News Column

SALIX PHARMACEUTICALS LTD - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 8, 2014

The following discussion should be read in conjunction with our Condensed Consolidated Financial Statements and notes thereto included elsewhere in this report.

OVERVIEW We are a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs and medical devices used in the treatment of a variety of gastrointestinal disorders, which are those affecting the digestive tract. Our strategy is to:



identify and acquire rights to products that we believe have potential for

near-term regulatory approval or are already approved; apply our regulatory, product development, and sales and marketing expertise to commercialize these products; and market our products through our specialty sales and marketing team by



primarily focusing on high-prescribing U.S. physicians in the following

specialties: gastroenterologists, who are doctors who specialize in

gastrointestinal disorders; hepatologists, who are doctors who specialize

in liver disease; colorectal surgeons, who are doctors who specialize in

disorders of the colon and rectum, endocrinologists, who are doctors who

specialize in diagnosing and treating hormone imbalances such as diabetes

mellitus; and primary care doctors.

Significant Developments since March 31, 2014

In April 2014, the European Medicines Agency accepted for review the submission by us and Progenics of Relistor SI for the treatment of OIC in adult patients with chronic non-cancer pain.



On July 1, 2014, we announced the successful outcome of TARGET 3, a Phase

3 randomized, double-blind, placebo-controlled study to evaluate the efficacy and safety of repeat treatment with rifaximin 550 mg TID (three



times daily) for 14 days in subjects with irritable bowel syndrome, or

IBS, with diarrhea, or IBS-D, who respond to an initial treatment course

with rifaximin 550 mg TID for 14 days. We intend to submit a response to

the CRL that we received from the FDA in March 2011 during the third quarter of 2014.



On July 8, 2014, we announced the Merger Agreement under which we will

combine with Cosmo Tech. Under the terms of the Merger Agreement, we will

become a wholly owned subsidiary of Irish domiciled Cosmo Tech, which will

change its name to Salix Pharmaceuticals, plc, or New Salix, and is expected to have its ordinary shares listed and traded on the NASDAQ Global Select Market. The transaction, which will be taxable to our shareholders, is expected to close in the fourth quarter of 2014. Upon



completion of the merger, our shareholders are expected to own slightly

less than 80% of the ordinary shares of New Salix and Cosmo is expected to

own slightly more than 20%.



On July 14, 2014, the FDA informed us and Progenics that Relistor SI for

the treatment of OIC in patients taking opiods for chronic non-cancer pain

could be approved on the data submitted in the Supplemental New Drug

Application, or sNDA. The FDA directed us to work with and submit

information to the Division of Gastroenterology and Inborn Errors Products

relating to proposed product labeling and a proposal for one or more

post-marketing observational cohort studies designed to assess the

relative incidence of major adverse cardiovascular events among chronic

non-cancer pain patients initiating Relistor via SI for OIC versus a comparator cohort. On July 25, 2014, Salix submitted the requested information.



On July 16, 2014, the FDA approved Ruconest for the treatment of acute

angioedema attacks in adult and adolescent patients with hereditary

angioedema, or HAE. Because of the limited number of patients with

laryngeal attacks, effectiveness was not established in HAE patients with

laryngeal attacks. On July 24, 2014, we received a purported notice of Paragraph IV



Certification on behalf of Alvogen advising of the submission of an ANDA

for Uceris. A Paragraph IV challenge is where the ANDA includes

certification by the generic company that, in the generic company's

opinion, its generic product does not infringe on the listed patents or

that those patents are not enforceable. We are currently reviewing the

notification and evaluating our options. Alvogen's current notice relates

to a patent that was not orange book listed on the date the letter was

received, but has subsequently been listed. We do not know if Alvogen's

ANDA has been accepted for filing, or if Alvogen has filed a Paragraph III

or Paragraph IV Certification as to the Company's other orange book listed

patents for Uceris. Introduction to Products



In connection with and following the integration of Santarus, we plan to execute our strategy by:

marketing our currently marketed products (including Santarus' product

portfolio) through our established channels and Santarus' network of high-volume specialty and primary care physician-focused sales representatives; utilizing our expertise to progress pipeline products and indications through late-stage development and approval; and making select acquisitions to further diversify our product portfolio and improve profitability. 29



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As of June 30, 2014, our products were:

XIFAXAN550 (rifaximin) tablets 550 mg, indicated for the reduction in risk

of overt HE recurrence in patients 18 years of age and older; XIFAXAN (rifaximin) tablets 200 mg, indicated for the treatment of



patients 12 years of age and older with TD caused by noninvasive strains

of E. coli; APRISO (mesalamine) extended-release capsules, indicated for the maintenance of remission of ulcerative colitis, or UC; UCERIS (budesonide MMX) extended release tablets, indicated for the induction of remission in patients with active, mild to moderate UC;



MOVIPREP (PEG 3350, sodium sulfate, sodium chloride, potassium chloride,

sodium ascorbate and ascorbic acid for oral solution), indicated for

cleansing of the colon as a preparation for colonoscopy in adults 18 years

of age or older; ZEGERID (omeprazole/sodium bicarbonate) capsules and powder for oral



suspension, indicated for the treatment of certain upper gastrointestinal

conditions, including active duodenal ulcer, active benign gastric ulcer and gastroesophageal reflux disease, or GERD;



GLUMETZA (metformin hydrochloride) extended release tablets, indicated as

an adjunct to diet and exercise to improve glycemic control in adults with

type 2 diabetes mellitus;



RELISTOR (methylnaltrexone bromide) SI indicated for the treatment of OIC

in patients with advanced illness who are receiving palliative care, when

the response to laxative therapy has not been sufficient; OSMOPREP (sodium phosphate monobasic monohydrate, USP and sodium phosphate



dibasic anhydrous, USP) tablets, indicated for cleansing of the colon as a

preparation for colonoscopy in adults 18 years of age or older; SOLESTA, a biocompatible tissue-bulking agent indicated for the treatment

of fecal incontinence in patients 18 years or older who have failed conservative therapy;



DEFLUX, a biocompatible tissue-bulking agent indicated for the treatment

of vesicoureteral reflux, grades II-IV; FULYZAQ (crofelemer) delayed-release tablets, indicated for the

symptomatic relief of non-infectious diarrhea in adult patients with HIV/AIDS on anti-retroviral therapy;



GIAZO (balsalazide disodium) tablets, indicated for the treatment of

mildly to moderately active UC in male patients 18 years of age and older;

CYCLOSET (bromocriptine mesylate) tablets, indicated as an adjunct to diet

and exercise to improve glycemic control in adults with type 2 diabetes

mellitus; FENOGLIDE (fenofibrate) tablets, indicated as an adjunct to diet to reduce



elevated low-density lipoprotein-cholesterol, total cholesterol,

triglycerides and apolipoprotein B, and to increase high-density

lipoprotein-cholesterol in adult patients with primary hyperlipidemia or

mixed dyslipidemia. Fenoglide also is indicated as an adjunct to diet for

treatment of adult patients with hypertriglyceridemia; METOZOLV ODT (metoclopramide hydrochloride) 5 mg and 10 mg orally disintegrating tablets, indicated for short-term (4 to 12 weeks) use in adults for treatment of GERD that fails to respond to conventional



therapy, and for relief of symptoms of acute and recurrent diabetic

gastroparesis; AZASAN (azathioprine, USP), 75 mg and 100 mg tablets, indicated as an



adjunct for the prevention of rejection in renal homotransplantations and

to reduce signs and symptoms of severe active rheumatoid arthritis;

