(32,699	)	49.80
Outstanding, September 30, 2006	7,425,153		$	52.33	6.4	$	83,738
Vested options at end of period	4,520,567		$	53.96	5.4	$	48,812

	Options Outstanding				Vested Options
Range of Exercise Price	Shares	Weighted Average Remaining Contractual Life (years)	Weighted Average Exercise Price		Shares	Weighted Average Exercise Price
$6.00-$14.99	274,550	1.8	$	9.47	274,550	$	9.47
$15.00-$29.99	166,401	2.8	26.50		166,401	26.50
$30.00-$50.99	2,443,652	7.4	47.62		899,165	47.08
$51.00-$59.99	2,870,175	6.6	51.72		1,592,976	52.14
$60.00-$71.96	1,670,375	5.5	69.88		1,587,475	70.26
	7,425,153	6.4	52.33		4,520,567	53.96

As of September 30, 2006, there was approximately $28.3 million of total unrecognized compensation cost related to outstanding options that is expected to be recognized over a weighted-average period of 1.3 years. For the nine months ended September 30, 2006 and 2005, we received net proceeds of $112.8 million and $2.2 million, respectively, from the exercise of stock options.

The intrinsic value of stock options exercised during the third quarter of 2006 and 2005 was $1.4 million and $0.4 million, respectively. The estimated fair value of shares that vested during the third quarter of 2006 and 2005 was $0.8 million for both periods.

Restricted Stock

The following table summarizes restricted stock award activity for the nine months ended September 30, 2006:

	Shares			Weighted Average Fair Value
Nonvested, January 1, 2006	624,575			$	49.52
Granted	5,000			70.50
Vested	—			—
Forfeited	(55,775		)	49.47
Nonvested, September 30, 2006	573,800			$	49.71
Intrinsic Value as of September 30, 2006	$	35,432,150

As of September 30, 2006, there was approximately $12.6 million of total unrecognized compensation cost related to nonvested restricted stock awards that is expected to be recognized over a weighted-average period of 1.4 years. Total compensation for restricted stock was $3.0 million and $2.5 million, respectively, for the three months ended September 30, 2006 and 2005 and $8.5 million and $7.6 million, respectively, for the nine months ended September 30, 2006 and 2005.

There were no restricted stock awards shares released from restriction during the third quarter of 2006 and 2005.

4. INVENTORY, NET

Inventory consisted of the following:

	September 30,		December 31,
	2006		2005
Raw materials	$	103,066	$	67,164
Work-in-process	20,636		28,430
Finished goods	40,962		42,292
	$	164,664	$	137,886

We capitalize inventory costs associated with marketed products and certain products prior to regulatory approval and product launch, based on management’s judgment of probable future commercial use and net realizable value. We could be required to expense previously capitalized costs related to pre-approval or pre-launch inventory upon a change in such judgment, due to a denial or delay of approval by regulatory bodies, a delay in commercialization, or other potential factors. At September 30, 2006, we had $83.2 million of capitalized inventory costs related to NUVIGIL, net of reserves of $5.0 million, as we do not expect that certain batches in inventory will be sold prior to their expiration date.

On August 9, 2006, we announced that we received a letter from the FDA stating that our supplemental new drug application (“sNDA”) for SPARLON™ (modafinil) Tablets [C-IV], a proprietary dosage form of modafinil for the treatment of attention-deficit/hyperactivity disorder (“ADHD”) in children and adolescents, is not approvable. In consideration of the FDA’s decision, we have determined that we will not pursue further development of SPARLON. Prior to the FDA’s decision that the sNDA for SPARLON is not approvable, we had net capitalized inventory costs related to SPARLON of $8.6 million. In light of the FDA’s decision, we have fully reserved all of these capitalized inventory costs related to SPARLON as of June 30, 2006.

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

5. INTANGIBLE ASSETS, NET

Intangible assets consisted of the following:

		September 30, 2006						December 31, 2005
	Estimated Useful Lives	Gross Carrying Amount		Accumulated Amortization		Net Carrying Amount		Gross Carrying Amount		Accumulated Amortization		Net Carrying Amount
Modafinil developed technology	15 years	$	99,000	$	31,350	$	67,650	$	99,000	$	26,400	$	72,600
DuraSolv® technology	14 years	70,000		10,348		59,652		70,000		6,696		63,304
ACTIQ marketing rights	10 years	75,465		37,097		38,368		75,465		31,359		44,106
GABITRIL product rights	9-15 years	105,380		44,581		60,799		115,371		38,053		77,318
TRISENOX product rights	8-13 years	113,515		11,324		102,191		112,942		4,494		108,448
VIVITROL product rights	15 years	110,000		3,667		106,333		—		—		—
Myocet trademark	20 years	185,890		6,971		178,919		182,500		—		182,500
Other product rights	5-20 years	256,207		70,363		185,844		243,465		48,867		194,598
		$	1,015,457	$	215,701	$	799,756	$	898,743	$	155,869	$	742,874

Intangible assets are amortized over their estimated useful economic life using the straight line method. Amortization expense was $20.8 million and $15.5 million for the three months ended September 30, 2006 and 2005, respectively, and $60.8 million and $42.2 million for the nine months ended September 30, 2006 and 2005, respectively.

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

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

6. LONG-TERM DEBT

Long-term debt consisted of the following:

	September 30,			December 31,
	2006			2005
2.0% convertible senior subordinated notes due June 1, 2015	$	920,000		$	920,000
2.5% convertible subordinated notes due December 2006	10,007			10,007
Zero Coupon convertible subordinated notes first putable June 2008 (Old)	265			313
Zero Coupon convertible subordinated notes first putable June 2010 (Old)	97			99
Zero Coupon convertible subordinated notes first putable June 2008 (New)	375,157			374,958
Zero Coupon convertible subordinated notes first putable June 2010 (New)	375,196			375,070
Mortgage and building improvement loans	8,482			8,975
Capital lease obligations	3,872			3,658
Other	2,822			3,177
Total debt	1,695,898			1,696,257
Less current portion	(933,494		)	(933,160		)
Total long-term debt	$	762,404		$	763,097

In January 2006, our 2008 and 2010 Zero Coupon Notes (collectively, the “Zero Coupon Notes”) became convertible and the related deferred debt issuance costs of $13.1 million were written off. Our convertible notes will be classified as current liabilities and presented in current portion of long-term debt if our stock price is above the restricted conversion prices of $56.04, $71.40 or $67.80 with respect to the 2.0% convertible senior subordinated notes due June 1, 2015 (the “2.0% Notes”), the 2008 Zero Coupon Notes or the 2010 Zero Coupon Notes, respectively at the balance sheet date. As of September 30, 2006, our 2.0% Notes are considered to be current liabilities and are presented in current portion of long-term debt in our consolidated balance sheet. For a more complete description of these notes, including the associated convertible note hedge, see Note 9 to our Consolidated Financial Statements included in Part II, Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2005.

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

7. LEGAL PROCEEDINGS

PROVIGIL Patent Litigation and Settlements

In March 2003, we filed a patent infringement lawsuit in the U.S. District Court in New Jersey against four companies—Teva Pharmaceuticals USA, Inc., Mylan Pharmaceuticals, Inc., Ranbaxy Laboratories Limited and Barr Laboratories, Inc.—based upon the abbreviated new drug applications (“ANDA”) filed by each of these firms with the FDA seeking approval to market a generic form of modafinil. The lawsuit claimed infringement of our U.S. Patent No. RE37,516 (the “‘516 Patent”) which covers the pharmaceutical compositions and methods of treatment with the form of modafinil contained in PROVIGIL and which expires on April 6, 2015. We believe that these four companies were the first to file ANDAs with Paragraph IV certifications and thus are eligible for the 180-day exclusivity provided by the provisions of the Federal Food, Drug and Cosmetic Act.

In late 2005 and early 2006, we entered into settlement agreements with each of Teva, Mylan, Ranbaxy and Barr. As part of these separate settlements, we agreed to grant to each of these parties a non-exclusive royalty-bearing right to market and sell a generic version of PROVIGIL in the United States. These licenses will become effective in April 2012. An earlier entry may occur based upon the entry of another generic version of PROVIGIL. Each of these settlements has been filed with both the United States Federal Trade Commission (the “FTC”) and the Antitrust Division of the Department of Justice (the “DOJ”) as required by the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Medicare Modernization Act”). The FTC has requested from us, and we have provided, certain information in connection with its review of the PROVIGIL settlements. In July 2006, the FTC requested that we voluntarily submit additional information and documents in connection with its investigation of this matter. We are cooperating fully with this request. The FTC could challenge in an administrative or judicial proceeding any or all of the settlements if they believe that the agreements violate the antitrust laws.

Ranbaxy as co-defendants and claiming, among other things, that the patent litigation settlements concerning PROVIGIL violate the antitrust laws of the United States and certain state laws. The proposed consolidated class action complaints have been designated by plaintiffs, each of which seeks to certify separate, purported classes of plaintiffs: direct purchasers of PROVIGIL, and consumers and other indirect purchasers of PROVIGIL. The plaintiffs in both cases are seeking monetary damages and/or equitable relief. Separately, in June 2006, Apotex, Inc., a subsequent ANDA filer seeking FDA approval of a generic form of modafinil, filed suit against us also in the U.S. District Court for the Eastern District of Pennsylvania alleging similar violations of antitrust laws and state law. Apotex asserts that the PROVIGIL settlement agreements improperly prevent it from obtaining FDA approval of its ANDA, and seeks monetary and equitable remedies, including a declaratory judgment that the ‘516 Patent is invalid and unenforceable. We filed a motion to dismiss the Apotex case in late September 2006. We believe that both the class action cases and the Apotex case are without merit. While we intend to vigorously defend ourselves and the propriety of the settlement agreements, these efforts will be both expensive and time consuming and, ultimately, due to the nature of litigation, there can be no assurance that these efforts will be successful.

In early 2005, we also filed a patent infringement lawsuit in the U.S. District Court in New Jersey against Carlsbad Technology, Inc. based upon the Paragraph IV ANDA filed related to modafinil that Carlsbad filed with the FDA. Carlsbad has asserted counterclaims for non-infringement of the ‘516 Patent and invalidity of the ‘516 Patent. In early August 2006, we entered into a settlement agreement with Carlsbad and its development partner, Watson Pharmaceuticals, Inc., which we understand has the right to commercialize the Carlsbad product if approved by FDA. As part of this settlement, we agreed to grant to Watson a non-exclusive royalty-bearing right to market and sell a generic version of PROVIGIL in the United States. This license will become effective on or after April 6, 2012, subject to applicable regulatory considerations. An earlier entry may occur based upon the entry of another generic version of PROVIGIL. This agreement has been filed with both the FTC and DOJ, as required by the Medicare Modernization Act.

In November 2005 and March 2006, we received notice that Caraco Pharmaceutical Laboratories, Ltd. and Apotex, Inc., respectively, also filed Paragraph IV ANDAs with the FDA in which each firm is seeking to market a generic form of PROVIGIL. We have not filed a patent infringement lawsuit against either Caraco or Apotex as of the filing date of this report, although Apotex has brought an antitrust action against us, as described above.

ACTIQ Patent Litigation and Settlement

In February 2006, we also announced that we had agreed to settle with Barr our pending patent infringement dispute in the United States related to Barr’s ANDA filed with the FDA seeking to sell generic OTFC. Under the settlement, we granted to Barr an exclusive royalty bearing right to market and sell generic OTFC in the United States. The settlement with Barr related to ACTIQ has been filed with both the FTC and the Antitrust Division of the DOJ as required by the Medicare Modernization Act. The FTC has requested from us, and we have provided, certain information in connection with its review of this settlement. The FTC, the DOJ, or a private party could challenge in an administrative or judicial proceeding the settlement with Barr if they believe that the agreement violates the antitrust laws. If the settlement is challenged, there is no assurance that we could successfully defend against such challenge and, in that case, we could be subject to, among other things, damages, fines and possible invalidation of the settlement agreement.

U.S. Attorney’s Office Investigation

In September 2004, we announced that we had received subpoenas from the U.S. Attorney’s Office in Philadelphia with respect to PROVIGIL, ACTIQ and GABITRIL. This investigation is ongoing and appears to be focused on our sales and promotional practices. We are cooperating with the investigation and are providing documents to the U.S. Attorney’s Office. In September 2004, we received a voluntary request for information from the Office of the Connecticut Attorney General asking us to provide information generally relating to our sales and promotional practices for our U.S. products. We have agreed to comply with this voluntary request and are engaged in ongoing discussions with that office. These matters may involve the bringing of criminal charges and fines, and/or civil penalties. We cannot predict or determine the outcome of these matters or reasonably estimate the amount or range of amounts of any fines or penalties that might result from an adverse outcome. However, an adverse outcome could have a material adverse effect on our financial position, liquidity and results of operations.

Other Matters

We are a party to certain other litigation in the ordinary course of our business, including, among others, European patent oppositions, and matters alleging employment discrimination, product liability and breach of commercial contract. We are vigorously defending ourselves in all of the actions against us and do not believe these matters, even if adversely adjudicated or settled, would have a material adverse effect on our financial condition, results of operations or cash flows.

8. COMPREHENSIVE INCOME (LOSS)

Our comprehensive income (loss) includes net income (loss), unrealized gains and (losses) from foreign currency translation adjustments and unrealized investment gains (losses). Our total comprehensive income (loss) is as follows:

	Three months ended September 30,						Nine months ended September 30,
	2006			2005			2006		2005
Net income (loss)	$	95,741		$	29,343		$	149,725	$	(193,027	)

Foreign currency translation gain (loss)	13,209			(539		)	47,635		(27,427		)
Unrealized investment gains (losses)	(159		)	(1,037		)	871		(1,658		)
Other comprehensive gain (loss)	13,050			(1,576		)	48,506		(29,085		)

Comprehensive income (loss)	$	108,791		$	27,767		$	198,231	$	(222,112	)

9. EARNINGS PER SHARE (“EPS”)

We compute income per common share in accordance with SFAS No. 128, “Earnings Per Share” (“SFAS 128”). Basic income per common share is computed based on the weighted average number of common shares outstanding during the period. Diluted income per common share is computed based on the weighted average number of common shares outstanding and the dilutive impact of common stock equivalents outstanding during the period. The dilutive effect of employee stock options, restricted stock awards, the Zero Coupon Convertible Notes issued in December 2004 (the “New Zero Coupon Notes”), the 2.0% Notes and the warrants are measured using the treasury stock method. The dilutive effect of our other convertible notes, including the remaining outstanding portions of the 2.5% Notes and the Zero Coupon Convertible Notes issued in June 2003 (the “Old Zero Coupon Notes”), are measured using the “if-converted” method. Common stock equivalents are not included in periods where there is a loss, as they are anti-dilutive.

