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Article by DailyStocks_admin    (03-10-08 09:55 AM)

The Daily Magic Formula Stock for 03/10/2008 is Salix Pharmaceuticals Ltd. According to the Magic Formula Investing Web Site, the ebit yield is 17% and the EBIT ROIC is 75-100 %.

Dailystocks.com only deals with facts, not biased journalism. What is a better way than to go to the SEC Filings? It's not exciting reading, but it makes you money. We cut and paste the important information from SEC filings for you to get started on your research on a specific company.


Dailystocks.com makes NO RECOMMENDATIONS whatsoever, and provides this for informational purpose only.

BUSINESS OVERVIEW

OVERVIEW

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


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identify and acquire rights to products that we believe have potential for near-term regulatory approval or are already approved;


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apply our regulatory, product development, and sales and marketing expertise to commercialize these products; and


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use our approximately 150-member specialty sales and marketing team focused on high-prescribing U.S. gastroenterologists, who are doctors who specialize in gastrointestinal diseases, to sell our products.

Our current products demonstrate our ability to execute this strategy. As of December 31, 2006, our primary products were:


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Colazal ® (balsalazide disodium) capsules;


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Xifaxan ® (rifaximin) tablets;


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Visicol ® (sodium phosphate monobasic monohydrate, USP, sodium phosphate dibasic anhydrous, USP) tablets;


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OsmoPrep™ (sodium phosphate monobasic monohydrate, USP, and sodium phosphate dibasic anhydrous, USP) tablets;


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MoviPrep ® (PEG 350, sodium sulfate, sodium chloride, potassium chloride, sodium ascorbate and ascorbic acid) oral solution;


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Azasan ® (azathioprine 75mg and 100mg) tablets;


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Anusol-HC ® 2.5% (hydrocortisone USP) cream, Anusol-HC ® 25 mg (hydrocortisone acetate) rectal suppositories; and


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Proctocort ® 1% (hydrocortisone USP) cream, Proctocort ® 30 mg (hydrocortisone acetate) rectal suppositories.

In February 2007, we added Pepcid ® Oral Suspension and Diuril ® Oral Suspension to our line of products by acquiring the U.S. rights to both products from Merck & Co., Inc.

The primary product candidates we are developing are:


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Balsalazide disodium tablets, which, if approved by the FDA, we intend to sell in the United States to expand our range of treatment options for ulcerative colitis;

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A patented, granulated formulation of mesalamine, which, if approved by the FDA, we intend to sell in the United States to expand our range of treatment options for ulcerative colitis;


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Rifaximin for various additional potential indications; and


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Sanvar ® IR (600 ug vials vapreotide acetate powder), which, if approved by the FDA, we intend to sell in the United States as a treatment of acute esophageal variceal bleeding.

We currently market our products, and intend, if approved by the FDA, to market future products to U.S. gastroenterologists through our own direct sales force. We enter into distribution relationships outside the United States and in markets where a larger sales organization is appropriate. Currently, our sales and marketing staff consists of approximately 150 people. We believe our sales force should also position us to sell additional products, if and when acquired and/or approved for U.S. marketing.

PRODUCTS

Colazal ® (balsalazide disodium) capsules

The FDA approved Colazal in 2000 for the treatment of mildly to moderately active uncreative colitis. In December 2006, the FDA approved Colazal for use in pediatric patients between 5 to 17 years of age with ulcerative colitis. The pediatric use of Colazal has been granted orphan drug status.

Ulcerative colitis is a chronic form of inflammatory bowel disease characterized by inflammation of the lining of the colon. Symptoms of active ulcerative colitis include rectal bleeding, abdominal pain, increased stool frequency, loss of appetite, fever and weight loss. The cause of ulcerative colitis is unknown and no known cure exists except for the removal of the colon. This disease affects roughly 500,000 people in the United States, typically with onset under the age of 40. Oral branded prescription products containing the active therapeutic agent 5-ASA are the first line of treatment and most frequently prescribed class of drugs for ulcerative colitis, with 2006 U.S. retail, mail order and non-retail sales of approximately $941 million. Colazal contains 5-ASA, as does Asacol ® , the market-leading drug which had retail, mail-order and non-retail sales of approximately $606 million in 2006.