ANUSOL-HC (hydrocortisone, USP) 2.5% cream and ANUSOL-HC (hydrocortisone

acetate) 25 mg suppositories, indicated for the relief of the inflammatory

and pruritic manifestations of corticosteroid-responsive dermatoses;

PROCTOCORT (hydrocortisone, USP) 1% cream and PROCTOCORT (hydrocortisone

acetate) 30 mg suppositories, indicated for the relief of the inflammatory

and pruritic manifestations of corticosteroid-responsive dermatoses;

PEPCID (famotidine) for oral suspension, indicated for the short-term

treatment of GERD, active duodenal ulcer, active benign gastric ulcer, erosive esophagitis due to GERD, and peptic ulcer disease;



DIURIL (chlorothiazide) oral suspension, indicated for the treatment of

hypertension and also as adjunctive therapy in edema associated with congestive heart failure, cirrhosis of the liver, corticosteroid and estrogen therapy, and kidney disease; and



COLAZAL (balsalazide disodium) capsules, indicated for the treatment of

mildly to moderately active UC in patients 5 years of age and older. 30



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Our primary product candidates currently under development and their status are as follows: Compound Condition Status Rifaximin Irritable Bowel Syndrome sNDA submitted June 7, with Diarrhea, or IBS 2010; CRL received on March 7, 2011; FDA meeting held on June 20, 2011; Advisory Committee meeting held on November 16, 2011; statistically significant primary endpoint result announced July 1, 2014; CRL response filing expected in third quarter of 2014 Methylnaltrexone bromide SI OIC in patients with sNDA accepted for chronic non-malignant filing; CRL received pain; subcutaneous July 27, 2012; notified injection by FDA in July 2014 that sNDA can be approved on the data submitted in the sNDA and requested additional information; requested information submitted to FDA on July 25, 2014 UCERIS (budesonide) rectal foam Ulcerative proctitis NDA accepted for filing January 2014; PDUFA action date September 15, 2014 Methylnaltrexone bromide oral OIC in patients with Phase 3 chronic non-malignant pain; oral Rifaximin delayed release Crohn's disease Phase 3 Rifaximin SSD/next generation Prevention of Phase 2 complications in compensated liver cirrhosis Ruconest Hereditary Angiodema, or BLA submitted April HAE 2013; PDUFA action date July 16, 2014; FDA approval of BLA on July 16, 2014



APPLICATION OF CRITICAL ACCOUNTING ESTIMATES

Critical Accounting Policies

In our Annual Report on Form 10-K for the fiscal year ended December 31, 2013, we identified our most critical accounting policies and estimates upon which our financial status depends as those relating to: revenue recognition, including allowance for product returns and allowance for rebates and coupons; inventories; valuation of intangible assets and contingent consideration liabilities acquired in business combinations; intangible assets and goodwill; research and development; convertible debt transactions; and deferred tax asset valuation. We reviewed our policies and determined that those policies remained our most critical accounting policies for the three-month period ended June 30, 2014. We did not make any changes in those policies during the quarter. We recognize revenue from sales transactions where the buyer has the right to return the product at the time of sale only if (1) our price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid us, or the buyer is obligated to pay us and the obligation is not contingent on resale of the product, (3) the buyer's obligation to us would not be changed in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has economic substance apart from any provided by us, (5) we do not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be reasonably estimated. We recognize revenues for product sales at the time title and risk of loss are transferred to the customer, which is generally at the time products are shipped. Our net product revenue represents our total revenues less allowances for customer credits, including estimated discounts, rebates, chargebacks, and product returns.



We establish allowances for estimated rebates, chargebacks and product returns based on numerous quantitative and qualitative factors, including:

the number of and specific contractual terms of agreements with customers;

estimated levels of inventory in the distribution channel; historical rebates, chargebacks and returns of products; direct communication with customers; anticipated introduction of competitive products or generics; 31



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Table of Contents anticipated pricing strategy changes by us and/or our competitors;



analysis of prescription data gathered by a third-party prescription data

provider; the impact of changes in state and federal regulations; and estimated remaining shelf life of products. In our analyses, we use prescription data purchased from a third-party data provider to develop estimates of historical inventory channel pull-through. We utilize an internal analysis to compare historical net product shipments to estimated historical prescriptions written. Based on that analysis, we develop an estimate of the quantity of product in the channel that might be subject to various rebate, chargeback and product return exposures. At least quarterly for each product line, we prepare an internal estimate of ending inventory units in the distribution channel by adding estimated inventory in the channel at the beginning of the period, plus net product shipments for the period, less estimated prescriptions written for the period. Based on that analysis, we develop an estimate of the quantity of product in the channel that might be subject to various rebate, chargeback and product return exposures. This is done for each product line by applying a rate of historical activity for rebates, chargebacks and product returns, adjusted for relevant quantitative and qualitative factors discussed above, to the potential exposed product estimated to be in the distribution channel. Internal forecasts that are utilized to calculate the estimated number of months in the channel are regularly adjusted based on input from members of our sales, marketing and operations groups. The adjusted forecasts take into account numerous factors including, but not limited to, new product introductions, direct communication with customers and potential product expiry issues. Adjustments to estimates are recorded in the period when significant events or changes in trends are identified. Consistent with industry practice, we periodically offer promotional discounts to our existing customers. These discounts are calculated as a percentage of the current published list price and are treated as off-invoice allowances. Accordingly, we record the discounts as a reduction of revenue in the period that we offer the program. In addition to promotional discounts, at the time that we implement a price increase, we generally offer our existing customers an opportunity to purchase a limited quantity of product at the previous list price. Shipments resulting from these programs generally are not in excess of ordinary levels, therefore, we recognize the related revenue upon shipment and include the shipments in estimating our various product related allowances. In the event we determine that these shipments represent purchases of inventory in excess of ordinary levels for a given wholesaler, the potential impact on product returns exposure would be specifically evaluated and reflected as a reduction in revenue at the time of such shipments. Allowances for estimated rebates, chargebacks and promotional programs were $231.6 million and $186.4 million as of June 30, 2014 and December 31, 2013, respectively. These allowances reflect an estimate of our liability for items such as rebates due to various governmental organizations under the Medicare/Medicaid regulations, rebates due to managed care organizations under specific contracts and chargebacks due to various organizations purchasing certain of our products through federal contracts and/or group purchasing agreements. We estimate our liability for rebates and chargebacks at each reporting period based on a methodology of applying the relevant quantitative and qualitative assumptions discussed above. Due to the subjectivity of our accrual estimates for rebates and chargebacks, we prepare various sensitivity analyses to ensure our final estimate is within a reasonable range as well as review prior period activity to ensure that our methodology is still reasonable. Had a change in one or more variables in the analyses (utilization rates, contract modifications, etc.) resulted in an additional percentage point change in the trailing average of estimated chargeback and rebate activity for the year ended December 31, 2013, we would have recorded an adjustment to revenues of approximately $9.3 million, or 1.3%, for the year. There was no material change in the results of this sensitivity analysis during the three-month period ended June 30, 2014. Allowances for product returns were $73.0 million and $60.4 million as of June 30, 2014 and December 31, 2013, respectively. These allowances reflect an estimate of our liability for product that may be returned by the original purchaser in accordance with our stated return policy. We estimate our liability for product returns at each reporting period based on historical return rates, the estimated inventory in the channel, and the other factors discussed above. Due to the subjectivity of our accrual estimates for product returns, we prepare various sensitivity analyses as well as review prior period activity to ensure that our methodology is still reasonable. For the three-month and six-month periods ended June 30, 2014 and 2013, our absolute exposure for rebates, chargebacks and product returns grew primarily as a result of increased sales of our existing products, the approval of new products and the acquisition of products. Accordingly, reductions to revenue and corresponding increases to allowance accounts have likewise increased. The estimated exposure to these revenue-reducing items as a percentage of gross product revenue in the three-month periods ended June 30, 2014 and 2013 was 18.0%, and 18.1% for rebates, chargebacks and discounts and was (0.1)% and 2.3% for product returns, respectively. The estimated exposure to these revenue-reducing items as a percentage of gross product revenue in the six-month periods ended June 30, 2014 and 2013 was 17.4%, and 16.9% for rebates, chargebacks and discounts and was 2.7% and 2.3% for product returns, respectively. 32