The 2.0% Notes and New Zero Coupon Notes each are considered to be instrument C securities as defined by Emerging Issues Task Force Issue No. 90-19, “Convertible Bonds with Issuer Option to Settle for Cash upon Conversion” (“EITF 90-19”); therefore, these notes are included in the dilutive earnings per share calculation using the treasury stock method. Under the treasury stock method, we must calculate the number of shares issuable under the terms of these notes based on the average market price of the stock during the period, and include that number in the total diluted shares figure for the period. Since the average share price of our stock during the three months ended September 30, 2006 exceeded the conversion price of $46.70 for the 2.0% Notes and $56.50 and $59.50 for each series of the New Zero Coupon Notes, the impact of these notes during the period was an additional 4.4 million and 0.5 million of incremental shares, respectively, included to calculate diluted EPS. Since the average share price of our stock during the nine months ended September 30, 2006 exceeded the conversion price of $46.70 for the 2.0% Notes and $56.50 and $59.50 for each series of the New Zero Coupon Notes, the impact of these notes during the period was an additional 5.4 million and 1.3 million of incremental shares, respectively, included to calculate diluted EPS.

We have entered into convertible note hedge and warrant agreements that, in combination, have the economic effect of reducing the dilutive impact of the 2.0% Notes and the New Zero Coupon Notes by increasing the effective conversion price for these notes, from our perspective, to $67.92 and $72.08, respectively. SFAS No. 128, however, requires us to analyze separately the impact of the convertible note hedge and warrant agreements on diluted EPS. As a result, the purchases of the convertible note hedges are excluded because their impact will always be anti-dilutive. SFAS No. 128 further requires that the impact of the sale of the warrants be computed using the treasury stock method. For example, using the treasury stock method, if the average price of our stock during the period ended December 31, 2005 had been $65.00, $75.00, $85.00 or $95.00, the shares from the warrants to be included in diluted EPS would have been zero, 2.4 million, 5.9 million and 8.7 million shares, respectively. The total number of shares that could potentially be included under the warrants is 32.6 million. Since the average share price of our stock during the three and nine months ended September 30, 2006 did not exceed the effective conversion prices of the 2.0% Notes and each series of the New Zero Coupon Notes, there was no impact of the warrants on diluted shares or diluted EPS during the periods.

The following is a reconciliation of net income (loss) and weighted average common shares outstanding for purposes of calculating basic and diluted income (loss) per common share:

	Three months ended				Nine months ended
	September 30,				September 30,
	2006		2005		2006		2005
Basic income (loss) per common share computation:
Numerator:
Net income (loss) used for basic income (loss) per common share	$	95,741	$	29,343	$	149,725	$	(193,027	)
Denominator:
Weighted average shares used for basic income (loss) per common share	60,762		58,064		60,415		58,035

Basic income (loss) per common share	$	1.58	$	0.51	$	2.48	$	(3.33	)

Diluted income (loss) per common share computation:
Numerator:
Net income (loss) used for basic income (loss) per common share	$	95,741	$	29,343	$	149,725	$	(193,027	)
Interest on convertible notes (net of tax) per common share	40		240		121		—
Net income (loss) used for diluted income (loss) per common share	$	95,781	$	29,583	$	149,846	$	(193,027	)
Denominator:
Weighted average shares used for basic income (loss) per common share	60,762		58,064		60,415		58,035
Effect of dilutive securities:
Convertible subordinated notes and warrants	5,070		825		6,798		—
Employee stock options and restricted stock awards	1,240		509		1,708		—
Weighted average shares used for diluted income (loss) per common share	67,072		59,398		68,921		58,035

Diluted income (loss) per common share	$	1.43	$	0.50	$	2.17	$	(3.33	)

The following reconciliation shows the shares excluded from the calculation of diluted income (loss) per common share as the inclusion of such shares would be anti-dilutive:

	Three months ended		Nine months ended
	September 30,		September 30,
	2006	2005	2006	2005
Weighted average shares excluded:
Employee stock options and restricted stock awards	2,513	8,486	2,343	8,820
Convertible subordinated notes and warrants	32,640	32,633	32,640	25,956
	35,153	41,119	34,983	34,776

10. SEGMENT AND SUBSIDIARY INFORMATION

Revenue and pre-tax income (loss) for the three and nine months ended September 30, 2006 and 2005, and long-lived assets as of September 30, 2006 and December 31, 2005 are provided below:

Revenues for the three months ended September 30:

	2006									2005
	United States			Europe			Total			United States			Europe			Total
Sales:
PROVIGIL	$	193,462		$	11,081		$	204,543		$	126,387		$	8,103		$	134,490
GABITRIL	14,604			723			15,327			15,178			1,333			16,511
CNS	208,066			11,804			219,870			141,565			9,436			151,001
Pain	179,651			7,585			187,236			95,485			4,759			100,244
Other	13,292			50,115			63,407			15,575			27,551			43,126
Total Sales	401,009			69,504			470,513			252,625			41,746			294,371
Other Revenues	9,189			2,631			11,820			13,260			1,905			15,165
Total External Revenues	410,198			72,135			482,333			265,885			43,651			309,536
Inter-Segment Revenues	3,233			28,176			31,409			4,594			11,276			15,870
Elimination of Inter-Segment Revenues	(3,233		)	(28,176		)	(31,409		)	(4,594		)	(11,276		)	(15,870		)
Total Revenues	$	410,198		$	72,135		$	482,333		$	265,885		$	43,651		$	309,536

Revenues for the nine months ended September 30:

	2006									2005
	United States			Europe			Total			United States			Europe			Total
Sales:
PROVIGIL	$	500,941		$	29,219		$	530,160		$	338,529		$	26,009		$	364,538
GABITRIL	42,166			3,510			45,676			54,023			4,562			58,585
CNS	543,107			32,729			575,836			392,552			30,571			423,123
Pain	457,679			19,213			476,892			282,105			11,904			294,009
Other	41,661			152,436			194,097			36,319			80,137			116,456
Total Sales	1,042,447			204,378			1,246,825			710,976			122,612			833,588
Other Revenues	26,510			6,052			32,562			36,176			5,724			41,900
Total External Revenues	1,068,957			210,430			1,279,387			747,152			128,336			875,488
Inter-Segment Revenues	12,073			76,370			88,443			9,064			56,405			65,469
Elimination of Inter-Segment Revenues	(12,073		)	(76,370		)	(88,443		)	(9,064		)	(56,405		)	(65,469		)
Total Revenues	$	1,068,957		$	210,430		$	1,279,387		$	747,152		$	128,336		$	875,488

	Three months ended					Nine months ended
	September 30,					September 30,
	2006			2005		2006			2005
Pre-tax income (loss):
United States	$	160,358		$	46,761	$	280,907		$	(159,788	)
Europe	(5,540		)	3,913		(39,615		)	10,238
Total	$	154,818		$	50,674	$	241,292		$	(149,550	)

	September 30, 2006		December 31, 2005
Long-lived assets:
United States	$	1,173,983	$	1,084,619
Europe	672,188		685,750
Total	$	1,846,171	$	1,770,369

We perform our annual test of impairment of goodwill as of July 1. We allocate goodwill to each of our reporting units based on their relative fair value. At September 30, 2006, $267.9 million of goodwill is allocated to our United States segment and $204.3 million is allocated to our Europe segment. We completed our annual test of impairment of goodwill as of July 1, 2006 and concluded that goodwill was not impaired.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide information to assist you in better understanding and evaluating our financial condition and results of operations. We recommend that you read this MD&A in conjunction with our consolidated financial statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q, as well as our Annual Report on Form 10-K for the year ended December 31, 2005.

EXECUTIVE SUMMARY

Cephalon is an international biopharmaceutical company dedicated to the discovery, development and marketing of innovative products to treat human diseases. We currently focus our efforts in four core therapeutic areas: central nervous system (“CNS”) disorders, pain, cancer and addiction. In addition to conducting an active research and development program, we market six products in the United States and numerous products in various countries throughout Europe.

Our two most significant products, PROVIGIL and ACTIQ, comprised approximately 80% of our worldwide net sales for the nine months ended September 30, 2006, of which approximately 95% was in the U.S. market. Based on our license and supply agreement with Barr Laboratories, Barr entered the U.S. market with generic OTFC on September 27, 2006. As a result, we expect to experience meaningful generic erosion of ACTIQ sales beginning in the fourth quarter of 2006.

We received FDA approval of FENTORA™ (fentanyl buccal tablet) [C-II] in late September 2006 and launched the product in the United States in early October. FENTORA is indicated for the management of breakthrough pain in patients with cancer who are already receiving and are tolerant to opioid therapy for their underlying persistent cancer pain. We are focusing our longer-term clinical strategy on developing FENTORA for patients with breakthrough pain associated with other conditions, including neuropathic pain and back pain. In October 2006, we announced that data from a Phase 3 clinical trial of FENTORA demonstrated efficacy in the management of breakthrough pain in opioid-tolerant patients with chronic low back pain.

In June 2006, we launched VIVITROL, which was approved by the FDA in April 2006 for the treatment of alcohol dependence. VIVITROL is indicated for alcohol dependent patients who are able to abstain from alcohol in an outpatient setting and are not actively drinking when initiating treatment. Treatment with VIVITROL should be used in combination with psychosocial support, such as counseling or group therapy. Under the license and collaboration agreement we signed with Alkermes in June 2005, Alkermes is responsible for manufacturing commercial supplies of VIVITROL and we have primary responsibility for the marketing and sale of the product.

In March 2006, we announced that the FDA’s Psychopharmacologic Drugs Advisory Committee voted not to recommend FDA approval of SPARLON. This recommendation was the result of concerns expressed by the advisory committee regarding a suspected case of Stevens-Johnson syndrome (“SJS”), a rare but serious skin rash condition, in a child who participated in one of the Phase 3 clinical trials. On August 9, 2006, we announced that the FDA had issued a letter indicating that the SPARLON sNDA was “not approvable.’’ In light of the FDA’s decision, we have determined that we will not pursue further development of SPARLON.

We are seeking to attain FDA approval to market NUVIGILÔ (armodafinil) with an anticipated indication for excessive sleepiness. We filed an NDA for NUVIGIL in the first quarter of 2005, received an approvable letter from the FDA in May 2006 and expect a final approval decision from the FDA on or before December 31, 2006. Assuming FDA approval, we expect that NUVIGIL will be available in 2007. In its approvable letter, the FDA indicated that SJS safety language would be prominent in the NUVIGIL label. Since NUVIGIL is derived from the active ingredient in PROVIGIL, we expect that the safety information in the PROVIGIL label will be appropriately modified to reflect the final NUVIGIL language, and we are in discussions with the FDA to reach agreement on the final safety language.

Settlements of PROVIGIL Patent Infringement Lawsuits

As a biopharmaceutical company, our future success is highly dependent on obtaining and maintaining patent protection for our products and technology. We intend to vigorously defend the validity, and prevent infringement, of our patents. The loss of patent protection on any of our existing products, whether by third-party challenge, invalidation, circumvention, license or patent expiration, would materially impact our results of operations.

In late 2005 and early 2006, we entered into settlement agreements with each of Teva Pharmaceuticals USA, Inc., Mylan Pharmaceuticals Inc., Ranbaxy Laboratories Limited and Barr Laboratories, Inc. As part of these separate settlements, we agreed to grant to each of these parties a non-exclusive royalty-bearing right to market and sell a generic version of

PROVIGIL in the United States. These licenses will become effective in April 2012. An earlier entry may occur based upon the entry of another generic version of PROVIGIL. Each of these settlements has been filed with both the FTC and the Antitrust Division of the DOJ as required by the Medicare Modernization Act. The FTC has requested from us, and we have provided, certain information in connection with its review of the PROVIGIL settlements. In July 2006, the FTC requested that we voluntarily submit additional information and documents in connection with its investigation of this matter. We are cooperating fully with this request. The FTC could challenge in an administrative or judicial proceeding any or all of the settlements if they believe that the agreements violate the antitrust laws.

We also are aware of a number of civil antitrust complaints, purportedly filed as class actions, recently filed by private parties in U.S. District Court for the Eastern District of Pennsylvania, each naming Cephalon, Barr, Mylan, Teva and Ranbaxy as co-defendants and claiming, among other things, that the patent litigation settlements concerning PROVIGIL violate the antitrust laws of the United States and certain state laws. The proposed consolidated class action complaints have been designated by plaintiffs, each of which seeks to certify separate, purported classes of plaintiffs: direct purchasers of PROVIGIL, and consumers and other indirect purchasers of PROVIGIL. The plaintiffs in both cases are seeking monetary damages and/or equitable relief. Separately, in June 2006, Apotex, Inc., a subsequent ANDA filer seeking FDA approval of a generic form of modafinil, filed suit against us also in the U.S. District Court for the Eastern District of Pennsylvania alleging similar violations of antitrust laws and state law. Apotex asserts that the PROVIGIL settlement agreements improperly prevent it from obtaining FDA approval of its ANDA, and seeks monetary and equitable remedies, including a declaratory judgment that the ‘516 Patent is invalid and unenforceable. We filed a motion to dismiss the Apotex case in late September 2006. We believe that both the class action cases and the Apotex case are without merit. While we intend to vigorously defend ourselves and the propriety of the settlement agreements, these efforts will be both expensive and time consuming and, ultimately, due to the nature of litigation, there can be no assurance that these efforts will be successful.

In connection with the Barr, Ranbaxy and Teva settlements, we also entered into a series of business arrangements related to modafinil with Barr, Ranbaxy and Teva. We received licenses to certain modafinil-related intellectual property developed by each party and in exchange for these licenses, we agreed to make payments to these three companies collectively totaling up to $136.0 million over the next several years, consisting of upfront payments, milestones and royalties on net sales of our modafinil products. In order to maintain an adequate supply of the active drug substance modafinil, we entered into agreements with three modafinil suppliers whereby we will purchase an annual minimum amount of modafinil over a six year period beginning in 2006, with the aggregate payments over that period totaling approximately $82.6 million.

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

Licenses to Barr Laboratories, Inc. Related to ACTIQ

Under two separate agreements with Barr Laboratories, Inc., we have agreed to license to Barr our U.S. rights to any intellectual property related to ACTIQ. In July 2004, we entered into a license and supply agreement with Barr to secure FTC clearance of our acquisition of CIMA LABS. In February 2006, we signed the second agreement as part of the settlement with Barr of our patent infringement dispute in the United States related to Barr’s ANDA filed with the FDA seeking to sell a generic version of oral transmucosal fentanyl citrate (“generic OTFC”).