In clinical trials, Colazal demonstrated at least comparable efficacy and had an improved safety profile as compared to some other oral 5-ASA products. Other 5-ASA products often do not deliver optimal doses of the active therapeutic agent to the colon. However, because Colazal’s proprietary formulation allows approximately 99% of the drug to reach the colon, it can work more quickly and effectively than comparable doses of other 5-ASA products that deliver less drug to the diseased area. In addition, some other 5-ASA products have historically been associated with side effects that cause up to 15-40% of patients to discontinue treatment.

We launched Colazal to physicians in the United States in January 2001 using our own sales force. We had net product sales of $33.5 million, $55.8 million, $85.4 million, $110.3 million, and $103.5 million of Colazal in the United States in 2002, 2003, 2004, 2005 and 2006, respectively. The number of prescriptions written in 2002, 2003, 2004, 2005 and 2006 for Colazal was approximately 210,000, 314,000, 374,000, 399,000 and 440,000, respectively, making Colazal the fastest-growing oral 5-ASA product in the marketplace during that time period.

Xifaxan ® (rifaximin) tablets

Xifaxan is a gastrointestinal-specific oral antibiotic that the FDA approved in May 2004 for the treatment of patients 12 years of age and older with travelers’ diarrhea caused by noninvasive strains of E coli . According to the Centers for Disease Control, each year between 20% and 50% of international travelers, an estimated 10.0 million people, develop diarrhea, with approximately 80% of the cases caused by bacteria. Approximately 7.0 million people sought treatment in the United States for infectious diarrhea in 2006 and approximately 4.6 million of those patients were prescribed a drug.

We believe the advantages of Xifaxan to treat these infections are two-fold: (1) site-targeted antibiotic delivery; and (2) improved tolerability compared to other treatments. Less than 0.5% of the drug is absorbed into the bloodstream when it is taken orally. In addition, the drug might also cause fewer side effects or discomforts such as nausea, headache or dizziness than observed with currently available, more highly-absorbed antibiotics. We believe Xifaxan is also less likely to cause harmful interaction with other drugs a patient is taking. Furthermore, we believe Xifaxan is unique because there is no other U.S.-approved oral antibiotic with its potential lack of systemic absorption and safety profile.

We launched Xifaxan in the United States in July 2004 using our own direct sales force. We had net product sales of $9.8 million, $30.1 million and $51.6 million of Xifaxan in the United States in 2004, 2005 and 2006, respectively. We are exploring potential additional indications, formulations, clinical trials and co-promotion arrangements to capitalize on the potential for Xifaxan. We believe Xifaxan can potentially compete in an annual U.S. market in excess of approximately $4 billion, comprised of over 10 million patients. By comparison, Colazal competes in an annual U.S. market of approximately $941 million, comprised of approximately 500,000 patients. While the potential market for Xifaxan is larger than that for Colazal, we expect to capture only a portion of each market and might not achieve the same success in the Xifaxan market as with Colazal due to competition, market acceptance and/or other factors.

Visicol ® and OsmoPrep™ (sodium phosphate monobasic monohydrate, USP, sodium phosphate dibasic anhydrous, USP) tablets

In September 2005, we acquired Visicol with the completion of the acquisition of InKine Pharmaceutical Company, Inc. Visicol tablets are indicated for cleansing of the colon as a preparation for colonoscopy in adults 18 years of age or older. Visicol was the first, and it and OsmoPrep are the only, tablet bowel cleansing products approved by the FDA and marketed in the United States. OsmoPrep is a patented, second-generation tablet bowel cleansing product approved by the FDA in March 2006. OsmoPrep tablets are indicated for cleansing of the colon as a preparation for colonoscopy in adults 18 years of age or older. OsmoPrep offers potential benefits compared to Visicol such as being microcrystalline cellulose-free, smaller tablet size and possible lower dose administration. The patent for the formulation and use of OsmoPrep expires in 2013. An additional U.S. patent application for OsmoPrep is pending that, if issued, could provide patent protection through 2024.