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The enactment of the "Patient Protection and Affordable Care Act" and "The Health Care and Education Reconciliation Act of 2010" in March 2010 brings significant changes to U.S. health care. These changes began to take effect in the first quarter of 2010. Changes to the rebates for prescription drugs sold to Medicaid beneficiaries, which increase the minimum statutory rebate for branded drugs from 15.1% to 23.1%, were generally effective in the first quarter of 2010. This rebate has been expanded to managed Medicaid, a program that provides for the delivery of Medicaid benefits via managed care organizations, under arrangements between those organizations and state Medicaid agencies. Additionally, a prescription drug discount program for outpatient drugs in health care facilities that serve low-income and uninsured patients, known as 340B facilities, has been expanded. The effect of these changes was not material to our financial results for the three-month and six-month periods ended June 30, 2014 and 2013. Based on our current product and payor mix, we believe the effect of these changes should not be material to our future financial results. Also, there are changes to the tax treatment of subsidies paid by the government to employers who provide their retirees with a drug benefit at least equivalent to the Medicare Part D drug benefit. Beginning in 2013, the federal government will tax the subsidy it provides to such employers. We do not provide retirees with any drug benefits; therefore this change should not affect our financial results. Beginning in 2011, drug manufacturers will provide a discount of 50% of the cost of branded prescription drugs for Medicare Part D participants who are in the "doughnut hole" coverage gap in Medicare prescription drug coverage. The doughnut hole will be phased out by the federal government between 2011 and 2020. Based on our current product and payor mix, the cost of this discount was approximately 1% of our gross revenue for the year ended December 31, 2013, which cost as a percentage of gross revenue did not materially change during the three-month and six-month periods ended June 30, 2014. However, the cost of this discount could have a material effect on our results of operations in future periods. Beginning in 2011, pharmaceutical manufacturers and importers that sell branded prescription drugs to specified government programs had to pay a non-tax deductible annual fee to the federal government. Companies have to pay an amount based on their prior calendar year market share for branded prescription drug sales into these government programs. Based on our current product and payor mix, the effect of this tax was not material to our financial results for the three-month and six-month periods ended June 30, 2014 and 2013, and we do not believe the effect of this tax will be material to future periods. Additionally, the 2010 healthcare reform legislation imposes a 2.3 % excise tax on U.S. sales of Class I, II and III medical devices beginning in 2013. This tax did not have a material effect on our financial statements for the three-month and six-month periods ended June 30, 2014 or 2013, and we do not believe the effect of this tax will be material to future periods.



Results of Operations

Three-month and Six-month Periods Ended June 30, 2014 and 2013

As a result of the acquisition of Santarus completed on January 2, 2014, period over period results are not necessarily comparable, especially for revenues, cost of goods sold, amortization of product rights, and selling, general and administrative expenses. 33



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Revenues

The following table summarizes net product revenues for the three-month and six-month periods ended June 30:

Three months ended Six months ended June 30, June 30, 2014 2013 2014 2013 Xifaxan $ 140,484$ 150,587$ 254,744$ 303,872 % of net product revenues 37 % 64 % 33 % 69 % Inflammatory Bowel Disease - Apriso/Uceris/Giazo/ Colazal 70,253 45,146 138,944 63,606 % of net product revenues 18 % 19 % 18 % 15 % Diabetes-Glumetza and Cycloset 110,262 - 250,633 - % of net product revenues 29 % 0 % 33 % 0 % Purgatives - OsmoPrep/ MoviPrep 9,053 20,814 16,188 34,876 % of net product revenues 2 % 9 % 2 % 8 % Zegerid 27,162 - 64,757 - % of net product revenues 7 % 0 % 8 % 0 % Other - Anusol/Azasan/Diuril/Pepcid/Proctocort/ Relistor/ Deflux/Solesta/Fulyzaq/Metozolv 24,786 18,894 41,108 35,688 % of net product revenues 7 % 8 % 6 % 8 % Net product revenues $ 382,000$ 235,441$ 766,374$ 438,042 Net product revenues for the three-month period ended June 30, 2014 were $382.0 million, compared to $235.4 million for the corresponding three-month period in 2013, a 62% increase. The net product revenue increase for the three-month period ended June 30, 2014 compared to the three-month period ended June 30, 2013 was primarily due to:



unit sales of Glumetza, Uceris, Cycloset, Zegerid, and Fenoglide due to

the acquisition of Santarus in January 2014, and wholesale inventory

stocking, and price increases on our products.



These increases were partially offset by reduced unit sales of Xifaxan, Relistor and MoviPrep due to wholesaler inventory de-stocking.

Total prescriptions of Xifaxan 550mg prescribed for the three-month period ended June 30, 2014 compared to the corresponding three-month period in 2013 increased 23%. Prescriptions for our purgatives decreased 12% for the three-month period ended June 30, 2014 compared to the corresponding three-month period in 2013. Prescriptions for MoviPrep decreased 11% for the three-month period ended June 30, 2014 compared to the corresponding three-month period in 2013. Prescriptions for OsmoPrep for the three-month period ended June 30, 2014 declined 20% compared to the corresponding three-month period in 2013. Prescriptions for Apriso increased 25% for the three-month period ended June 30, 2014 compared to the corresponding three-month period in 2013. Net product revenues for the six-month period ended June 30, 2014 were $766.4 million, compared to $438.0 million for the corresponding six-month period in 2013, a 75% increase. The net product revenue increase for the six-month period ended June 30, 2014 compared to the six-month period ended June 30, 2013 was primarily due to:



unit sales of Glumetza, Uceris, Cycloset, Zegerid, and Fenoglide due to

the acquisition of Santarus, Inc. in January 2014, and wholesale inventory

stocking, and price increases on our products.