The rights we granted to Barr under these agreements became effective on September 5, 2006 and Barr entered the United States market with generic OTFC on September 27, 2006. On this same date, we also entered the market with a generic OTFC. We are utilizing Watson as our sales agent in this effort. With the entry of generic OTFC into the market, we expect to experience meaningful generic erosion of ACTIQ beginning in the fourth quarter of 2006.

Under the license and supply agreement, we also agreed to sell to Barr generic OTFC for resale in the United States until the earlier of such time that Barr is able to gain FDA approval of its ANDA or three years. Under the agreement, we are responsible for delivering bulk units to Barr and Barr is responsible for all packaging and labeling of the product. In June 2006, we announced that Barr had invoked this supply option and provided a forecast to us. As of the filing date of this report, we have manufactured approximately 7.6 million generic OTFC units for Barr. However, at this time, we do not have available quota of fentanyl from the U.S. Drug Enforcement Administration (the “DEA”) to produce certain orders from Barr to be delivered in November and December 2006 and, to our knowledge, Barr does not have sufficient quota required for it to accept such orders from us. It is possible that either Barr or the FTC could claim our failure to deliver product to Barr is a breach of our agreements with these parties. We currently are in discussions with the DEA to secure additional quota to provide for the manufacture of Barr’s OTFC, our OTFC and ACTIQ during the remainder of 2006. We believe that we currently have sufficient inventory on hand or in the

distribution channel to meet demand for our fentanyl-based products through early 2007 and we expect to obtain quota from the DEA for 2007 in January 2007.

Indebtedness

We have significant levels of indebtedness outstanding, nearly all of which consists of convertible notes with restricted conversion prices that are either below or close to our stock price as of the date of the filing of this Quarterly Report on Form 10-Q. Under the terms of the indentures governing the notes, we are obligated to repay in cash the aggregate principal balance of any such notes presented for conversion. For a more complete description of these notes, see Note 9 to our Consolidated Financial Statements included in Part II, Item 8 of our Annual Report on Form 10-K. We do not have available cash, cash equivalents and investments sufficient to repay all of the convertible notes, if presented. In addition, there are no restrictions on our use of this cash, and the cash available to repay indebtedness has, and may continue to, decline over time.

As of September 30, 2006, the fair value of both the 2.0% Notes and the Zero Coupon Notes is greater than the value of the shares into which such notes are convertible. We believe that the share price of our common stock would have to significantly increase over the market price as of September 30, 2006 before the fair value of the convertible notes would be less than the value of the common stock shares underlying the notes and, as such, we believe it is highly unlikely that holders of the 2.0% Notes or the Zero Coupon Notes will present significant amounts of such notes for conversion. In the unlikely event that a significant conversion did occur, we believe that we have the ability to raise sufficient cash to repay the principal amounts due through a combination of utilizing our existing cash on hand, raising money in the capital markets or selling our note hedge instruments for cash. Nevertheless, because the financing markets may be unwilling to provide funding to us or may only be willing to provide funding on terms that we would consider unacceptable, we may not have cash available or be able to obtain funding to permit us to meet our repayment obligations, thus adversely affecting the market price for our securities.

While we seek to increase profitability and cash flow from operations, we will need to continue to achieve growth of product sales and other revenues sufficient for us to attain these objectives. The rate of our future growth will depend, in part, upon our ability to obtain and maintain adequate intellectual property protection for our currently marketed products, or to successfully develop or acquire and commercialize new product candidates.

RECENT ACQUISITIONS AND TRANSACTIONS

Co-Promotion Agreement with Takeda

On June 12, 2006, we entered into a co-promotion agreement effective July 1, 2006 with Takeda Pharmaceuticals North America, Inc. (“Takeda”) with respect to PROVIGIL in the United States.

The co-promotion agreement has a three-year term. If we undergo a change of control during the three-year term, we have the option to terminate the co-promotion agreement, subject to our obligation to make certain specified payments to Takeda.

Zeneus Holdings Limited Acquisition

On December 22, 2005, we completed our acquisition of all of the issued share capital of Zeneus Holdings Limited. Total consideration paid in connection with the acquisition was approximately $365.8 million, net of cash acquired. For a more complete description of this acquisition, see Note 2 to the Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q.

TRISENOX Acquisition

On July 18, 2005, we completed the acquisition of substantially all assets related to TRISENOX® (arsenic trioxide) from Cell Therapeutics, Inc. (“CTI”) and CTI Technologies, Inc., a wholly-owned subsidiary of CTI, for $69.7 million in cash, funded from existing cash on hand. The acquisition agreement provides for contingent future cash payments to CTI,

totaling up to $100.0 million, upon the achievement of certain label expansions and sales milestones. The results of operations of TRISENOX have been included in the consolidated statements of operations since the acquisition date.

VIVITROL License and Collaboration

In June 2005, we entered into a license and collaboration agreement with Alkermes, Inc. to develop and commercialize VIVITROL in the United States. Concurrent with the execution of this agreement, we entered into a supply agreement under which Alkermes provides to us finished commercial supplies of VIVITROL. We made an initial payment of $160 million to Alkermes upon execution of this agreement, all of which was recorded as an IPR&D charge as the product had not yet received FDA approval. In April 2006, we made an additional payment of $110 million to Alkermes upon FDA approval of the product. Alkermes also could receive up to an additional $220 million in milestone payments from us upon attainment of certain agreed-upon sales levels of VIVITROL. Until December 31, 2007, Alkermes is responsible for any cumulative losses up to $120 million, and we are responsible for any cumulative losses in excess of $120 million. Pre-tax profit, as adjusted for certain items, and losses incurred after December 31, 2007 will be split equally between the parties. We recognizing revenue for VIVITROL effective in the third quarter of 2006.

In October 2006, Cephalon and Alkermes amended the existing license and collaboration agreement to provide that Cephalon would be responsible for its own VIVITROL-related costs during the period August 1, 2006 through December 31, 2006 and, for that period, such costs will not be chargeable to the collaboration and against the $120 million cumulative loss cap. The parties also agreed to amend the existing supply agreement to provide that Cephalon will purchase from Alkermes two VIVITROL manufacturing lines (and related equipment). As of the filing date of this report, Alkermes has spent approximately $19 million on construction of these two manufacturing lines and will be reimbursed by Cephalon for these expenses and for certain future capital improvements related to these two manufacturing lines. Cephalon also has granted Alkermes an option, exercisable after two years, to purchase these manufacturing lines at the then-current net book value of the assets.

Salmedix, Inc. Acquisition

On June 14, 2005, we completed our acquisition of Salmedix, Inc. Under the agreement relating to the acquisition, we acquired all of the outstanding capital stock of Salmedix for $160.9 million in cash and future payments totaling up to $40 million upon achievement of certain regulatory milestones. The acquisition was funded from our existing cash on hand and was accounted for as an asset acquisition, as Salmedix is a development stage company. As a result of the acquisition, we obtained the rights to market TREANDAÔ (bendamustine hydrochloride). The results of operations for Salmedix have been included in our consolidated financial statements as of the acquisition date.

RESULTS OF OPERATIONS

(In thousands)

Three months ended September 30, 2006 compared to three months ended September 30, 2005:

	For the three months ended
	September 30,
	2006						2005						% Increase (Decrease)
	United States		Europe		Total		United States		Europe		Total		United States		Europe		Total
Sales:
PROVIGIL	$	193,462	$	11,081	$	204,543	$	126,387	$	8,103	$	134,490	53	%	37	%	52	%
GABITRIL	14,604		723		15,327		15,178		1,333		16,511		(4	)%	(46	)%	(7	)%
CNS	208,066		11,804		219,870		141,565		9,436		151,001		47	%	25	%	46	%
Pain	179,651		7,585		187,236		95,485		4,759		100,244		88	%	59	%	87	%
Other	13,292		50,115		63,407		15,575		27,551		43,126		(15	)%	82	%	47	%
Total Sales	401,009		69,504		470,513		252,625		41,746		294,371		59	%	66	%	60	%
Other Revenues	9,189		2,631		11,820		13,260		1,905		15,165		(31	)%	38	%	(22	)%
Total Revenues	$	410,198	$	72,135	$	482,333	$	265,885	$	43,651	$	309,536	54	%	65	%	56	%

Sales—In the United States, we sell our products to pharmaceutical wholesalers, the largest three of which accounted for 77% of our worldwide net sales for the three months ended September 30, 2006 and 80% for the nine months ended September 30, 2006. Decisions made by these wholesalers regarding the levels of inventory they hold (and thus the amount of product they purchase from us) can materially affect the level of our sales in any particular period and thus may not necessarily correlate to the number of prescriptions written for our products as reported by IMS Health Incorporated (“IMS Health”).

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

As of September 30, 2006, we received information from all of our U.S. wholesaler customers about the levels of inventory they held for our non-generic products. Based on this information, which we have not independently verified, we believe that total inventory held at these wholesalers is approximately 0.4 million units (approximately $12.2 million) of ACTIQ and less than two weeks supply of our other products at our current sales levels.

During the quarter, sales were impacted by changes in the product sales allowances deducted from gross sales as described further below and by changes in the relative levels of the number of units of inventory held in the supply chain. For the three months ended September 30, 2006, total sales increased by 60% over the prior year. The other key factors that contributed to the increase in sales are summarized by product as follows:

· In CNS, sales of PROVIGIL increased 52 percent. Demand for PROVIGIL increased as evidenced by an increase in U.S. prescriptions for PROVIGIL of 18%, according to IMS Health. During the third quarter of 2006, sales of PROVIGIL also were impacted by domestic price increases of approximately 5% from period to period.

· In Pain, sales increased 87 percent. Sales of ACTIQ were impacted by an increase in domestic prices of approximately 72% from period to period. Also during the third quarter of 2006, demand for ACTIQ declined as evidenced by a decrease in U.S. prescriptions of 12%, according to IMS Health. Sales of ACTIQ during the quarter were not meaningfully impacted by Barr’s launch of its own generic OTFC on September 27, 2006. During the third quarter of 2006, we recognized $8.2 million of revenue related to shipments of our generic OTFC to Barr.

· Other sales, which consist primarily of sales of other products and certain third party products, increased 47 percent. This increase is primarily attributable to sales of products acquired in the TRISENOX and Zeneus acquisitions in July 2005 and December 2005, respectively.

Other Revenues—The decrease of 22% from period to period is primarily due to a decrease in partner reimbursements on our CEP-1347 program and a decrease in revenues from clinical studies performed for collaborators.

Analysis of gross sales to net sales—The following table presents the product sales allowances deducted from gross sales to arrive at a net sales figure:

	For the three months ended
	September 30,
	2006			2005			Change			% Change
Gross sales:	$	492,385		$	335,284		$	157,101		47	%
Product sales allowances:
Prompt payment discounts	8,007			5,424			2,583			48	%
Wholesaler discounts	437			5,593			(5,156		)	(92	)%
Returns	4,407			668			3,739			560	%
Coupons	5,887			6,688			(801		)	(12	)%
Medicaid discounts	8,828			15,276			(6,448		)	(42	)%
Medicare Part D discounts	226			—			226			100	%
Managed care and governmental contracts	(5,920		)	7,264			(13,184		)	(181	)%
	21,872			40,913			(19,041		)
Net sales	$	470,513		$	294,371		$	176,142		60	%
Product sales allowances as a percentage of gross sales	4.4		%	12.2		%

Wholesaler discounts decreased due to the fact that fewer incremental wholesaler discounts were required during the third quarter of 2006 as a result of 2006 price increases. Returns allowances increased in the third quarter of 2006 as compared to the third quarter of 2005 because the 2005 returns reserve balance was low relative to historical levels and because 2006 actual returns experience has increased. Decreases in product sales allowances were also caused by lower Medicaid discounts resulting from a significant number of participants transferring to the new Medicare Part D program effective January 1, 2006. We recognized a reduction in the managed care and governmental contracts allowance of $13.3 million in the third quarter of 2006, representing amounts paid to the U.S. Department of Defense (“DoD”) under the Tricare program from October 2004 through June 30, 2006. In October 2006, the DoD announced that it would reimburse all companies that had voluntarily made such payments under the Tricare program due to the U.S. Court of Appeals September 2006 ruling. In the future, we expect product sales allowances as a percentage of gross sales to trend upward due to the impact of potential future price increases on Medicaid discounts and potential increases related to Medicaid, Medicare Part D, managed care and governmental contracts sales.

We also recorded discounts for Medicare Part D in the third quarter of 2006 of $0.2 million. This reserve was established based on the number of Medicare Part D contracts that we have signed and an estimate of the amounts expected to be incurred under each contract based on expected enrollment and usage. These estimates are based on preliminary data and may change significantly in the future based on actual experience.

	For the three months ended
	September 30,
	2006		2005		Change			% Change
Costs and expenses:
Cost of sales	$	62,356	$	37,629	$	24,727		66	%
Research and development	81,012		91,934		(10,922		)	(12	)%
Selling, general and administrative	157,490		103,253		54,237			53	%
Depreciation and amortization	29,849		22,346		7,503			34	%
Acquired in-process research and development	—		5,500		(5,500		)	(100	)%
	$	330,707	$	260,662	$	70,045		27	%

Cost of Sales—The cost of sales was 13.3% of net sales for the three months ended September 30, 2006 and 12.8% of net sales for the three months ended September 30, 2005. In the third quarter of 2006, cost of sales was affected by the inclusion of Zeneus’ product sales for which the margins are lower than the average margins of our other products, as well as additional royalty expenses for PROVIGIL, offset by the net effect of price increases and lower product sales allowances on our three major U.S. products and higher margins on certain of our European products.

Research and Development Expenses—Research and development expenses decreased $10.9 million, or 12%, for the third quarter of 2006 as compared to the third quarter of 2005. This decrease is primarily attributable to lower expenses associated with reduced levels of clinical activity in 2006, partially offset by the recognition of $3.4 million of stock-based

compensation expense (representing one-half of the total stock-based compensation expense recorded during the quarter based on the employees’ compensation allocation) as a result of the adoption of SFAS 123(R).

Selling, General and Administrative Expenses—Selling, general and administrative expenses increased $54.2 million, or 53%, for the third quarter of 2006, primarily due to higher selling and marketing costs and the inclusion of Zeneus selling, general and administrative expenses (approximately $10.4 million) in 2006. In addition, we recognized $3.4 million of stock-based compensation expense (representing one-half of the total stock-based compensation expense recorded during the quarter based on the employees’ compensation allocation) as a result of the adoption of SFAS 123(R). U.S. selling and marketing costs increased $30.4 million due to increases in our U.S. sales force, increased promotional spending on PROVIGIL, VIVITROL and FENTORA and payments to Takeda under our co-promotion agreement.