Approximately 4.4 million prescriptions for bowel cleansing products were written in 2006, representing a market value of $148 million. In terms of prescription dollar sales, the market for bowel cleansing products has been growing at a 26% annual compound rate for the last 5 years. Visicol and OsmoPrep compete with a number of liquid polyethylene glycol-salt (PEG-salt solution) bowel cleansing products and an over-the-counter oral sodium phosphate solution bowel cleansing product. Net product sales for Visicol were $7.5 million, $14.4 million, $20.7 million, $19.9 million and $18.0 million in 2002, 2003, 2004, 2005 and 2006, respectively. Net product sales for OsmoPrep were $22.5 million in 2006.

MoviPrep ® (PEG 350, sodium sulfate, sodium chloride, potassium chloride, sodium ascorbate and ascorbic acid) oral solution

In December 2005, we acquired exclusive rights to sell MoviPrep in the United States from Norgine B.V. MoviPrep is a patent-protected, liquid PEG bowel cleansing product that was approved by the FDA in August 2006. MoviPrep is differentiated from currently marketed, liquid PEG bowel cleansing products because it has ascorbic acid in its formulation. MoviPrep is indicated for bowel cleansing prior to colonoscopy, intestinal surgery and barium enema X-ray examinations. In January 2007 the United States Patent Office issued a patent providing coverage to September 1, 2024. Net product sales for MoviPrep were $5.0 million in 2006, despite not having launched it until October 2006.

Azasan ® (azathioprine tablets)

In November 2003, we acquired from aaiPharma LLC the exclusive right to sell 25, 75 and 100 milligram dosage strengths of azathioprine tablets in North America under the brand name Azasan. Azasan is an FDA-approved drug that suppresses immune system responses and is indicated for preventing rejection of kidney transplants and treatment of severe arthritis. In February 2004, we launched the 75 and 100 milligram dosage strengths of Azasan in the United States. Net product sales for Azasan were $2.3 million, $4.4 million and $4.8 million in 2004, 2005 and 2006, respectively.

Anusol-HC ® and Proctocort ® (hydrocortisone creams and suppositories)

In June 2004, we acquired the exclusive right to sell Anusol-HC 2.5% (hydrocortisone USP) cream, Anusol-HC 25 mg (hydrocortisone acetate) rectal suppositories, Proctocort 1% (hydrocortisone USP) cream and Proctocort 30 mg (hydrocortisone acetate) rectal suppositories from King Pharmaceuticals, Inc. The two cream products are topical corticosteroids indicated for relief of the inflammatory and pruritic, or itching, manifestations of corticosteroid-responsive dermatoses. The two suppository products are indicated for use in inflamed hemorrhoids and postirradiation proctitis, as well as an adjunct in the treatment of chronic ulcerative colitis and other inflammatory conditions. Combined net product sales for the Anusol-HC and Proctocort product lines were $4.1 million, $4.8 million and $3.0 million in 2004, 2005 and 2006, respectively.

Pepcid ® and Diuril ® (Oral Suspensions)

In February 2007, we purchased the U.S. prescription pharmaceutical product rights to Pepcid Oral Suspension and Diuril Oral Suspension from Merck & Co., Inc. Pepcid Oral Suspension is a widely-known prescription pharmaceutical product indicated for several gastrointestinal indications including the treatment of duodenal ulcer, benign gastric ulcer and gastro esophageal reflux disease. The acquisition reflects the ongoing execution of the Company’s strategy to expand and diversify revenue. Pepcid Oral Suspension achieved net product sales in the U.S. of approximately $20 million in 2006. Pepcid Oral Suspension and Diuril Oral Suspension, both liquid formulations of their solid dosage form counterparts, compete in an approximately $150 million market that is concentrated in pediatric and hospitalized patient populations.

DEVELOPMENT PROGRAMS

Balsalazide Disodium tablets

We are systematically and thoughtfully executing a life cycle management program designed to maximize Colazal’s commercial success. In September the FDA approved a supplemental NDA providing for changes to the label based upon the pharmacokinetics of Colazal administered with food as well as sprinkled over food. Throughout 2006 we invested additional resources to ensure the timely progression and completion of our balsalazide 1100 mg tablet program. We intend to submit an FDA regulatory package during the second half of 2007 seeking approval for this addition to our product portfolio, which should complement Colazal and enable us to continue to grow and expand our inflammatory bowel disease business.