These increases were partially offset by reduced unit sales of Xifaxan, Relistor and MoviPrep due to wholesaler inventory de-stocking.

Total prescriptions of Xifaxan 550mg prescribed for the six-month period ended June 30, 2014 compared to the corresponding six-month period in 2013 increased 21%. Prescriptions for our purgatives decreased 11% for the six-month period ended June 30, 2014 compared to the corresponding six-month period in 2013. Prescriptions for MoviPrep decreased 10% for the six-month period ended June 30, 2014 compared to the corresponding six-month period in 2013. Prescriptions for OsmoPrep for the six-month period ended June 30, 2014 declined 21% compared to the corresponding six-month period in 2013. Prescriptions for Apriso increased 39% for the six-month period ended June 30, 2014 compared to the corresponding six-month period in 2013. 34



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Costs and Expenses

Costs and expenses for the three-month period ended June 30, 2014 were $333.6 million, compared to $185.3 million for the corresponding three-month period in 2013, and $756.0 million for the six-month period ended June 30, 2014, compared to $338.6 million for the corresponding six-month period in 2013. Higher costs and expenses were due primarily to increased costs due to the acquisition of Santarus, and increased cost of products sold related to increased product sales. The acquisition of Santarus resulted in increased costs primarily due to the expansion of our field sales force from approximately 250 sales representatives to approximately 500 sales representatives, and transaction and integration costs. Cost of Products Sold Cost of products sold for the three-month period ended June 30, 2014 was $104.3 million, compared with $46.5 million for the corresponding three-month period in 2013. Gross margin on total product revenue, excluding $54.9 million and $11.2 million in amortization of product rights and intangible assets for the three-month periods ended June 30, 2014 and 2013, respectively, was 72.7% for the three-month period ended June 30, 2014 and 80.3% for the three-month period ended June 30, 2013. Excluding $16.7 million associated with the step-up in the value of the inventory in connection with the fair value accounting related to the Santarus acquisition, the gross margin on total product revenue for the three-month period ended June 30, 2014 was 76.9%. The lower gross margin in the three-month period ended June 30, 2014 compared to the same period in 2013 is due primarily to sales of Glumetza and Cycloset, which have lower gross margins than Xifaxan, which had reduced sales during the quarter, and other changes in the product revenue mix in the respective periods. Cost of products sold for the six-month period ended June 30, 2014 was $219.9 million, compared with $79.6 million for the corresponding six-month period in 2013. Gross margin on total product revenue, excluding $109.8 million and $22.3 million in amortization of product rights and intangible assets for the six-month periods ended June 30, 2014 and 2013, respectively, was 71.3% for the six-month period ended June 30, 2014 and 81.8% for the six-month period ended June 30, 2013. Excluding $34.7 million associated with the step-up in the value of the inventory in connection with the fair value accounting related to the Santarus acquisition, the gross margin on total product revenue for the six-month period ended June 30, 2014 was 75.8%. The lower gross margin in the six-month period ended June 30, 2014 compared to the same period in 2013 is due primarily to sales of Glumetza and Cycloset, which have lower gross margins than Xifaxan, which had reduced sales during the quarter, and other changes in the product revenue mix in the respective periods.



Amortization of Product Rights and Intangible Assets

Amortization of product rights and intangible assets for the three-month period ended June 30, 2014 was $54.9 million, compared with $11.2 million for the corresponding three-month period in 2013. Amortization of product rights and intangible assets for the six-month period ended June 30, 2014 was $109.8 million, compared with $22.3 million for the corresponding six-month period in 2013. The higher amortization of product rights and intangible assets in the three-month and six-month periods ended June 30, 2014 compared to the same periods in 2013 is due primarily to amortization expense resulting from the fair value adjustment for purchase accounting for the acquisition of Santarus.



Research and Development

Research and development expenses were $39.2 million for the three-month period ended June 30, 2014, compared to $45.2 million for the comparable period in 2013. The decrease in research and development expenses for the three-month period ended June 30, 2014 compared to the corresponding period in 2013 was due primarily to:



decreased expenses of approximately $7.5 million primarily related to our

development programs for rifaximin for IBS, rifaximin for HE, relistor for

OIC, and UCERIS (budesonide) rectal foam; and



the $10.0 million payment to Olon S.p.A. for the purchase of intellectual

property made during the three-month period ended June 30, 2013. 35



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These decreases were partially offset by increased expenses of approximately $9.1 million related to our development program for rifaximin SSD/next generation, rifaximin delayed release, and other development expenses, and increased personnel costs of approximately $2.4 million.

Research and development expenses were $92.0 million for the six-month period ended June 30, 2014, compared to $75.5 million for the comparable period in 2013. The increase in research and development expenses for the six-month period ended June 30, 2014 compared to the corresponding period in 2013 was due primarily to:



payments related to license and patent agreements, of $14.5 million,

primarily related to the RedHill agreement;



increased expenses of approximately $13.7 million primarily related to our

development programs for rifaximin SSD/next generation, rifaximin delayed

release, and other development expenses; and increased personnel costs of approximately $4.4 million. These increases were partially offset by decreased expenses of approximately $6.1 million related to our development program for rifaximin for IBS, relistor for OIC, UCERIS (budesonide) rectal foam, and other development expenses, and the $10.0 million payment to Olon S.p.A. for the purchase of intellectual property made during the three-month period ended June 30, 2013. Since inception through June 30, 2014, we have incurred research and development expenditures of approximately $41.7 million for balsalazide, $257.5 million for rifaximin, $32.3 million for granulated mesalamine, $37.5 million for crofelemer, $42.6 million for methylnaltrexone bromide and $42.6 million for budesonide foam. Due to the significant risks and uncertainties inherent in the clinical development and regulatory approval processes, we cannot reasonably estimate the cost to complete projects and development timelines for their completion. Enrollment in clinical trials might be delayed or occur faster than anticipated for reasons beyond our control, requiring additional cost and time or accelerating spending. Results from clinical trials might not be favorable, or might require us to perform additional unplanned clinical trials, accelerating spending, requiring additional cost and time, or resulting in termination of the project. Further, as evidenced by the Complete Response Letter for rifaximin as a treatment for IBS, data from clinical trials is subject to varying interpretation, and might be deemed insufficient by the regulatory bodies reviewing applications for marketing approvals, requiring additional cost and time, or resulting in termination of the project. Regulatory reviews can also be delayed. For example the PDUFA action dates for Relistor and crofelemer were each extended by three months. Process development and manufacturing scale-up for production of clinical and commercial product supplies might take longer and cost more than our forecasts. As a result, clinical development and regulatory programs are subject to risks and changes that might significantly impact cost projections and timelines.



The following table summarizes costs incurred for our significant projects, in thousands. We consider a project significant if expected spend for any year exceeds 10% of our development project budget for that period.