Depreciation and Amortization Expenses—Depreciation and amortization expenses increased $7.5 million, or 34%, for the third quarter of 2006 primarily as a result of additional amortization expense resulting from intangible assets acquired during the last quarter of 2005 and 2006.

Acquired In-Process Research and Development—In 2005, we recorded $5.5 million for research and development activities related to development stage opportunities with no alternative future uses.

	For the three months ended
	September 30,
	2006			2005			Change			% Change
Other income (expense):
Interest income	$	7,046		$	7,247		$	(201	)	(3	)%
Interest expense	(4,749		)	(7,494		)	2,745			37	%
Gain on early extinguishment of debt	—			2,085			(2,085		)	(100	)%
Other income (expense), net	895			(38		)	933
	$	3,192		$	1,800		$	1,392		77	%

Other Income (Expense)—Other income (expense), net increased $1.4 million for the third quarter of 2006, attributable to the following factors:

· a decrease in interest expense in 2006 due primarily to the repurchase of substantially all of our 2.5% convertible subordinated notes in July 2005 and to the write-off of deferred debt issuance costs related to our Zero Coupon Notes in January 2006. This decrease was partially offset by interest expense on our 2.0% Notes issued in June 2005.

· A $2.1 million net gain on early extinguishment of debt in the third quarter of 2005 that includes a $7.4 million gain on the repurchase of approximately $512 million of the 2.5% convertible subordinated notes and a loss of $5.3 million on the termination of the interest rate swap agreement associated with $200 million notional amount of the 2.5% convertible subordinated notes in a private transaction.

· A $0.9 million increase in other income (expense), net primarily due to fluctuations in foreign currency gains and losses in the comparable periods.

	For the three months ended
	September 30,
	2006		2005		Change		% Change
Income tax expense	$	59,077	$	21,331	$	37,746	177	%

Income Taxes—During the third quarter of 2006, we recognized $59.1 million of income tax expense on income before income taxes of $154.8 million, resulting in an overall effective tax rate of 38.2 percent. This compared to income tax expense in the third quarter of 2005 of $21.3 million on income before income taxes of $50.7 million, yielding an effective tax rate of 42.1 percent. The 2005 effective tax rate was impacted by IPR&D charges during the third quarter of 2005 for which no tax benefit was realized.

Nine months ended September 30, 2006 compared to nine months ended September 30, 2005:

	For the nine months ended
	September 30,
	2006						2005						% Increase (Decrease)
	United States		Europe		Total		United States		Europe		Total		United States		Europe		Total
Sales:
PROVIGIL	$	500,941	$	29,219	$	530,160	$	338,529	$	26,009	$	364,538	48	%	12	%	45	%
GABITRIL	42,166		3,510		45,676		54,023		4,562		58,585		(22	)%	(23	)%	(22	)%
CNS	543,107		32,729		575,836		392,552		30,571		423,123		38	%	7	%	36	%
Pain	457,679		19,213		476,892		282,105		11,904		294,009		62	%	61	%	62	%
Other	41,661		152,436		194,097		36,319		80,137		116,456		15	%	90	%	67	%
Total Sales	1,042,447		204,378		1,246,825		710,976		122,612		833,588		47	%	67	%	50	%
Other Revenues	26,510		6,052		32,562		36,176		5,724		41,900		(27	)%	6	%	(22	)%
Total Revenues	$	1,068,957	$	210,430	$	1,279,387	$	747,152	$	128,336	$	875,488	43	%	64	%	46	%

Sales— During the nine months ended September 30, 2006, sales were impacted by changes in the product sales allowances deducted from gross sales as described further below and by changes in the relative levels of the number of units of inventory held in the supply chain. For the nine months ended September 30, 2006, total sales increased by 50% over the prior year. The other key factors that contributed to the increase in sales are summarized by product as follows:

· In CNS, sales of PROVIGIL increased 45 percent. Demand for PROVIGIL increased as evidenced by an increase in U.S. prescriptions for PROVIGIL of 17%, according to IMS Health. During the nine months ended September 30, 2006, sales of PROVIGIL also were impacted by domestic price increases of approximately 14% from period to period.

· In Pain, sales increased 62 percent. Sales of ACTIQ were impacted by an increase in domestic prices of approximately 60% from period to period. Also during the nine months ended September 30, 2006, demand for ACTIQ declined slightly as evidenced by a decrease in U.S. prescriptions of 3%, according to IMS Health. Sales of ACTIQ were not meaningfully impacted by Barr’s launch of its own generic OTFC on September 27, 2006. During the third quarter of 2006, we recognized $8.2 million of revenue related to shipments of our generic OTFC to Barr.

· Other sales, which consist primarily of sales of other products and certain third party products, increased 67 percent. This increase is primarily attributable to sales of products acquired in the TRISENOX and Zeneus acquisitions in July 2005 and December 2005, respectively.

Analysis of gross sales to net sales—The following table presents the product sales allowances deducted from gross sales to arrive at a net sales figure:

	For the nine months ended
	September 30,
	2006			2005			Change			% Change
Gross sales:	$	1,356,371		$	955,429		$	400,942		42	%
Product sales allowances:
Prompt payment discounts	23,226			15,839			7,387			47	%
Wholesaler discounts	2,629			18,139			(15,510		)	(86	)%
Returns	14,517			10,634			3,883			37	%
Coupons	21,365			16,683			4,682			28	%
Medicaid discounts	32,711			43,156			(10,445		)	(24	)%
Medicare Part D discounts	1,468			—			1,468			100	%
Managed care and governmental contracts	13,630			17,390			(3,760		)	(22	)%
	109,546			121,841			(12,295		)
Net sales	$	1,246,825		$	833,588		$	413,237		50	%
Product sales allowances as a percentage of gross sales	8.1		%	12.8		%

Wholesaler discounts decreased due to the fact that fewer incremental wholesaler discounts were required during the nine months ended September 30, 2006 as a result of 2006 price increases. Returns allowances increased for the nine months ended September 30, 2006 as compared to the nine months ended September 30, 2005 because the 2005 returns reserve balance was low relative to historical levels and because 2006 actual returns experience has increased. Decreases in product sales allowances were also caused by lower Medicaid discounts resulting from a significant number of participants transferring to the new Medicare Part D program effective January 1, 2006. We recognized a reduction in the managed care and governmental contracts allowance of $13.3 million in the third quarter of 2006, representing amounts paid to the DoD under the Tricare program from October 2004 through June 30, 2006. In October 2006, the DoD announced that it would reimburse all companies that had voluntarily made such payments under the Tricare program due to the U.S. Court of Appeals September 2006 ruling. In the future, we expect product sales allowances as a percentage of gross sales to trend upward due to the impact of potential future price increases on Medicaid discounts and potential increases related to Medicaid, Medicare Part D, managed care and governmental contracts sales.

We also recorded discounts for Medicare Part D during the nine months ended September 30, 2006 of $1.5 million. This reserve was established based on the number of Medicare Part D contracts that we have signed and an estimate of the amounts expected to be incurred under each contract based on expected enrollment and usage. These estimates are based on preliminary data and may change significantly in the future based on actual experience.

	For the nine months ended
	September 30,
	2006		2005		Change			% Change
Costs and expenses:
Cost of sales	$	189,848	$	114,093	$	75,755		66	%
Research and development	279,765		255,591		24,174			9	%
Selling, general and administrative	460,068		302,904		157,164			52	%
Depreciation and amortization	85,989		61,151		24,838			41	%
Impairment charge	12,417		—		12,417			100	%
Acquired in-process research and development	—		295,615		(295,615		)	(100	)%
	$	1,028,087	$	1,029,354	$	(1,267	)	—	%

Cost of Sales—The cost of sales was 15.2% of net sales for the nine months ended September 30, 2006 and 13.7% of net sales for the nine months ended September 30, 2005. The increase is primarily due to an $8.6 million inventory reserve related to SPARLON recorded in the second quarter of 2006 (see Note 4 to the Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q), the inclusion of Zeneus’ product sales in 2006 for which the margins are lower than the average margin of our other products, as well as additional royalty expenses in 2006 for PROVIGIL, partially offset by the net effect of price increases and lower product sales allowances on our three major U.S. products and higher margins on certain of our European products.

Research and Development Expenses—Research and development expenses increased $24.2 million, or 9%, for the nine months ended September 30, 2006 as compared to the nine months ended September 30, 2005. This increase is primarily attributable to $45.0 million of payments related to rights acquired to certain development stage products under three product development collaboration agreements and the recognition of $11.6 million of stock-based compensation expense (representing one-half of the total stock-based compensation expense recorded during the nine months ended based on the employees’ compensation allocation) as a result of the adoption of SFAS 123(R), partially offset by lower expenses associated with reduced levels of clinical activity in 2006.

Selling, General and Administrative Expenses—Selling, general and administrative expenses increased $157.2 million, or 52%, for the nine months ended September 30, 2006, primarily due to higher selling and marketing costs and the inclusion of Zeneus selling, general and administrative expenses (approximately $36.0 million) in 2006. In addition, we paid $6.0 million in connection with the PROVIGIL settlement agreements and recognized $11.6 million of stock-based compensation expense (representing one-half of the total stock-based compensation expense recorded during the nine months ended based on the employees’ compensation allocation) as a result of the adoption of SFAS 123(R). U.S. selling and marketing costs increased $98.1 million due to increases in our U.S. sales force, increased promotional spending on PROVIGIL, VIVITROL and FENTORA and payments to Takeda under our co-promotion agreement

Depreciation and Amortization Expenses—Depreciation and amortization expenses increased $24.8 million, or 41%, for the nine months ended September 30, 2006 primarily as a result of additional amortization expense resulting from intangible assets acquired during the last quarter of 2005 and 2006.

Impairment Charge—In June 2006, we announced that data from our Phase 3 clinical program evaluating GABITRIL for the treatment of GAD did not reach statistical significance on the primary study endpoints. We have no further plans to continue studying GABITRIL for the treatment of GAD. As a result, we performed a test of impairment on the carrying value of our investment in GABITRIL product rights and recorded an impairment charge of $12.4 million in the second quarter of 2006 related to our European rights.

Acquired In-Process Research and Development—In connection with our acquisition of Salmedix, Inc. and the license and collaboration agreement we entered into with Alkermes for VIVITROL, we recorded $130.1 million and $160.0 million, respectively, in acquired IPR&D expense during the second quarter of 2005. In the third quarter of 2005, we recorded $5.5 million for research and development activities related to development stage opportunities with no alternative future uses.

	For the nine months ended
	September 30,
	2006			2005			Change			% Change
Other income (expense):
Interest income	$	16,736		$	19,559		$	(2,823	)	(14	)%
Interest expense	(13,523		)	(19,311		)	5,788			30	%
Write-off of deferred debt issuance costs	(13,105		)	—			(13,105		)	(100	)%
Gain on early extinguishment of debt	—			2,085			(2,085		)	(100	)%
Other income (expense), net	(116		)	1,983			(2,099		)	(106	)%
	$	(10,008	)	$	4,316		$	(14,324	)	(332	)%

Other Income (Expense)—Other income (expense), net decreased $14.3 million for the nine months ended September 30, 2006, attributable to the following factors:

· a decrease in interest income in 2006 due to lower average investment balances, partially offset by higher investment returns.

· A decrease in interest expense in 2006 due primarily to the repurchase of substantially all of our 2.5% convertible subordinated notes in July 2005 and to the write-off of deferred debt issuance costs related to our Zero Coupon Notes in January 2006. This decrease was partially offset by interest expense on our 2.0% Notes issued in June 2005.

· A $13.1 million write-off of deferred debt issuance costs in 2006 related to our Zero Coupon Notes.

· A $2.1 million decrease in other income (expense), net primarily due to fluctuations in foreign currency gains and losses in the comparable periods.

	For the nine months ended
	September 30,
	2006		2005		Change		% Change
Income tax expense	$	91,567	$	43,477	$	48,090	111	%

Income Taxes—During the nine months ended September 30, 2006, we recognized $91.6 million of income tax expense on income before income taxes of $241.3 million, resulting in an overall effective tax rate of 37.9 percent. This compared to income tax expense in the nine months ended September 30, 2005 of $43.5 million on loss before income taxes of $149.6 million, yielding an effective tax rate of (29.1) percent. The 2005 effective tax rate was impacted by IPR&D charges during the second and third quarters of 2005 for which no tax benefit was realized.

LIQUIDITY AND CAPITAL RESOURCES

(In thousands)

Cash, cash equivalents and investments at September 30, 2006 were $668.0 million, representing 21% of total assets, as compared to $484.1 million, representing 17% of total assets, at December 31, 2005.

The change in cash and cash equivalents is as follows:

	For the nine months ended
	September 30,
	2006		2005
Net cash provided by operating activities	$	251,190	$	68,409
Net cash provided by (used for) investing activities	30,538		(281,171		)
Net cash provided by financing activities	131,745		227,016
Effect of exchange rate changes on cash and cash equivalents	11,830		(3,222		)
Net increase in cash and cash equivalents	$	425,303	$	11,032

Working capital, which is calculated as current assets less current liabilities, was $39.4 million at September 30, 2006, an increase of $269.2 million, compared to a working capital deficit of $229.8 million at December 31, 2005. The increase in working capital was primarily the result of a $183.9 million increase in cash, cash equivalents and investments and a $35.6 million increase in receivables, net, driven primarily by the growth in product sales, a $26.8 million increase in inventory, net, in anticipation of new product launches and a decrease in accounts payable and accrued expenses of $36.9 million due to the timing of cash payments.

Net Cash Provided by Operating Activities

Net cash provided by operating activities was $251.2 million for the nine months ended September 30, 2006 as compared to $68.4 million for the nine months ended September 30, 2005. The primary change between the two periods is the result of a payment of $160.0 million cash in June 2005 to Alkermes under the license and collaboration agreement related to VIVITROL. This payment was recorded as an in-process research and development charge and is reflected in our operating activities for the nine months ended September 30, 2005 as the product had not yet received FDA approval. The change between the two periods was also impacted by the change in net income for the nine months ended September 30, 2006 as compared to net loss for the nine months ended September 30, 2005 and the timing of cash receipts and payments in the ordinary course of business.

Net Cash Provided by (Used for) Investing Activities

Net cash provided by investing activities was $30.5 million for the nine months ended September 30, 2006 as compared to net cash used for investing activities $281.2 million for the nine months ended September 30, 2005. The change is primarily due to our acquisition of Salmedix, Inc. in June 2005 for $130.7 million, net of cash, and our acquisition of TRISENOX in July 2005 for $69.7 million. Additionally, higher net redemptions of our investment portfolio during 2006 were offset by a cash payment of $110 million to Alkermes upon FDA approval of VIVITROL in April 2006.