Three Months Six Months Cumulative Ended June 30, Ended June 30, through June 30, Project 2014 2013 2014 2013 2014 Rifaximin for HE $ 2,073$ 2,633$ 4,458$ 4,150 $ 57,540 Rifaximin for IBS 4,810 9,372 13,489 18,520 128,692



Crofelemer for HIV-associated diarrhea 845 374 1,091

685 37,503 Budesonide foam for ulcerative proctitis 789 2,032 3,304 3,381 42,642 Methylnaltrexone bromide for OIC in patients with chronic pain 1,212 2,293 2,470 2,912 42,608 Next generation rifaximin 5,160 1,802 7,624 2,988 15,492 Other non-significant rifaximin clinical projects (2 in 2014, 2 in 2013) 312 81 830 420 N/A All other clinical programs (10 in 2014, 6 in 2013) 1,987 1,981 4,082 4,105 N/A We generally expect research and development costs to increase in absolute terms in future periods as we pursue additional indications and formulations for rifaximin SSD/next generation, rifaximin delayed release and other development programs and if and when we acquire new products.



Selling, General and Administrative

Selling, general and administrative expenses were $124.9 million for the three-month period ended June 30, 2014, compared to $80.3 million in the corresponding three-month period in 2013. This increase was primarily due to:

transaction and integration costs related to the Santarus acquisition and

the pending transaction with Cosmo Tech of approximately $8.2 million;

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increased personnel and other direct operational costs of $25.2 million as

result of the increase in our field sale representatives from

approximately 250 personnel to approximately 500 personnel in connection

with the Santarus acquisition; increased marketing expenses of $9.6 million related to Xifaxan, Relistor,

Uceris and Glumetza; and



increased legal expenses of approximately $1.6 million related to our Napo

lawsuit, our patent infringement complaint against Lupin, and the subpoena

from the U.S. Attorney's Office for the Southern District of New York received in February 2013.



These increases were partially offset by reduced marketing expenses related to Solesta.

Selling, general and administrative expenses were $320.1 million for the six-month period ended June 30, 2014, compared to $156.6 million in the corresponding six-month period in 2013. This increase was primarily due to:

transaction and integration costs related to the Santarus acquisition and

the pending transaction with Cosmo Tech of approximately $94.6 million;

increased personnel and other direct operational costs of $46.2 million as

result of the increase in our field sale representatives from

approximately 250 personnel to approximately 500 personnel in connection

with the Santarus acquisition; increased marketing expenses of $15.5 million related to Xifaxan,

Relistor, Uceris and Glumetza; and



increased legal expenses of approximately $7.2 million related to our Napo

lawsuit, our patent infringement complaint against Lupin, and the subpoena

from the U.S. Attorney's Office for the Southern District of New York received in February 2013.



These increases were partially offset by reduced marketing expenses related to Solesta.

We expect selling, general and administrative expenses to increase as we expand our sales and marketing efforts for our current products, including Relistor, Solesta, Deflux, and the products acquired in our Santarus acquisition, and other indications for rifaximin and methylnaltrexone bromide, if approved.



Interest Expense

Interest expense was $42.4 million for the three-month period ended June 30, 2014, compared to $15.5 million in the corresponding three-month period in 2013. Interest expense for the three-month period ended June 30, 2014 consisted primarily of:



$7.2 million of interest expense on our 2015 Notes issued in June 2010,

including $4.5 million of amortization of debt discount;



$8.4 million of interest expense on our 2019 Notes issued in March 2012,

including $5.3 million of amortization of debt discount; $14.4 million of interest expense on our 2020 Term Loan B Facility; and $12.4 million of interest expense on our 2021 Notes.



Interest expense for the three-month period ended June 30, 2013 consisted of:

$6.9 million of interest expense on our 2015 Notes issued in June 2010,

including $4.1 million of amortization of debt discount;



$0.4 million of interest expense on our 2028 Notes issued in August 2008,

which are no longer outstanding, including $0.2 million of amortization of

debt discount; and



$8.2 million of interest expense on our 2019 Notes issued in March 2012,

including $5.0 million of amortization of debt discount.

Interest expense was $84.9 million for the six-month period ended June 30, 2014, compared to $30.8 million in the corresponding six-month period in 2013. Interest expense for the six-month period ended June 30, 2014 consisted primarily of:

$14.4 million of interest expense on our 2015 Notes issued in June 2010,

including $8.8 million of amortization of debt discount;



$16.8 million of interest expense on our 2019 Notes issued in March 2012,

including $10.5 million of amortization of debt discount; 37



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$28.8 million of interest expense on our 2020 Term Loan B Facility; and $24.4 million of interest expense on our 2021 Notes.



Interest expense for the six-month period ended June 30, 2013 consisted of:

$13.7 million of interest expense on our 2015 Notes issued in June 2010,

including $8.1 million of amortization of debt discount;



$0.8 million of interest expense on our 2028 Notes issued in August 2008,

which are no longer outstanding, including $0.4 million of amortization of

debt discount; and



$16.3 million of interest expense on our 2019 Notes issued in March 2012,

including $10.0 million of amortization of debt discount.

Interest and Other Income

Interest and other income was $0.0 million for the three-month period ended June 30, 2014 and $0.6 million for the three-month period ended June 30, 2013. Other income for the three-month period ended June 30, 2014 includes $0.2 million of foreign currency exchange losses and $0.1 million of other expenses, offset by interest income of $0.3 million. Other income for the three-month period ended June 30, 2013 includes interest income of $0.6 million. Interest and other income was $0.3 million for the six-month period ended June 30, 2014 and $0.6 million for the six-month period ended June 30, 2013. Other income for the six-month period ended June 30, 2014 includes interest income of $0.5 million, offset by $0.2 million of the other expenses. Other income for the six-month period ended June 30, 2013 includes $0.4 million of foreign currency exchange losses, offset by interest income of $1.0 million. We expect 2014 interest rates paid to us on our cash and cash equivalents will be equal to or lower than we experienced during 2013 due to the current economic climate, and we expect 2014 cash balances will be lower due to debt service on the additional debt issued in connection with our acquisition of Santarus.



Provision for Income Tax

Income tax expense was $2.7 million and $14.3 million for the three-month periods ended June 30, 2014 and 2013, respectively. Our effective tax rate for the three-month periods ended June 30, 2014 and 2013 was 45.2% and 40.5%, respectively. Income tax expense (benefit) was ($33.7) million and $25.8 million for the six-month periods ended June 30, 2014 and 2013, respectively. Our effective tax rate for the six-month periods ended June 30, 2014 and 2013 was 45.3% and 37.3%, respectively. The increase in our effective tax rate during the three-month period ended June 30, 2014, as compared to the same period ended June 30, 2013, is due primarily to non-deductible acquisition costs that occurred during the first quarter of 2014. Our effective rate for the three-month and six-month periods ended June 30, 2014 differs from the statutory federal income tax rate of 35% primarily due to state income taxes and expenses and losses which are non-deductible for federal and state income tax purposes. The Company's effective tax rate might fluctuate throughout the year due to various items including, but not limited to, certain transactions the Company enters into, settlement of uncertain tax positions, the implementation of tax planning strategies, and changes in the tax law. As of June 30, 2014, Congress had not extended the federal Research and Development tax credit for tax year 2014. As such, the Company has not included the projected tax benefit of this credit in its effective tax rate for the quarter. During Q1 of the current year, the Internal Revenue Service commenced an audit for the 2011 tax year. At this time we are not aware of any potential audit adjustments that will materially impact the Company's financial statements.