Net Cash Provided by Financing Activities

Net cash provided by financing activities was $131.7 million for the nine months ended September 30, 2006, as compared to $227.0 million for the nine months ended September 30, 2005.

The change is primarily the result of net proceeds of $776.0 million received from the sale of $800 million of our 2% Notes in 2005. Concurrent with the sale of the 2% Notes, we purchased a convertible note hedge for $339.1 million and sold warrants to purchase an aggregate of 17,130,621 shares of our common stock for net proceeds of $194.0 million.

In addition, the cash received from exercises of common stock options increased significantly in the nine months ended September 30, 2006 as compared to the nine months ended September 30, 2005. The extent and timing of option exercises are primarily dependent upon the market price of our common stock and general financial market conditions, as well as the exercise prices and expiration dates of the options.

Outlook

We expect to use our existing cash, cash equivalents and investments for working capital and general corporate purposes, including the acquisition of businesses, products, product rights, or technologies, the payment of contractual obligations, including scheduled interest payments on our convertible notes and regulatory, sales or other milestones that may become due to third parties, and/or the purchase, redemption or retirement of our convertible notes. However, during 2007, we expect that sales of our currently marketed products should allow us to generate positive cash flow from operations. At this time, we cannot accurately predict the effect of certain developments on the rate of sales growth in 2008 and beyond, such as the degree of market acceptance, patent protection and exclusivity of our products, the impact of competition, the effectiveness of our sales and marketing efforts and the outcome of our current efforts to develop, receive approval for and successfully launch NUVIGIL and our other products presently in clinical development.

Based on our current level of operations, projected sales of our existing products and estimated sales from our product candidates, if approved, combined with other revenues and interest income, we also believe that we will be able to service our existing debt and meet our capital expenditure and working capital requirements in the near term. However, we cannot be sure that our anticipated revenue growth will be realized or that we will continue to generate significant positive cash flow from operations. We may need to obtain additional funding for future significant strategic transactions, to repay our outstanding indebtedness, particularly if such indebtedness is presented for conversion by holders (see “—Indebtedness” below), or for our future operational needs, and we cannot be certain that funding will be available on terms acceptable to us, or at all.

Marketed Products

Continued sales growth of PROVIGIL depends, in part, on the continued effectiveness of the various settlement agreements we entered into in late 2005 and early 2006, as well as our maintenance of protection in the United States and abroad of the modafinil particle-size patent through its expiration beginning in 2014. See Note 7 to the Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. Future growth of modafinil-based product sales in 2007 and beyond also will depend in part on our ability to achieve final FDA approval of NUVIGIL, which we anticipate in late 2006.

The growth of our pain franchise depends in large part on our ability to successfully market FENTORA, which we launched in the United States in October 2006. Our other pain product, ACTIQ, now faces generic competition and we expect to experience meaningful generic erosion of ACTIQ sales beginning in the fourth quarter of 2006.

For VIVITROL, our ability to achieve commercial success with this product in 2006 and thereafter will be impacted by our success in building awareness and acceptance of the product among the 2,000 — 3,000 addiction specialists and physicians who have been actively treating alcohol dependence with pharmacotherapy and our work towards educating the counseling community about VIVITROL. During the first few months of launch, we focused our efforts on establishing the logistical platform to effectively deliver the product to patients. Having significantly reduced product delivery times and expanded the distribution channel, we are now focusing more of our sales and marketing efforts on driving product demand by educating physicians about VIVITROL’s benefits.

Clinical Studies

Over the past few years, we have incurred significant expenditures related to conducting clinical studies to develop new pharmaceutical products and exploring the utility of our existing products in treating disorders beyond those currently approved in their respective labels. For the remainder of 2006 and into 2007, we expect to continue to incur significant levels of research and development expenditures. We also expect to continue or begin a number of significant clinical programs including, among others: a Phase 3 program evaluating TREANDA for the treatment of non-Hodgkin’s lymphoma (“NHL”) and other possible studies for the treatment of chronic lymphocytic leukemia, small cell lung cancer and myeloma; a Phase 3 program evaluating CEP-701 for the treatment of acute myelogenous leukemia (“AML”) and other possible studies of CEP-701 in patients with myeloproliferative disorder; Phase 3 programs with FENTORA in non-cancer breakthrough pain; and clinical programs with NUVIGIL in the areas of fatigue and cognition.. We may seek to mitigate the risk in our research and development programs by seeking sources of funding for a portion of these expenses through collaborative arrangements with third parties. However, we intend to retain a portion of the commercial rights to these programs and, as a result, we still expect to spend significant funds on our share of the cost of these programs, including the costs of research, preclinical development, clinical research and manufacturing.

Manufacturing, Selling and Marketing Efforts

During the remainder of 2006 and into 2007, we expect to continue to incur significant expenditures associated with manufacturing, selling and marketing our products. The aggregate amount of our sales and marketing expenses in 2006 will

be significantly higher than that incurred in 2005, primarily as a result of higher expenses associated with an increase in the size of our sales force and product launch costs related to FENTORA. Likewise, for 2007, we expect our sales and marketing expense to exceed 2006. In 2006 and 2007, we also expect to continue in-process capital expenditure projects at our research and development facilities in France and West Chester and at our Salt Lake City manufacturing facility.

Indebtedness

We have significant indebtedness outstanding, consisting principally of indebtedness on convertible subordinated notes. The following table summarizes the principal terms of our most significant convertible subordinated notes outstanding as of September 30, 2006:

Security	Outstanding		Conversion Price			Redemption Rights and Obligations
	(in millions)
2.0% Convertible Senior Subordinated Notes due June 2015 (the “2.0% Notes”)	$	920.0	$	46.70	*	Generally not redeemable by the holder prior to December 2014.

Zero Coupon Convertible Notes due June 2033, first putable June 15, 2008 (the “2008 Zero Coupon Notes”)	$	374.8	$	59.50	*	Redeemable on June 15, 2008 at either option of holder or us at a redemption price of 100.25% of the principal amount redeemed.

Zero Coupon Convertible Notes due June 2033, first putable June 15, 2010 (the “2010 Zero Coupon Notes”)	$	374.9	$	56.50	*	Redeemable on June 15, 2010 at either option of holder or us at a redemption price of 100.25% of the principal amount redeemed.

* Stated conversion prices as per the terms of the notes. However, each convertible note contains certain terms restricting a holder’s ability to convert the notes, including that a holder may only convert if the closing price of our stock on the day prior to conversion is higher than $56.04, $71.40 or $67.80 with respect to the 2.0% Notes, the 2008 Zero Coupon Notes or the 2010 Zero Coupon Notes, respectively. For a more complete description of these notes, including the associated convertible note hedge, see Note 9 to our Consolidated Financial Statements included in Part II, Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2005.

Nearly all of our indebtedness outstanding contain restricted conversion prices that are either below or close to our stock price as of the date of the filing of this Form 10-Q. At September 30, 2006, approximately $930.0 million of our convertible notes are considered to be current liabilities and are presented in current portion of long-term debt in our September 30, 2006 consolidated balance sheet. These notes will remain as current liabilities unless our stock price decreases to a level where these notes are no longer convertible. Under the terms of the indentures governing the notes, we are obligated to repay in cash the aggregate principal balance of any such notes presented for conversion. As of September 30, 2006, the fair value of both the 2.0% Notes and the Zero Coupon Notes is greater than the value of the shares into which such notes are convertible. We believe that the share price of our common stock would have to significantly increase over the market price as of September 30, 2006 before the fair value of the convertible notes would be less than the value of the common stock shares underlying the notes and, as such, we believe it is highly unlikely that holders of the 2.0% Notes or the Zero Coupon Notes will present significant amounts of such notes for conversion. As of the filing date of this Quarterly Report on Form 10-Q, we do not have available cash, cash equivalents and investments sufficient to repay all of the convertible notes, if presented. In addition, there are no restrictions on our use of this cash and the cash available to repay indebtedness may decline over time. If we do not have sufficient funds available to repay any principal balance of notes presented for conversion, we will be required to raise additional funds. In the unlikely event that a significant conversion did occur, we believe that we have the ability to raise sufficient cash to repay the principal amounts due through a combination of utilizing our existing cash on hand, raising money in the capital markets or selling our note hedge instruments for cash. Nevertheless, because the financing markets may be unwilling to provide funding to us or may only be willing to provide funding on terms that we would consider unacceptable, we may not have cash available or be able to obtain funding to permit us to meet our repayment obligations, thus adversely affecting the market price for our securities.

The annual interest payments on our convertible notes outstanding as of September 30, 2006 are $18.7 million, payable at various dates throughout the year. In the future, we may agree to exchanges of the notes for shares of our common stock or debt, or may determine to use a portion of our existing cash on hand to purchase or retire all or a portion of the outstanding convertible notes.

Our 2.0% Notes and 2008 and 2010 Zero Coupon Notes each are considered instrument C securities as defined by EITF 90-19, “Convertible Bonds with Issuer Option to Settle for Cash upon Conversion”; therefore, these notes are included in the dilutive earnings per share calculation using the treasury stock method. Under the treasury stock method, we must calculate the number of shares issuable under the terms of these notes based on the average market price of our common stock during the period, and include that number in the total diluted shares figure for the period. At the time we sold our 2.0% Notes and Zero Coupon Notes, we entered into convertible note hedge and warrant agreements that together are intended to have the economic effect of reducing the net number of shares that will be issued upon conversion of the notes by increasing the effective conversion price for these notes, from our perspective, to $67.92 and $72.08, respectively. However, from a U.S. GAAP perspective, SFAS No. 128 considers only the impact of the convertible notes and the warrant agreements; since the impact of the convertible note hedge agreements is always anti-dilutive, SFAS No. 128 requires that we exclude from the calculation of fully diluted shares the number of shares of our common stock that we would receive from the counterparties to these agreements upon settlement.

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

Share Price	Convertible Notes Shares	Warrant Shares	Total Treasury Stock Method Incremental Shares(1)	Shares Due to Cephalon under Note Hedge		Incremental Shares Issued by Cephalon upon Conversion(2)
$65.00	6,947	—	6,947	(6,947	)	—
$75.00	10,374	2,363	12,737	(10,374	)	2,363
$85.00	12,993	5,926	18,919	(12,993	)	5,926
$95.00	15,061	8,738	23,799	(15,061	)	8,738
$105.00	16,735	11,014	27,749	(16,735	)	11,014

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

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

Acquisition Strategy

As part of our business strategy, we plan to consider and, as appropriate, make acquisitions of other businesses, products, product rights or technologies. Our cash reserves and other liquid assets may be inadequate to consummate such acquisitions and it may be necessary for us to issue stock or raise substantial additional funds in the future to complete future transactions. In addition, as a result of our acquisition efforts, we are likely to experience significant charges to earnings for merger and related expenses (whether or not our efforts are successful) that may include transaction costs, closure costs or acquired in-process research and development charges.

Other

We may experience significant fluctuations in quarterly results based primarily on the level and timing of:

· cost of product sales;

· achievement and timing of research and development milestones;

· collaboration revenues;

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

· marketing and other expenses;

· manufacturing or supply disruptions; and

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

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which we have prepared in accordance with accounting principles generally accepted in the United States of America. In preparing these financial statements, we must make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We develop and periodically change these estimates and assumptions based on historical experience and on various other factors that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2005 in the “Critical Accounting Policies and Estimates” section and the “Recent Accounting Pronouncements” section.

Revenue recognition—The following is in addition to, and should be read in conjunction with, the revenue recognition critical accounting policy included in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2005.

On September 27, 2006, Barr began selling generic OTFC in the U.S. market. On that same date, we also entered the market with a generic OTFC, utilizing Watson as our sales agent in this effort. As of the end of the third quarter of 2006, inventory held at the wholesalers of ACTIQ totaled approximately 0.4 million units and inventory held at the wholesalers and retailers of our generic OTFC totaled approximately 1.3 million units. According to prescription data provided by IMS Health, the average demand for ACTIQ during the 12-month period between August 2005 and July 2006 was approximately 2.4 million units per month.

The terms of sale of Cephalon’s generic OTFC product to wholesalers and retailers provide for both the right of return of expired product and retroactive price reductions under certain conditions. Given the limited sales data history for the generic OTFC products and the estimated level of inventory at the wholesalers and retailers, it is not possible at this time to accurately assess the relative future market shares for each of the generic OTFC products and the branded ACTIQ product or the potential for further generic entrants into the market. In light of these uncertainties, we do not believe that the price charged to wholesalers and retailers for the majority of our generic OTFC sold during the quarter was fixed or determinable. As such, we have not recognized revenue during the quarter. We will continue to assess the development in the market and our ability to estimate returns and the final sales price.

Product sales allowances—We record product sales net of the following significant categories of product sales allowances, each of which is described in more detail in Part II, Item 7 of our Annual Report on Form 10-K: prompt payment discounts, wholesaler discounts, returns, coupons, Medicaid discounts and managed care and governmental contracts. In addition to these product sales allowances, in the first quarter of 2006 we also began recording an allowance to product sales for Medicare Part D discount reserves. Calculating each of these items involves significant estimates and judgments and requires us to use information from external sources.

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

During the nine months ended September 30, 2006, we recorded a provision for Medicare Part D discounts at a weighted average rate of 0.1% of gross sales from our six products marketed in the U.S. Actual Medicare Part D discounts could exceed our estimates of expected future Medicare patient activity or unit rebate amounts. If the Medicare Part D discounts provision percentage were to increase by 0.5% of 2006 gross sales for the nine months ended September 30, 2006 from our six products marketed in the U.S., then an additional provision of $5.6 million would result.

2) Managed care and governmental contracts—We recognized a reduction in the managed care and governmental contracts allowance of $13.3 million in the third quarter of 2006, representing amounts paid to the DoD under the Tricare program from October 2004 through June 30, 2006. In October 2006, the DoD announced that it would reimburse all companies that had voluntarily made such payments under the Tricare program due to the U.S. Court of Appeals September 2006 ruling.

The following table summarizes activity in each of the above categories for the year ended December 31, 2005 and the nine months ended September 30, 2006:

(In thousands)	Prompt Payment Discounts			Wholesaler Discounts			Returns*			Coupons			Medicaid Discounts			Medicare Part D Discounts			Managed Care & Governmental Contracts			Total
Balance at January 1, 2005	$	(2,899	)	$	—		$	(11,727	)	$	(4,165	)	$	(18,075	)	$	—		$	(4,409	)	$	(41,275	)

Provision:
Current period	(22,284		)	(24,373		)	(13,132		)	(23,313		)	(66,653		)	—			(26,072		)	(175,827		)
Prior periods	—			—			(2,721		)	—			(592		)	—			56			(3,257		)
Total	(22,284		)	(24,373		)	(15,853		)	(23,313		)	(67,245		)	—			(26,016		)	(179,084		)

Actual:
Current period**	20,367			21,645			(1,572		)	18,633			33,199			—			19,506			111,778
Prior periods	2,899			—			6,554			4,150			18,667			—			4,353			36,623
Total	23,266			21,645			4,982			22,783			51,866			—			23,859			148,401
Balance at December 31, 2005	$	(1,917	)	$	(2,728	)	$	(22,598	)	$	(4,695	)	$	(33,454	)	$	—		$	(6,566	)	$	(71,958	)

Provision:
Current period	(23,226		)	(2,629		)	(14,517		)	(20,681		)	(33,434		)	(1,468		)	(26,526		)	(122,481		)
Tricare program***	—			—			—			—			—			—			13,273			13,273
Prior periods	—			—			—			(684		)	723			—			(377		)	(338		)
Total	(23,226		)	(2,629		)	(14,517		)	(21,365		)	(32,711		)	(1,468		)	(13,630		)	(109,546		)

Actual:
Current period	20,625			2,192			—			15,951			12,395			32			23,094			74,289
Tricare program***	—			—			—			—			—			—			(13,273		)	(13,273		)
Prior periods	1,917			2,728			13,716			5,378			32,731			—			6,943			63,413
Total	22,542			4,920			13,716			21,329			45,126			32			16,764			124,429
Balance at September 30, 2006	$	(2,601	)	$	(437	)	$	(23,399	)	$	(4,731	)	$	(21,039	)	$	(1,436	)	$	(3,432	)	$	(57,075	)

*		Given our return goods policy, we assume that all returns in a current year relate to prior period sales.

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

***		Includes $13.3 million related to DoD Tricare program.

Inventories—The following is in addition to, and should be read in conjunction with, the inventories critical accounting policy included in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2005.

We expense pre-launch inventory unless it is probable that the inventory will be saleable. We have capitalized inventory costs associated with marketed products and certain products prior to regulatory approval and product launch, based on management’s judgment of probable future commercial use and net realizable value. We could be required to expense previously capitalized costs related to pre-approval or pre-launch inventory upon a change in such judgment, due to a denial or delay of approval by regulatory bodies, a delay in commercialization, or other potential factors. During the second quarter of 2006, we recorded an $8.6 million inventory reserve related to the FDA’s determination that the SPARLON sNDA is not approvable (see Note 4 to the Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q).

Stock-based compensation— Effective January 1, 2006, we adopted the Financial Accounting Standards Board Statement No. 123(R), “Share Based Payment” (“SFAS 123(R)”) using the modified prospective method, in which compensation cost was recognized based on the requirements of SFAS 123(R) for (a) all share-based payments granted after the effective date and (b) for all awards granted to employees prior to the effective date of SFAS 123(R) that remain unvested on the effective date. SFAS 123(R) requires the use of judgment and estimates in performing multiple calculations. We estimate the fair value using the Black-Scholes option-pricing model when assessing the fair value of options granted. The Black-Scholes option-pricing model requires several inputs, one of which is volatility. The fair value of options is most sensitive to the volatility input. Our estimate of volatility is based upon the historical volatility experienced in our stock price as well as the implied volatility from publicly traded options on our stock. To the extent volatility of our stock price or the option market on our stock increases in the future, our estimates of the fair value of options granted in the future could increase, thereby increasing stock-based compensation expense in future periods. For instance, an increase in estimated volatility of ten percentage points on all options would result in additional estimated annual pre-tax expense of approximately $4.1 million in 2006. In addition, we apply an expected forfeiture rate when amortizing stock-based compensation expense. Our estimate of the forfeiture rate is based primarily upon historical experience of employee turnover. To the extent we revise this estimate in the future or actual experience differs from this estimate, our stock-based compensation expense could be materially impacted. An estimated forfeiture rate of one percentage point lower would have resulted in an insignificant increase in stock-based compensation expense in 2006. Our expected term of options granted was derived from the average midpoint between vesting and the contractual term, as described in SEC’s Staff Accounting Bulletin No. 107, “Share-Based Payment.” In the future, as information regarding post vesting termination becomes more accessible, we may change our method of deriving the expected term. This change could impact our fair value of options granted in the future. We expect to refine our method of deriving expected term no later than January 1, 2008.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to foreign currency exchange risk related to our operations in European subsidiaries that have transactions, assets, and liabilities denominated in foreign currencies that are translated into U.S. dollars for consolidated financial reporting purposes. Historically, we have not hedged any of these foreign currency exchange risks. For the nine months ended September 30, 2006, an average 10% weakening of the U.S. dollar relative to the currencies in which our European subsidiaries operate would have resulted in an increase of $21.0 million in reported total revenues and a corresponding increase in reported expenses. This sensitivity analysis of the effects of changes in foreign currency exchange rates does not assume any changes in the level of operations of our European subsidiaries.

Since all of our outstanding debt is fixed rate, our only exposure to market risk for a change in interest rates relates to our investment portfolio. Our investments are classified as short-term and as “available for sale.” We do not believe that short-term fluctuations in interest rates would materially affect the value of our securities.

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Securities Exchange Act of 1934 is accumulated and communicated to the issuer’s management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this report have been designed and are functioning effectively to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. We believe that a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

(b) Change in Internal Control over Financial Reporting

There have been no changes in our internal control over financial reporting during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The information required by this Item is incorporated by reference to footnote 7 of the Consolidated Financial Statements included in Part I, Item 1 of this Report.

ITEM 1A. RISK FACTORS

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

A significant portion of our revenue is derived from our two largest products, and our future success will depend on the continued growth and acceptance of PROVIGIL.

For the nine months ended September 30, 2006, approximately 38% and 43% of our worldwide net sales were derived from sales of ACTIQ and PROVIGIL, respectively. As a result of our license and supply agreement with Barr Laboratories, Barr entered the market with generic OTFC on September 27, 2006. We expect to experience meaningful generic erosion of ACTIQ sales in the United States beginning in the fourth quarter of 2006. With respect to PROVIGIL, we cannot be certain that it will continue to be accepted in its market. Specifically, the following factors, among others, could affect the level of market acceptance of PROVIGIL:

· a change in the perception of the healthcare community of the safety and efficacy of the product, both in an absolute sense and relative to that of competing products;

· the level and effectiveness of our and Takeda’s sales and marketing efforts;

· any unfavorable publicity regarding PROVIGIL or similar products;

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

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

· regulatory developments affecting the manufacture, marketing or use of these products, including, for example, any changes to the PROVIGIL label resulting from the FDA’s non-approvable letter for SPARLON.

Any adverse developments with respect to the sale or use of PROVIGIL could significantly reduce our product revenues and have a material adverse effect on our ability to generate net income and positive net cash flow from operations.

We may not be able to maintain adequate protection for our intellectual property or market exclusivity for our key products and, therefore, competitors may develop competing products, which could result in a decrease in sales and market share, cause us to reduce prices to compete successfully and limit our commercial success.

We place considerable importance on obtaining patent protection for new technologies, products and processes. To that end, we file applications for patents covering the compositions or uses of our drug candidates or our proprietary processes. The patent positions of pharmaceutical and biotechnology companies can be highly uncertain and involve complex legal, scientific and factual questions. Accordingly, the patents and patent applications relating to our products, product candidates and technologies may be challenged, invalidated or circumvented by third parties and might not protect us against competitors with similar products or technology. Patent disputes in our industry are frequent and can preclude commercialization of products. If we ultimately engage in and lose any such disputes, we could be subject to competition or significant liabilities, we could be required to enter into third party licenses or we could be required to cease using the technology or product in dispute. In addition, even if such licenses are available, the terms of any license requested by a third party could be unacceptable to us.

PROVIGIL

The U.S. composition of matter patent for modafinil expired in 2001. We own U.S. and foreign patent rights that expire between 2014 and 2015 and cover pharmaceutical compositions and uses of modafinil, specifically, certain particle sizes of modafinil contained in the pharmaceutical composition. Ultimately, these patents might be found invalid as the result

of a challenge by a third party, or a potential competitor could develop a competing product or product formulation that avoids infringement of these patents. While we intend to vigorously defend the validity of these patents and prevent infringement, these efforts will be both expensive and time consuming and, ultimately, may not be successful. The loss of patent protection for PROVIGIL would significantly and negatively impact future PROVIGIL sales.

As of the filing date of this Quarterly Report on Form 10-Q, we are aware of seven ANDAs on file with the FDA for pharmaceutical products containing modafinil. Each of these ANDAs contains a Paragraph IV certification in which the ANDA applicant certified that the U.S. particle-size modafinil patent covering PROVIGIL either is invalid or will not be infringed by the ANDA product. In March 2003, we filed a patent infringement lawsuit in the U.S. District Court in New Jersey against four companies—Teva Pharmaceuticals USA, Inc., Mylan Pharmaceuticals, Inc., Ranbaxy Laboratories Limited and Barr Laboratories, Inc.—based upon the ANDAs filed by each of these companies with the FDA seeking approval to market a generic form of modafinil. The lawsuit claimed infringement of our U.S. Patent No. RE37,516 (the “‘516 Patent”) which covers the pharmaceutical compositions and methods of treatment with the form of modafinil contained in PROVIGIL and which extends to April 6, 2014. We believe that these four companies were the first to file ANDAs with Paragraph IV certifications and thus are eligible for the 180-day exclusivity provided by the provisions of the Federal Food, Drug and Cosmetic Act.

In late 2005 and early 2006, we entered into settlement agreements with each of these four defendants. As part of these separate settlements, we agreed to grant to each of Teva, Mylan, Ranbaxy and Barr a non-exclusive royalty-bearing right to market and sell a generic version of PROVIGIL in the United States. These licenses will become effective in April 2012. An earlier entry may occur based upon the entry of another generic version of PROVIGIL. Each of these settlements, as well as the ACTIQ settlement agreement described below, has been filed with both the FTC and the Antitrust Division of the DOJ as required by the Medicare Modernization Act. The FTC has requested from us, and we have provided, certain information in connection with its review of the settlements. In July 2006, the FTC requested that we voluntarily submit additional information and documents in connection with its investigation of the PROVIGIL settlements. We are cooperating fully with this request. The FTC could challenge in an administrative or judicial proceeding any or all of the settlements if they believe that the agreements violate the antitrust laws.

In early 2005, we also filed a patent infringement lawsuit in the U.S. District Court in New Jersey against Carlsbad Technology, Inc. based upon the Paragraph IV ANDA filed related to modafinil that Carlsbad filed with the FDA. Carlsbad had asserted counterclaims for non-infringement of the ‘516 Patent and invalidity of the ‘516 Patent. In early August 2006, we entered into a settlement agreement with Carlsbad and its development partner, Watson Pharmaceuticals, Inc., which we understand has the right to commercialize the Carlsbad modafinil product if approved by FDA. As part of this settlement, we agreed to grant to Watson a non-exclusive royalty-bearing right to market and sell a generic version of PROVIGIL in the United States. This license will become effective on or after April 6, 2012, subject to applicable regulatory considerations. An earlier entry may occur based upon the entry of another generic version of PROVIGIL. This agreement has been filed with both the FTC and DOJ, as required by the Medicare Modernization Act.

In November 2005 and March 2006, we received notice that Caraco Pharmaceutical Laboratories, Ltd. and Apotex, Inc., respectively, also filed Paragraph IV ANDAs with the FDA in which each firm is seeking to market a generic form of PROVIGIL. We have not filed patent infringement lawsuits against either Caraco or Apotex as of the filing date of this report, although Apotex has brought an antitrust claim against us, as described above.

ACTIQ

With respect to ACTIQ, we hold an exclusive license to U.S. patents covering the currently marketed compressed powder pharmaceutical composition and methods for administering fentanyl via this composition that expired on September 5, 2006, pending a decision by the FDA expected by early December 2006 with respect to our request for a pediatric extension of such patents. Corresponding patents in foreign countries are set to expire between 2009 and 2010. Our patent protection with respect to the ACTIQ formulation we sold prior to June 2003 expired in May 2005.

Under two separate agreements with Barr Laboratories, Inc., we licensed to Barr our U.S. rights to any intellectual property related to ACTIQ. In July 2004, we entered into a license and supply agreement with Barr to secure FTC clearance of our acquisition of CIMA LABS. In February 2006, we signed the second agreement as part of the settlement with Barr of our patent infringement dispute in the United States related to Barr’s ANDA filed with the FDA seeking to sell generic OTFC. Pursuant to the rights we granted to Barr, Barr entered the market with generic OTFC on September 27, 2006. We expect to experience meaningful generic erosion of ACTIQ sales in the United States beginning in the fourth quarter of 2006.

Under the license and supply agreement, we also agreed to sell to Barr a generic form of ACTIQ for resale in the United States until the earlier of such time that Barr is able to gain FDA approval of its ANDA or three years. In June 2006, we announced that Barr had invoked this supply option and provided a forecast to us. We are responsible for delivering bulk units to Barr and Barr is responsible for all packaging and labeling of the product.

We also rely on trade secrets, know-how and continuing technological advancements to support our competitive position. Although we have entered into confidentiality and invention rights agreements with our employees, consultants, advisors and collaborators, these parties could fail to honor such agreements or we could be unable to effectively protect our rights to our unpatented trade secrets and know-how. Moreover, others could independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets and know-how. In addition, many of our scientific and management personnel have been recruited from other biotechnology and pharmaceutical companies where they were conducting research in areas similar to those that we now pursue. As a result, we could be subject to allegations of trade secret violations and other claims.

Our activities and products are subject to significant government regulations and approvals, which are often costly and could result in adverse consequences to our business if we fail to comply.

We currently have a number of products that have been approved for sale in the United States, foreign countries or both. All of our approved products are subject to extensive continuing regulations relating to, among other things, testing, manufacturing, quality control, labeling, and promotion. The failure to comply with any rules and regulations of the FDA or any foreign medical authority, or the post-approval discovery of previously unknown problems relating to our products, could result in, among other things:

· fines, recalls or seizures of products;

· total or partial suspension of manufacturing or commercial activities;

· non-approval of product license applications;

· restrictions on our ability to enter into strategic relationships; and

· criminal prosecution.

In September 2004, we announced that we had received subpoenas from the U.S. Attorney’s Office in Philadelphia. That same month, we received a voluntary request for information from the Office of the Connecticut Attorney General. Both the subpoenas and the voluntary request for information appear to be focused on Cephalon’s sales and promotional practices with respect to ACTIQ, GABITRIL and PROVIGIL, including the extent of off-label prescribing of our products by physicians. We are cooperating with the U.S. Attorney’s Office and the Office of the Connecticut Attorney General and are providing documents and other information to both offices in response to these and additional requests. These matters may involve the bringing of criminal charges and fines, and/or civil penalties. We cannot predict or determine the outcome of these matters or reasonably estimate the amount or range of amounts of any fines or penalties that might result from an adverse outcome. However, an adverse outcome could have a material adverse effect on our financial position, liquidity and results of operations.