Net Income (Loss)

Net income was $3.3 million for the three-month period ended June 30, 2014, compared to net income of $21.0 million for the three-month period ended June 30, 2013. Net loss was $(40.6) million for the six-month period ended June 30, 2014, compared to net income of $43.4 million for the six-month period ended June 30, 2013.

Liquidity and Capital Resources

From inception until first achieving profitability in the third quarter of 2004, we financed product development, operations and capital expenditures primarily from public and private sales of equity securities and from funding arrangements with collaborators. Since launching Colazal in January 2001, net product revenue has been a growing source of cash. In August 2008, we closed an offering of $60.0 million of the 2028 Notes, with net proceeds of $57.3 million. None of the 2028 Notes currently are outstanding. On June 3, 2010, we closed an offering of $345.0 million of the 2015 Notes, with net proceeds of approximately $334.2 million. On March 16, 2012, we closed an offering of $690.0 million of the 2019 Notes, with net proceeds of approximately $668.3 million. On December 27, 2013, we closed an offering of the 2021 Notes, with net proceeds of approximately $723.3 million. 38



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On January 2, 2014, we completed our acquisition of Santarus. We financed the acquisition and transaction costs through a combination of (i) $1.2 billion in borrowings under our Term Loan B Facility, (ii) the net proceeds from our issuance of the 2021 Notes and (iii) $848.1 million of cash on hand. As of June 30, 2014 we had $435 million in cash and cash equivalents, compared to $1.2 billion as of December 31, 2013. In addition, on December 31, 2013, we had $750 million in restricted cash representing the gross proceeds from the sale of our 2021 Notes on December 27, 2013, which were held in escrow to finance a portion of the consideration for our acquisition of Santarus. We expect our future cash balances to be lower due to debt service on the additional debt issued in connection with our acquisition of Santarus. At June 30, 2014, our cash and cash equivalents consisted primarily of demand deposits, certificates of deposit, overnight investments in Eurodollars and money market funds at reputable financial institutions, and did not include any auction rate securities. We have not realized any material loss in principal or liquidity in any of our investments to date. However, declines in the stock market and deterioration in the overall economy could lead to a decrease in demand for our marketed products, which could have an adverse effect on our business, financial condition and results of operations. Based on our current projections, we believe that our cash flow from operations should be sufficient to satisfy our expected cash requirements, including debt service for our current debt, including the debt issued in connection with our acquisition of Santarus, without requiring additional capital. However, we might seek additional debt or equity financing or both to fund our operations or acquisitions, and our actual cash needs might vary materially from those now planned because of a number of factors including: whether we acquire additional products or companies; risk associated with acquisitions; FDA and foreign regulation and regulatory processes; the status of competitive products, including potential generics in an increasingly global industry; intellectual property and related litigation risks in an increasingly global industry; product liability litigation; our success selling products; the results of research and development activities; establishment of and change in collaborative relationships; general economic conditions; and technological advances by us and other pharmaceutical companies. The Credit Agreement and the 2021 Notes discussed below contain covenants that restrict our ability to issue additional debt or additional capital, and any additional debt we issue might be subject to financial and restrictive covenants. If we issue additional equity, our stockholders could suffer dilution. We might also enter into additional collaborative arrangements that could provide us with additional funding in the form of equity, debt, licensing, milestone and/or royalty payments. We might not be able to enter into such arrangements or raise any additional funds on terms favorable to us or at all. Cash Flows Net cash used by operating activities was $158.9 million for the six-month period ended June 30, 2014 and was primarily attributable to our net loss for the period, net of non-cash charges, and increased accounts receivable, offset by, among other things, increased reserves for product returns, rebates and chargebacks due to the timing of quarterly payments, and non-cash depreciation and amortization expense. Net cash provided by operating activities was $66.0 million for the six-month period ended June 30, 2013 and was primarily attributable to our net income for the period, net of non-cash charges, offset by increases in accounts receivable, inventory and current liabilities. Net cash used in investing activities was $2.4 billion for the six-month period ended June 30, 2014 and was due to the acquisition of Santarus and the purchase of other property and equipment, partially offset by the sale of short-term investments that we acquired as part of the Santarus acquisition. Net cash used in investing activities was $2.8 million for the six-month period ended June 30, 2013 and was primarily due to purchases of property and equipment. Net cash provided by financing activities was $1.9 billion for the six-month period ended June 30, 2014 and was primarily due to proceeds from our Term Loan B Facility and 2021 senior notes, offset by debt issuance costs associated with our Term Loan B Facility and 2021 Notes, principal payments on the Term Loan B Facility, and net settlement of stock-based compensation. Net cash provided by financing activities of $4.0 million for the six-month period ended June 30, 2013 consisted primarily of the proceeds from the exercise of stock options.



Commitments

As of June 30, 2014, we had binding purchase order commitments for inventory purchases of approximately $216.4 million, which included any minimum purchase commitments under our manufacturing agreements. We anticipate significant expenditures related to our on-going sales, marketing, product launch efforts and our on-going development efforts for rifaximin, our budesonide product candidates, methylnaltrexone bromide and crofelemer. To the extent we acquire rights to additional products, we will incur additional expenditures. 39



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Our acquisition of Santarus on January 2, 2014 caused material changes in our contractual commitments. Our contractual commitments for non-cancelable purchase commitments of inventory, minimum lease obligations for all non-cancelable operating leases, debt and minimum capital lease obligations (including interest) as of June 30, 2014, were as follows (in thousands): Total < 1 year 1-3 years 3-5 years > 5 years Operating leases $ 61,769$ 7,629$ 15,470$ 14,536$ 24,134 Purchase commitments 216,373 117,373 44,000 44,000 11,000 2015 Notes(1) 353,276 353,276 - - - 2019 Notes(2) 738,731 10,350 20,700 707,681 - 2021 Notes(3) 1,042,500 45,000 90,000 90,000 817,500 Credit Agreement(4) 1,406,673 108,769 209,888 199,688 888,328 Revolving Credit Facility 3,375 750 1,500 1,125 - Long term contractual obligations 152 134 16 2 - Capital lease obligations 29 29 - - - Total $ 3,822,878$ 643,310$ 381,574$ 1,057,032$ 1,740,962



(1) Contractual interest and principal obligations related to our 2015 Notes due

in one year or less total $353.3 million at June 30, 2014. If these notes had

been converted at June 30, 2014 based on the closing price of our stock of

$123.35 per share on that date and we chose to settle them in cash, the

settlement amount would have been approximately $917.5 million.

(2) Contractual interest and principal obligations related to our 2019 Notes

total $738.7 million at June 30, 2014, including $10.4 million, $20.7

million, and $707.7 million due in one year or less, one to three years, and

three to five years, respectively. If these notes had been converted at

June 30, 2014 based on the closing price of our stock of $123.35 per share on

that date and we chose to settle them in cash, the settlement amount would

have been approximately $1.3 billion.

(3) Contractual interest and principal obligations related to our 2021 Notes

total $1,042.5 million at June 30, 2014, including $45.0 million, $90.0

million, $90.0 million and $817.5 million due in one year or less, one to

three years, and three to five years, and greater than five years,

respectively.

(4) Contractual interest and principal obligations related to our Credit

Agreement total $1,406.7 million at June 30, 2014, including $108.8 million,

$209.9 million, $199.7 million and $888.3 million due in one year or less,

one to three years, and three to five years, and greater than five years,

respectively. Contractual interest and principal obligations related to our

Credit Agreement exclude excess cash flow payment obligations that commence

in 2015.

We enter into license agreements with third parties that sometimes require us to make royalty, milestone or other payments contingent upon the occurrence of certain future events linked to the successful development and commercialization of pharmaceutical products. Some of the payments are contingent upon the successful achievement of an important event in the development life cycle of these pharmaceutical products, which might or might not occur. If required by the agreements, we will make royalty payments based upon a percentage of the sales of a pharmaceutical product if regulatory approval to market this product is obtained and the product is commercialized. Because of the contingent nature of these payments, we have not attempted to predict the amount or period in which such payments would possibly be made and thus they are not included in the table of contractual obligations. See Note 4, "Commitments," for additional information.



2028 Notes

On August 22, 2008 we closed an offering of $60.0 million in 2028 Notes. Net proceeds from the offering were $57.3 million. In March 2012, we entered into a note repurchase agreement with the holder of a majority in principal amount of the 2028 Notes. We used a portion of the proceeds from our offering of the 2019 Notes discussed below to purchase from this holder and another holder approximately 42.1% of the 2028 Notes for an aggregate purchase price of approximately $137.2 million. In December 2012 one of the holders of the 2028 Notes converted notes with a par value of $22.3 million under the terms of the note indenture, and received cash equal to the par value of the notes and interest on these notes through February 15, 2013, and 1.9 million shares of common stock. We called the 2028 Notes for redemption in September 2013 but before the redemption date, the holders elected to convert the remaining 2028 Notes with a par value of $12.5 million under the terms of the note indenture, and the holders received cash equal to the par value of the notes and interest on these notes through August 15, 2013, and 1.2 million shares of common stock. 40



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2015 Notes

On June 3, 2010 we closed an offering of $345.0 million in 2015 Notes. Net proceeds from the offering were $334.2 million. The 2015 Notes are governed by an indenture, dated as of June 3, 2010, between the Company and U.S. Bank National Association, as trustee. The 2015 Notes bear interest at a rate of 2.75% per year, payable semiannually in arrears on May 15 and November 15 of each year. The 2015 Notes will mature on May 15, 2015, unless previously converted or repurchased in accordance with their terms prior to such date. The 2015 Notes are senior unsecured obligations, and rank (i) equally to any of our existing and future unsecured senior debt, (ii) senior to any of our future indebtedness that is expressly subordinated to these 2015 Notes, and (iii) effectively junior to any secured indebtedness to the extent of the value of the assets securing such indebtedness. The 2015 Notes are convertible into approximately 7,439,000 shares of our common stock under certain circumstances prior to maturity at a conversion rate of 21.5592 shares per $1,000 principal amount of 2015 Notes, which represents a conversion price of approximately $46.38 per share, subject to adjustment under certain conditions. Holders may submit their 2015 Notes for conversion at their option at specified times prior to the maturity date of May 15, 2015 only if: (1) the last reported sale price of our common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is equal to or more than 130% of the conversion price of the 2015 Notes on the last day of such preceding fiscal quarter; (2) the trading price for the 2015 Notes, per $1,000 principal amount of the 2015 Notes, for each such trading day was less than 98% of the product of the last reported sale price of our common stock and the conversion rate of the 2015 Notes on such date; or (3) we enter into specified corporate transactions. The first of these conditions had been met as of the fiscal quarter ended June 30, 2014. The 2015 Notes will be convertible, at the option of the noteholders, regardless of whether any of the foregoing conditions have been satisfied, on or after January 13, 2015 at any time prior to the close of business on the second scheduled trading day immediately preceding the stated maturity date of May 15, 2015. Upon conversion, we may pay cash, shares of our common stock or a combination of cash and stock, as determined by us at our discretion. On July 2, 2014, the Company notified the trustee that it has irrevocably elected to satisfy any conversion obligation related to the 2015 Notes submitted for conversion on or after July 3, 2014 by paying a combination of cash and stock. In connection with the issuance of the 2015 Notes, we entered into capped call transactions covering approximately 7,439,000 shares of our common stock. The capped call transactions have a strike price of $46.38 and a cap price of $62.44, and are exercisable when and if the 2015 Notes are converted. If upon conversion of the 2015 Notes, the price of our common stock is above the strike price of the capped calls, the counterparties will deliver shares of our common stock and/or cash with an aggregate value approximately equal to the difference between the price of our common stock at the conversion date (as defined, with a maximum price for purposes of this calculation equal to the cap price) and the strike price, multiplied by the number of shares of our common stock related to the capped call transactions being exercised. We paid $44.3 million for these capped calls, and charged that amount to additional paid-in capital.



2019 Notes

On March 16, 2012 we closed an offering of $690.0 million in 2019 Notes. Net proceeds from the offering were approximately $668.3 million. The 2019 Notes are governed by an indenture, dated as of March 16, 2012 between the Company and U.S. Bank National Association, as trustee. The 2019 Notes bear interest at a rate of 1.50% per year, payable semiannually in arrears on March 15 and September 15 of each year. The 2019 Notes will mature on March 15, 2019, unless earlier converted or repurchased in accordance with their terms prior to such date. The 2019 Notes are senior unsecured obligations, and rank (i) equally to any of our existing and future unsecured senior debt, (ii) senior to any of our future indebtedness that is expressly subordinated to them, and (iii) effectively junior to any secured indebtedness to the extent of the value of the assets securing such indebtedness. The 2019 Notes are convertible into approximately 10,484,000 shares of our common stock under certain circumstances prior to maturity at a conversion rate of 15.1947 shares per $1,000 principal amount of 2019 Notes, which represents a conversion price of approximately $65.81 per share, subject to adjustment under certain conditions. Holders may submit their 2019 Notes for conversion at their option at specified times prior to the maturity date of March 15, 2019 only if: (1) the last reported sale price of our common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is equal to or more than 130% of the conversion price of the 2019 Notes on the last day of such preceding fiscal quarter; (2) the trading price for the 2019 Notes, per $1,000 principal amount of the 2019 Notes, for each such trading day was less than 98% of the product of the last reported sale price of our common stock and the conversion rate of the 2019 Notes on such date; or (3) we enter into specified corporate transactions. The first of these conditions had been met as of the fiscal quarter ended June 30, 2014. The 2019 Notes will be convertible, at the option of the noteholders, regardless of whether any of the foregoing conditions have been satisfied, on or after November 9, 2018 at any time prior to the close of business on the second scheduled trading day immediately preceding the stated maturity date of March 15, 2019. Upon conversion, we may pay cash, shares of our common stock or a combination of cash and stock, as determined by us at our discretion. On July 2, 2014, the Company notified the trustee that it has irrevocably elected to satisfy any conversion obligation related to the 2015 Notes submitted for conversion on or after July 3, 2014 by paying a combination of cash and stock. 41