It is both costly and time-consuming for us to comply with these inquiries and with the extensive regulations to which we are subject. Additionally, incidents of adverse drug reactions, unintended side effects or misuse relating to our products could result in additional regulatory controls or restrictions, or even lead to withdrawal of a product from the market.

With respect to our product candidates, we conduct research, preclinical testing and clinical trials, each of which requires us to comply with extensive government regulations. We cannot market these product candidates or these new indications in the United States or other countries without receiving approval from the FDA or the appropriate foreign medical authority. The approval process is highly uncertain and requires substantial time, effort and financial resources. Ultimately, we may never obtain approval in a timely manner, or at all. Without these required approvals, our ability to substantially grow revenues in the future could be adversely affected.

In addition, because our products PROVIGIL, FENTORA and ACTIQ and our product candidate NUVIGIL contain active ingredients that are controlled substances, we are subject to regulation by the U.S. Drug Enforcement Administration (“DEA”) and analogous foreign organizations relating to the manufacture, shipment, sale and use of the applicable products. These regulations also are imposed on prescribing physicians and other third parties, making the storage, transport and use of such products relatively complicated and expensive. With the increased concern for safety by the FDA and the DEA with respect to products containing controlled substances and the heightened level of media attention given to this issue, it is possible that these regulatory agencies could impose additional restrictions on marketing or even withdraw regulatory approval for such products. In addition, adverse publicity may bring about a rejection of the product by the medical community. If the DEA, FDA or a foreign medical authority withdrew the approval of, or placed additional significant restrictions on the marketing of any of our products, our ability to promote our products and product sales could be substantially affected.

We rely on third parties for the timely supply of specified raw materials, equipment, contract manufacturing, formulation or packaging services, product distribution services, customer service activities and product returns processing. Although we actively manage these third party relationships to ensure continuity and quality, some events beyond our control could result in the complete or partial failure of these goods and services. Any such failure could have a material adverse effect on our financial condition and result of operations.

Manufacturing, supply and distribution problems may create supply disruptions that could result in a reduction of product sales revenue and an increase in costs of sales, and damage commercial prospects for our products.

The manufacture, supply and distribution of pharmaceutical products, both inside and outside the United States, is highly regulated and complex. We, and the third parties we rely upon for the manufacturing and distribution of our products, must comply with all applicable regulatory requirements of the FDA and foreign authorities, including cGMP regulations.

We also must comply with all applicable regulatory requirements of the DEA and analogous foreign authorities for certain of our products that contain controlled substances. The DEA also has authority to grant or deny requests for quota of controlled substances such as the fentanyl citrate that is the active ingredient in ACTIQ. Under our license and supply agreement with Barr, we are obligated to sell a generic version of ACTIQ to Barr for its resale in the United States. However, at this time, we do not have available quota of fentanyl from the DEA to produce certain orders from Barr to be delivered in November and December 2006 and, to our knowledge, Barr does not have sufficient quota required for it to accept such orders from us. It is possible that either Barr or the FTC could claim our failure to deliver product to Barr is a breach of our agreements with these parties. We currently are in discussions with the DEA to secure additional quota to provide for the manufacture of Barr’s OTFC, our OTFC and ACTIQ during the remainder of 2006. We believe that we currently have sufficient inventory on hand or in the distribution channel to meet demand for our fentanyl-based products through early 2007 and we expect to obtain quota from the DEA for 2007 in January 2007.

The facilities used to manufacture, store and distribute our products also are subject to inspection by regulatory authorities at any time to determine compliance with regulations. These regulations are complex, and any failure to comply with them could lead to remedial action, civil and criminal penalties and delays in production or distribution of material.

For certain of our products in the United States and abroad, we depend upon single sources for the manufacture of both the active drug substances contained in our products and for finished commercial supplies. The process of changing or adding a manufacturer or changing a formulation requires prior FDA and/or European medical authority approval and is very time-consuming. If we are unable to manage this process effectively or if an unforeseen event occurs at any facility, we could face supply disruptions that would result in significant costs and delays, undermine goodwill established with physicians and patients, damage commercial prospects for our products and adversely affect operating results.

With respect to VIVITROL, Alkermes is obligated to provide to us finished commercial supplies of the product under the terms of a supply agreement. We cannot be sure that they will be able to continue to successfully manufacture VIVITROL at a commercial scale in a timely or economical manner. If Alkermes is unable to successfully manufacture VIVITROL, the commercial prospects for the product could be impacted. In addition, Alkermes is responsible for the entire supply chain for VIVITROL, including the sourcing of raw materials and active pharmaceutical agents from third parties. Alkermes has no previous experience in managing a complex, cGMP supply chain and issues with its supply sources could impair its ability to supply VIVITROL under the supply agreement and have a material adverse effect on our commercial prospects for VIVITROL.

As our products are used commercially, unintended side effects, adverse reactions or incidents of misuse may occur that could result in additional regulatory controls, changes to product labeling, adverse publicity and reduced sales of our products.

During research and development, the use of pharmaceutical products, such as ours, is limited principally to clinical trial patients under controlled conditions and under the care of expert physicians. The widespread commercial use of our products could identify undesirable or unintended side effects that have not been evident in our clinical trials or the commercial use as of the filing date of this report. For example, in February 2005, working with the FDA, we updated our prescribing information for GABITRIL to include a bolded warning describing the risk of new onset seizures in non-induced patients without epilepsy. In addition, in patients who take multiple medications, drug interactions could occur that can be difficult to predict. Additionally, incidents of product misuse, product diversion or theft may occur, particularly with respect to products such as FENTORA, ACTIQ and PROVIGIL, which contain controlled substances. More recently, an FDA Advisory Committee reviewing SPARLON expressed concern regarding a suspected case of SJS in a child who participated in one of the Phase 3 clinical trials. In light of the FDA’s ongoing review of our NUVIGIL NDA, we expect that the safety information in the PROVIGIL label will be appropriately modified to reflect the final NUVIGIL language and we are in discussions with the FDA to reach agreement on the final safety language.

These events, among others, could result in adverse publicity that harms the commercial prospects of our products or lead to additional regulatory controls that could limit the circumstances under which the product is prescribed or even lead to the withdrawal of the product from the market. In particular, FENTORA and ACTIQ have been approved under regulations concerning drugs with certain safety profiles, under which the FDA has established special restrictions to ensure safe use. Any violation of these special restrictions could lead to the imposition of further restrictions or withdrawal of the product from the market.

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

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

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

The administration of drugs to humans, whether in clinical trials or commercially, can result in product liability claims whether or not the drugs are actually at fault for causing an injury. Furthermore, our products may cause, or may appear to have caused, adverse side effects (including death) or potentially dangerous drug interactions that we may not learn about or understand fully until the drug has been administered to patients for some time. As our products are used more widely and in patients with varying medical conditions, the likelihood of an adverse drug reaction, unintended side effect or incidence of misuse may increase. Product liability claims can be expensive to defend and may result in large judgments or settlements against us, which could have a negative effect on our financial performance. The cost of product liability insurance has increased in recent years, and the availability of coverage has decreased. Nevertheless, we maintain product liability insurance in amounts we believe to be commercially reasonable but which would be unlikely to cover the potential liability associated with a significant unforeseen safety issue. Any claims could easily exceed our current coverage limits. Even if a product liability claim is not successful, the adverse publicity and time and expense of defending such a claim may interfere with our business.

Our product sales and related financial results will fluctuate, and these fluctuations may cause our stock price to fall, especially if investors do not anticipate them.

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

· cost of product sales;

· achievement and timing of research and development milestones;

· collaboration revenues;

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

· marketing and other expenses;

· manufacturing or supply disruptions; and

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

We may be unable to repay our substantial indebtedness and other obligations.

Nearly all of our indebtedness outstanding contain restricted conversion prices that are either below or close to our stock price as of the date of the filing of this Form 10-Q. As a result, certain of our convertible notes have been classified as a current liability on our balance sheet as of September 30, 2006. Under the terms of the indentures governing the notes, we are obligated to repay in cash and common stock the aggregate principal balance of any such notes presented for conversion. As of the filing date of this report, we do not have available cash, cash equivalents and investments sufficient to repay all of the convertible notes, if presented. In addition, there are no restrictions on our use of this cash and the cash available to repay indebtedness may decline over time. If we do not have sufficient funds available to repay the principal balance of notes presented for conversion, we will be required to raise additional funds. Because the financing markets may be unwilling to provide funding to us or may only be willing to provide funding on terms that we would consider unacceptable, we may not have cash available or be able to obtain funding to permit us to meet our repayment obligations, thus adversely affecting the market price for our securities.

Our research and development and marketing efforts are often dependent on corporate collaborators and other third parties who may not devote sufficient time, resources and attention to our programs, which may limit our efforts to develop and market potential products.

To maximize our growth opportunities, we have entered into a number of collaboration agreements with third parties. For example, in the United States, we are party to an agreement with Takeda Pharmaceuticals North America, Inc. under which Takeda will co-promote PROVIGIL for up to three years. Our ability to increase PROVIGIL sales in the future will depend to a significant degree on the efforts of our partner. If Takeda fails to meet its obligations under the co-promotion agreement, is ineffective in its efforts, or determines to terminate the agreement prior to the end of its term, the growth of PROVIGIL sales could be materially and negatively impacted.

In certain countries outside the United States, we have entered into agreements with a number of partners with respect to the development, manufacturing and marketing of our products. In some cases, our collaboration agreements call for our partners to control:

· the supply of bulk or formulated drugs for use in clinical trials or for commercial use;

· the design and execution of clinical studies;

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

· marketing and selling of an approved product.

In each of these areas, our partners may not support fully our research and commercial interests because our program may compete for time, attention and resources with the internal programs of our corporate collaborators. As such, our program may not move forward as effectively, or advance as rapidly, as it might if we had retained complete control of all research, development, regulatory and commercialization decisions. We also rely on some of these collaborators and other third parties for the production of compounds and the manufacture and supply of pharmaceutical products. Additionally, we may find it necessary from time to time to seek new or additional partners to assist us in commercializing our products, though we ultimately might not be successful in establishing any such new or additional relationships.

The efforts of government entities and third party payers to contain or reduce the costs of health care may adversely affect our sales and limit the commercial success of our products.

In certain foreign markets, pricing or profitability of pharmaceutical products is subject to various forms of direct and indirect governmental control, including the control over the amount of reimbursements provided to the patient who is prescribed specific pharmaceutical products. For example, we are aware of governmental efforts in France to limit or eliminate reimbursement for some of our products, particularly FONZYLANE, FONLIPOL and OLMIFON, which could impact revenues from our French operations.

In the United States, there have been, and we expect there will continue to be, various proposals to implement similar controls. The commercial success of our products could be limited if federal or state governments adopt any such proposals. In addition, in the United States and elsewhere, sales of pharmaceutical products depend in part on the availability of reimbursement to the consumer from third party payers, such as government and private insurance plans. These third party payers are increasingly utilizing their significant purchasing power to challenge the prices charged for pharmaceutical products and seek to limit reimbursement levels offered to consumers for such products. Moreover, many governments and private insurance plans have instituted reimbursement schemes that favor the substitution of generic pharmaceuticals for more expensive brand-name pharmaceuticals. In the United States in particular, generic substitution statutes have been enacted in virtually all states and permit or require the dispensing pharmacist to substitute a less expensive generic drug instead of an original branded drug. These third party payers could focus their cost control efforts on our products, especially with respect to prices of and reimbursement levels for products prescribed outside their labeled indications. In these cases, their efforts could negatively impact our product sales and profitability.

On January 1, 2006, the U.S. Department of Health & Human Services began implementing Medicare Part D in accordance with the Medicare Modernization Act. Under this plan, voluntary prescription drug coverage, subsidized by Medicare, is offered to over 40 million Medicare beneficiaries through competing private prescription drug plans (“PDPs”) and Medicare Advantage (“MA”) plans. At this time, because this program is new and we have limited data, it is difficult to determine the on-going impact this program will have on our business. While the overall usage of pharmaceuticals may increase as the result of the expanded access to prescription drugs afforded under Medicare Part D, at this time, it is difficult to determine the on-going overall impact on Medicaid and other government and private plans, as well as, the impact on pricing, rebates and discounts for our products.

We experience intense competition in our fields of interest, which may adversely affect our business.

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

The conditions that our products treat, and some of the other disorders for which we are conducting additional studies, are currently treated with many drugs, several of which have been available for a number of years or are available in inexpensive generic forms. With respect to PROVIGIL, and, if approved, NUVIGIL, there are several other products used for the treatment of excessive sleepiness or narcolepsy in the United States, including methylphenidate products such as RITALIN® by Novartis, and in our other territories, many of which have been available for a number of years and are available in inexpensive generic forms. With respect to FENTORA, we face competition from numerous short-and long-acting opioid products, including three products—Johnson & Johnson’s DURAGESIC® and Purdue Pharmaceutical’s OXYCONTIN® and MS-CONTIN®—that dominate the market. In addition, we are aware of numerous other companies developing other technologies for rapidly delivering opioids to treat breakthrough pain, that will compete against FENTORA. In addition, it is possible that the existence of generic OTFC could negatively impact the growth of FENTORA. With respect to ACTIQ, we now face generic competition from Barr that will meaningfully erode branded ACTIQ sales beginning in the fourth quarter of 2006 and impact sales of our own generic OTFC through Watson. Our generic sales also could be significantly impacted by the entrance into the market of additional generic OTFC products. With respect to VIVITROL, we face competition from CAMPRAL® and oral naltrexone. With respect to TRISENOX, the pharmaceutical market for the treatment of patients with relapsed or refractory APL is served by a number of available therapeutics, particularly those that are indicated for the treatment of hematologic cancers, such as THALOMID® by Celgene and VELCADE® by Millennium Pharmaceuticals.

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

Many of our competitors have substantially greater capital resources, research and development staffs and facilities than we have, and substantially greater experience in conducting clinical trials, obtaining regulatory approvals and manufacturing and marketing pharmaceutical products. These entities represent significant competition for us. In addition, competitors who are developing products for the treatment of neurological or oncological disorders might succeed in developing technologies and products that are more effective than any that we develop or sell or that would render our technology and products obsolete or noncompetitive. Competition and innovation from these or other sources, including advances in current treatment methods, could potentially affect sales of our products negatively or make our products obsolete. Furthermore, we may be at a competitive marketing disadvantage against companies that have broader product lines and whose sales personnel are able to offer more complementary products than we can. Any failure to maintain our competitive position could adversely affect our business and results of operations.

We plan to consider and, as appropriate, make acquisitions of technologies, products and businesses, which may subject us to a number of risks and/or result in us experiencing significant charges to earnings that may adversely affect our stock price, operating results and financial condition.

As part of our efforts to acquire businesses or to enter into other significant transactions, we conduct business, legal and financial due diligence with the goal of identifying and evaluating material risks involved in the transaction. Despite our efforts, we ultimately may be unsuccessful in ascertaining or evaluating all such risks and, as a result, we might not realize the intended advantages of the acquisition. If we fail to realize the expected benefits from acquisitions we may consummate in the future, whether as a result of unidentified risks, integration difficulties, regulatory setbacks or other events, our business, results of operations and financial condition could be adversely affected. For example, in connection with our acquisitions in 2005 of Zeneus, Salmedix and TRISENOX and the license and collaboration agreement with Alkermes, we estimated the values of these transactions by making certain assumptions about, among other things, likelihood of regulatory approval for unapproved products and the market potential for each of the marketed products and the product candidates. Ultimately, our assumptions may prove to be incorrect, which could cause us to fail to realize the anticipated benefits of these transactions.

In addition, we have experienced, and will likely continue to experience, significant charges to earnings related to our efforts to consummate acquisitions. For transactions that ultimately are not consummated, these charges may include fees and expenses for investment bankers, attorneys, accountants and other advisers in connection with our efforts. Even if our efforts are successful, we may incur as part of a transaction substantial charges for closure costs associated with the elimination of duplicate operations and facilities and acquired in-process research and development charges. In either case, the incurrence of these charges could adversely affect our results of operations for particular quarterly or annual periods.

We may be unable to successfully consolidate and integrate the operations of businesses we acquire, which may adversely affect our stock price, operating results and financial condition.

We must consolidate and integrate the operations of acquired businesses with our business. In 2005, we completed the acquisitions of Zeneus and Salmedix, purchased assets related to TRISENOX and entered into a license agreement with Alkermes for VIVITROL. Integration efforts often take a significant amount of time, place a significant strain on our managerial, operational and financial resources and could prove to be more difficult and expensive than we predicted. The diversion of our management’s attention and any delays or difficulties encountered in connection with these recent acquisitions, and any future acquisitions we may consummate, could result in the disruption of our ongoing business or inconsistencies in standards, controls, procedures and policies that could negatively affect our ability to maintain relationships with customers, suppliers, employees and others with whom we have business dealings.

The results and timing of our research and development activities, including future clinical trials, are difficult to predict, subject to potential future setbacks and, ultimately, may not result in viable pharmaceutical products, which may adversely affect our business.

In order to sustain our business, we focus substantial resources on the search for new pharmaceutical products. These activities include engaging in discovery research and process development, conducting preclinical and clinical studies and seeking regulatory approval in the United States and abroad. In all of these areas, we have relatively limited resources and compete against larger, multinational pharmaceutical companies. Moreover, even if we undertake these activities in an effective and efficient manner, regulatory approval for the sale of new pharmaceutical products remains highly uncertain because the majority of compounds discovered do not enter clinical studies and the majority of therapeutic candidates fail to show the human safety and efficacy necessary for regulatory approval and successful commercialization.

In the pharmaceutical business, the research and development process can take up to 12 years, or even longer, from discovery to commercial product launch. During each stage of this process, there is a substantial risk of failure. Preclinical testing and clinical trials must demonstrate that a product candidate is safe and efficacious. The results from preclinical testing and early clinical trials may not be predictive of results obtained in subsequent clinical trials, and these clinical trials may not demonstrate the safety and efficacy necessary to obtain regulatory approval for any product candidates. A number of companies in the biotechnology and pharmaceutical industries have suffered significant setbacks in advanced clinical trials, even after obtaining promising results in earlier trials. For ethical reasons, certain clinical trials are conducted with patients having the most advanced stages of disease and who have failed treatment with alternative therapies. During the course of treatment, these patients often die or suffer other adverse medical effects for reasons that may not be related to the pharmaceutical agent being tested. Such events can have a negative impact on the statistical analysis of clinical trial results.

The completion of clinical trials of our product candidates may be delayed by many factors, including the rate of enrollment of patients. Neither we nor our collaborators can control the rate at which patients present themselves for enrollment, and the rate of patient enrollment may not be consistent with our expectations or sufficient to enable clinical trials of our product candidates to be completed in a timely manner or at all. In addition, we may not be permitted by regulatory authorities to undertake additional clinical trials for one or more of our product candidates. Even if such trials are conducted, our product candidates may not prove to be safe and efficacious or receive regulatory approvals. Any significant delays in, or termination of, clinical trials of our product candidates could impact our ability to generate product sales from these product candidates in the future.

The price of our common stock has been and may continue to be highly volatile, which may make it difficult for stockholders to sell our common stock when desired or at attractive prices.

The market price of our common stock is highly volatile, and we expect it to continue to be volatile for the foreseeable future. For example, from January 1, 2005 through November 1, 2006 our common stock traded at a high price of $82.92 and a low price of $37.35. Negative announcements, including, among others:

· adverse regulatory decisions;

· disappointing clinical trial results;

· disputes and other developments concerning our patents or other proprietary products; or

· sales or operating results that fall below the market’s expectations

could trigger significant declines in the price of our common stock. In addition, external events, such as news concerning economic conditions, our competitors or our customers, changes in government regulations impacting the biotechnology or pharmaceutical industries or the movement of capital into or out of our industry, also are likely to affect the price of our common stock, regardless of our operating performance.

Our internal controls over financial reporting may not be considered effective, which could result in possible regulatory sanctions and a decline in our stock price.

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to furnish annually a report on our internal controls over financial reporting. The internal control report must contain an assessment by our management of the effectiveness of our internal control over financial reporting (including the disclosure of any material weakness) and a statement that our independent auditors have attested to and reported on management’s evaluation of such internal controls. The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and internal controls over financial reporting. In order for management to evaluate our internal controls, we must regularly review and document our internal control processes and procedures and test such controls. Ultimately, we or our independent auditors could conclude that our internal control over financial reporting may not be effective if, among others things:

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

· we fail to remediate assessed deficiencies.

In early 2006, we implemented a new worldwide financial reporting system that has required changes to certain aspects of our existing system of internal control over financial reporting. Due to the number of controls to be examined, both with respect to the new reporting system and our other internal controls over financial reporting, the complexity of these projects, and the subjectivity involved in determining the effectiveness of controls, we cannot be certain that, in the future, all of our controls will continue to be considered effective by management or, if considered effective by our management, that our auditors will agree with such assessment.

If, in the future, we are unable to assert that our internal control over financial reporting is effective, or if our auditors are unable to attest that our management’s report is fairly stated or they are unable to express an opinion on our management’s evaluation, we could be subject to regulatory sanctions or lose investor confidence in the accuracy and completeness of our financial reports, either of which could have an adverse effect on the market price for our securities.

A portion of our revenues and expenses is subject to exchange rate fluctuations in the normal course of business, which could adversely affect our reported results of operations.

Historically, a portion of our revenues and expenses has been earned and incurred, respectively, in currencies other than the U.S. dollar. For the nine months ended September 30, 2006, approximately 16% of our revenues were denominated in currencies other than the U.S. dollar. We translate revenues earned and expenses incurred into U.S. dollars at the average exchange rate applicable during the relevant period. A weakening of the U.S. dollar would, therefore, increase both our revenues and expenses. Fluctuations in the rate of exchange between the U.S. dollar and the euro and other currencies may affect period-to-period comparisons of our operating results. Historically, we have not hedged our exposure to these fluctuations in exchange rates.

Our customer base is highly concentrated.

Our principal customers are wholesale drug distributors. These customers comprise a significant part of the distribution network for pharmaceutical products in the United States. Three large wholesale distributors, Cardinal Health, Inc., McKesson Corporation and AmerisourceBergen Corporation, control a significant share of this network. These three wholesaler customers, in the aggregate, accounted for 80% of our worldwide net sales for the nine months ended September 30, 2006. Fluctuations in the buying patterns of these customers, which may result from seasonality, wholesaler buying decisions or other factors outside of our control, could significantly affect the level of our net sales on a period to period basis. Because of this, the amounts purchased by these customers during any quarterly or annual period may not correlate to the level of underlying demand evidenced by the number of prescriptions written for such products, as reported by IMS Health Incorporated. Furthermore, the loss or bankruptcy of any of these customers could materially and adversely affect our results of operations and financial condition.

We are involved, or may become involved in the future, in legal proceedings that, if adversely adjudicated or settled, could materially impact our financial condition.

As a biopharmaceutical company, we are or may become a party to litigation in the ordinary course of our business, including, among others, matters alleging employment discrimination, product liability, patent or other intellectual property rights infringement, patent invalidity or breach of commercial contract. In general, litigation claims can be expensive and time consuming to bring or defend against and could result in settlements or damages that could significantly impact results of operations and financial condition. We currently are vigorously defending ourselves against certain litigation matters in addition to those matters specifically described in Note 7 of the Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q. While we currently do not believe that the settlement or adverse adjudication of these other litigation matters would materially impact our results of operations or financial condition, the final resolution of these matters and the impact, if any, on our results of operations, financial condition or cash flows is unknown but could be material.

Our dependence on key executives and scientists could impact the development and management of our business.

We are highly dependent upon our ability to attract and retain qualified scientific, technical and managerial personnel. There is intense competition for qualified personnel in the pharmaceutical and biotechnology industries, and we cannot be sure that we will be able to continue to attract and retain the qualified personnel necessary for the development and management of our business. Although we do not believe the loss of one individual would materially harm our business, our business might be harmed by the loss of the services of multiple existing personnel, as well as the failure to recruit additional key scientific, technical and managerial personnel in a timely manner. Much of the know-how we have developed resides in our scientific and technical personnel and is not readily transferable to other personnel. While we have employment agreements with our key executives, we do not ordinarily enter into employment agreements with our other key scientific, technical and managerial employees. We do not maintain “key man” life insurance on any of our employees.

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

Our research and development activities involve the controlled use of hazardous, infectious and radioactive materials that could be hazardous to human health and safety or the environment. We store these materials, and various wastes resulting from their use, at our facilities pending ultimate use and disposal. We are subject to a variety of federal, state and local laws and regulations governing the use, generation, manufacture, storage, handling and disposal of these materials and wastes, and we may be required to incur significant costs to comply with related existing and future environmental laws and regulations.

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

Anti-takeover provisions may delay or prevent changes in control of our management or deter a third party from acquiring us, limiting our stockholders’ ability to profit from such a transaction.

Our board of directors has the authority to issue up to 5,000,000 shares of preferred stock, $0.01 par value, of which 1,000,000 have been reserved for issuance in connection with our stockholder rights plan, and to determine the price, rights, preferences and privileges of those shares without any further vote or action by our stockholders. Our stockholder rights plan could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock.

We are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which prohibits us from engaging in a “business combination” with an “interested stockholder” for a period of three years after the date of the transaction in which the person becomes an interested stockholder, unless the business combination is approved in a prescribed manner. The application of Section 203 could have the effect of delaying or preventing a change of control of Cephalon. Section 203, the rights plan, and certain provisions of our certificate of incorporation, our bylaws and Delaware corporate law, may have the effect of deterring hostile takeovers, or delaying or preventing changes in control of our management, including transactions in which stockholders might otherwise receive a premium for their shares over then-current market prices.

ITEM 5. OTHER INFORMATION

Ratios of Earnings to Fixed Charges
(In thousands)

	Years ended December 31,													Nine months ended September 30,
	2001			2002		2003		2004			2005			2006
Pre-tax income (loss) from continuing operations	$	(55,484	)	$	62,433	$	130,314	$	(28,184	)	$	(245,118	)	$	241,292

Fixed charges:
Interest expense and amortization of debt discount and premium on all indebtedness	20,630			38,215		28,905		22,186			25,235			13,523
Capitalized interest	—			—		—		—			1,044			2,812
Appropriate portion of rentals	1,092			1,433		2,286		3,437			5,750			6,831
Preferred stock dividend requirements of consolidated subsidiaries	5,664			—		—		—			—			—
Total fixed charges	27,386			39,648		31,191		25,623			32,029			23,166
Amortization of interest capitalized in current or prior periods	—			—		—		—			—			472
Pre-tax income (loss) from continuing operations, plus fixed charges and amortization of interest capitalized in current or prior periods, less capitalized interest and preferred stock dividend requirements of consolidated subsidiaries	$	(33,762	)	$	102,081	$	161,505	$	(2,561	)	$	(214,133	)	$	262,118

Ratio of earnings to fixed charges(1)	—			2.57		5.18		—			—			11.31
Deficiency of earnings to fixed charges	61,148			—		—		28,184			246,162			—

(1) For the years ended December 31, 2001, 2004 and 2005 no ratios are provided because earnings were insufficient to cover fixed charges and preferred dividends and fixed charges, respectively.

ITEM 6. EXHIBITS

Exhibits:

Exhibit No.		Description
10.1*		Settlement and License Agreement by and among Cephalon, Inc., Carlsbad Technology, Inc. and Watson Pharmaceuticals, Inc. dated as of August 2, 2006. (1)
10.2*		Separation Agreement by and between Cephalon, Inc. and Paul Blake dated as of August 23, 2006.
31.1*		Certification of Frank Baldino, Jr., Ph.D., Chairman and Chief Executive Officer of the Company, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2*		Certification of J. Kevin Buchi, Executive Vice President and Chief Financial Officer of the Company, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1#		Certification of Frank Baldino, Jr., Ph.D., Chairman and Chief Executive Officer of the Company, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2#		Certification of J. Kevin Buchi, Executive Vice President and Chief Financial Officer of the Company, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

* Filed herewith.

# This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liability of that section. Further, this exhibit shall not be deemed to be incorporated by reference in any document filed under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended.

(1) Portions of the Exhibit have been omitted and have been filed separately pursuant to an application for confidential treatment filed with the Securities and Exchange Commission pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, as amended.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	CEPHALON, INC.
	(Registrant)


November 8, 2006	By	/s/ FRANK BALDINO, JR
		Frank Baldino, Jr., Ph.D.
		Chairman and Chief Executive Officer
		(Principal executive officer)


	By	/s/ J. KEVIN BUCHI
		J. Kevin Buchi
		Executive Vice President and Chief Financial Officer
		(Principal financial and accounting officer)

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Cephalon (CEPH) Inactive 10-Q2006 Q3 Quarterly report

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