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In connection with the issuance of the 2019 Notes, we entered into convertible bond hedge transactions with certain counterparties covering approximately 10,484,000 shares of our common stock. The convertible bond hedge transactions have a strike price of $65.81 and are exercisable when and if the 2019 Notes are converted. If upon conversion of the 2019 Notes, the price of our common stock is above the strike price of the convertible bond hedge transactions, the counterparties will deliver shares of our common stock and/or cash with an aggregate value approximately equal to the difference between the price of our common stock at the conversion date and the strike price, multiplied by the number of shares of our common stock related to the convertible bond hedge transaction being exercised. We paid $167.0 million for these convertible bond hedge transactions and charged this to additional paid-in capital. Simultaneously with entering into the convertible bond hedge transactions, we entered into privately negotiated warrant transactions whereby we sold the counterparties to these transactions warrants to acquire, subject to customary adjustments, approximately 10,484,000 shares of our common stock at a strike price of $85.31 per share, also subject to adjustment. We received $99.0 million for these warrants and credited this amount to additional paid-in capital.



2021 Notes

On December 27, 2013, we closed an offering of $750.0 million in 2021 Notes. The 2021 Notes were issued pursuant to an indenture, dated as of December 27, 2013, between the Company and U.S. Bank National Association, as trustee. We used the net proceeds from the sale of the 2021 Notes to finance a portion of the approximately $2.7 billion that was payable as consideration for our acquisition of Santarus, which closed on January 2, 2014, and to pay the related fees and expenses in connection therewith. The 2021 Notes will mature on January 15, 2021 and bear interest at a rate of 6.00% per annum, accruing from December 27, 2013. The 2021 Notes are senior unsecured obligations, and rank (i) equally to any of our existing and future unsecured senior debt, (ii) senior to any of our future indebtedness that is expressly subordinated to them, and (iii) effectively junior to any secured indebtedness to the extent of the value of the assets securing such indebtedness. Following the acquisition of Santarus, Santarus, Salix Pharmaceuticals, Inc. and Oceana became guarantors of the 2021 Notes. At any time prior to January 15, 2017, we are entitled, at our option, to redeem some or all of the 2021 Notes at a redemption price of 100% of the principal amount thereof, plus a make-whole premium set forth in the indenture and accrued and unpaid interest, if any, to the redemption date. On and after January 15, 2017, we may redeem the 2021 Notes, in whole or in part, at redemption prices (expressed as percentages of principal amount thereof) equal to 104.50% for the 12-month period beginning on January 15, 2017, 103.00% for the 12-month period beginning on January 15, 2018, 101.50% for the 12-month period beginning on January 15, 2019 and 100.00% for the period beginning on January 15, 2020 and thereafter, plus accrued and unpaid interest, if any. At any time prior to January 15, 2017, we also may redeem up to 35% of the principal amount of the 2021 Notes at a redemption price equal to 106.00% of the principal amount thereof plus accrued and unpaid interest, if any, with the net cash proceeds of certain equity offerings. The indenture for the 2021 Notes contains covenants that restrict the ability of us and certain of our subsidiaries to, among other things: (i) borrow money or issue preferred stock; (ii) pay dividends or make other payments or distributions on equity or purchase, redeem or otherwise acquire equity; (iii) make principal payments on, or purchase or redeem subordinated indebtedness prior to any scheduled principal payment or maturity; (iv) make certain investments; (v) create liens on their assets; (vi) sell their assets; (vii) enter into certain transactions with affiliates; (viii) engage in unrelated businesses and (ix) consolidate, merge or sell substantially all of our assets. These covenants are subject to a number of exceptions and qualifications, including the fall away of certain of these covenants if the 2021 Notes receive an investment grade credit rating in the future. The indenture for the 2021 Notes also requires us to make an offer to repurchase the 2021 Notes upon the occurrence of certain events constituting either a change of control that reduces our credit rating or an asset sale.



Credit Agreement

On January 2, 2014, we entered the Credit Agreement with Jefferies Finance LLC, as collateral agent and administrative agent, and the lenders party thereto, providing for (i) the $1.2 billion Term Loan B Facility, and (ii) the $150 million Revolving Credit Facility. We refer to the Term Loan and the Revolving Credit Facility, collectively, as the Senior Secured Facilities. The proceeds of the Term Loan B Facility were used to fund a portion of the purchase price of the acquisition of Santarus. The proceeds of the Revolving Credit Facility can be used in the future for working capital and general corporate purposes, including permitted investments and acquisitions. The Guarantors have guaranteed our obligations under the Credit Agreement and the obligations of each of the other Guarantors under the loan documents. Additionally, we and the Guarantors have granted to the collateral agent, for the benefit of the lenders under the Credit Agreement, a first priority security interest in substantially all of our and their respective assets. The term loans under the Term Loan B Facility are subject to quarterly amortization equal to 1.25% of the original aggregate principal amount thereof and the remaining principal balance is due and payable on January 2, 2020, unless earlier prepaid. The Senior Secured Facilities bear interest at an annual rate of, at our option, either (i) Adjusted LIBOR (as defined by the Credit Agreement), 42



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with a floor of 1.00%, plus a margin of 3.25% or (ii) the highest of (A) the Wall Street Journal's published "U.S. Prime Lending Rate," (B) the Federal Funds Effective Rate (as defined by the Credit Agreement) in effect on such day plus 0.5%, (C) one-month Adjusted LIBOR plus 1.00% per annum and (D) 2.00%, in each case plus a margin of 2.25%. If the Total Leverage Ratio is less than 3.75 to 1.00, the margins will be reduced by 25 basis points. We are required to prepay term loans under the Term Loan B Facility with (i) 100% of the proceeds of asset sales not reinvested within generally one year, (ii) 100% of the proceeds from certain debt financings and (iii) 50% of Excess Cash Flow (as defined in the Credit Agreement). The percentage of Excess Cash Flow that must be used to prepay the Term Loan B Facility decreases to 25% if the Total Leverage Ratio is less than 3:50 to 1:00 and to zero if the Total Leverage Ratio is less than 2:50 to 1:00. The Credit Agreement includes customary affirmative and negative covenants, including restrictions on additional indebtedness, liens, investments, asset sales, stock buybacks and dividends, mergers, consolidations, and transactions with affiliates and capital expenditures. The negative covenants are generally subject to various exceptions. The Credit Agreement does not include any financial maintenance covenants, with the exception that if 25% or more of the Revolving Credit Facility is being utilized, a Total Leverage Ratio requirement (measured as of the last day of each quarter), which decreases over time, must be satisfied.


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