Granulated Mesalamine

In July 2002 we acquired the exclusive development rights in the United States to a granulated mesalamine product from Dr. Falk Pharma GmbH, one of the most recognized gastroenterology companies worldwide. As part of that transaction, we also received a right of first negotiation with respect to additional Falk products in the United States. The Falk granulated mesalamine product has already been approved in most of the principal markets of Europe. If approved in the United States, the Falk granulated mesalamine product’s unique prolonged release mechanism might allow us to expand the range of treatment options for ulcerative colitis. In December 2004, we initiated two Phase III studies to investigate the product as a maintenance treatment for ulcerative colitis using a dosing regimen that represents improvements in convenience. We intend to submit an FDA regulatory package during the second half of 2007 seeking approval for this addition to our product portfolio, which should complement Colazal and enable us to continue to grow and expand our inflammatory bowel disease business. The patent for the treatment of the intestinal tract with the granulated mesalamine product will expire in 2018.

Sanvar ® IR (600 ug vials vapreotide acetate powder)

In September 2006, we acquired exclusive marketing rights for Sanvar in the United States from the Debiopharm Group. The product is currently undergoing a confirmatory Phase III trial in the United States as a treatment of acute esophageal variceal bleeding. If approved by the FDA, Sanvar will be the only approved treatment for esophageal variceal bleeding in the United States. Sanvar has been granted orphan drug status in the United States.

Xifaxan ® (rifaximin) tablets

We are committed to maximizing the commercial potential of our GI-targeted antibiotic, Xifaxan. We have prioritized our development efforts and have budgeted resources to expedite our late-stage trials in irritable bowel syndrome, hepatic encephalopathy, C. difficile–associated diarrhea and the prevention of travelers’ diarrhea. These studies are generating data that should provide the basis for forthcoming New Drug Applications. In January 2006 we announced the completion of our first of two Phase III trials to evaluate Xifaxan in the prevention of travelers’ diarrhea. In this study 210 U.S. students in Mexico received either 600 mg of Xifaxan or a matching placebo daily for 14 days. The results of the study were highly statistically significant (p<0.0001) with 84 percent of Xifaxan-treated travelers remaining free from TD versus 50 percent of placebo-treated travelers. In our second Phase III trial to evaluate Xifaxan in the prevention of travelers’ diarrhea, the incidence rate at which international travelers to southern Thailand are acquiring bacterial diarrhea has been lower than the historical incidence rate. Consequently, we changed our original target of enrolling approximately 170 travelers to target enrolling approximately 230 travelers. At the end of 2005 we initiated patient enrollment in three late-stage trials designed to evaluate Xifaxan for the treatment of irritable bowel syndrome, hepatic encephalopathy and C. difficile–associated diarrhea. Patient enrollment progressed throughout 2006 across all these indications and our development team remains focused on the timely completion of these trials.

COLLABORATIVE AND PRODUCT ACQUISITION AGREEMENTS

We have and will continue to enter into various collaborations and product acquisition agreements with licensors, licensees and others. To date, we have entered into the following agreements:

aaiPharma LLC

In November 2003, we acquired from aaiPharma LLC the exclusive right to sell 25, 75 and 100 milligram dosage strengths of azathioprine tablets in North America under the name Azasan. Pursuant to Salix’s license agreement with aaiPharma LLC, Salix paid $2.0 million. In addition, the agreement provides that Salix is to pay aaiPharma, on a quarterly basis, a percentage royalty payment based on Salix’s net sales of Azasan in exchange for aaiPharma supplying us with drug product. As the amount of the royalty payment is based on net sales during a quarter, with no minimum royalty amount, Salix is unable to prospectively disclose the absolute amount of such royalty payments. Royalties are only incurred if there is associated revenue, and then are included in “Cost of products sold” in the Statements of Operations.

Alfa Wassermann S.P.A.

In June 1996, Salix entered into a license agreement with Alfa Wassermann S.p.A, a privately held pharmaceutical company headquartered in Italy, pursuant to which Alfa Wassermann licensed to Salix the exclusive rights to make, use and sell rifaximin (Xifaxan) in the United States and Canada for the treatment of gastrointestinal and respiratory tract diseases. Pursuant to the license agreement, we agreed to pay Alfa Wassermann a net sales-based royalty, as well as milestone payments. Salix made annual milestone payments in varying amounts to Alfa Wassermann until the commercial launch of Xifaxan in July 2004. No more milestone payments remain under this agreement. Our obligation to pay royalties commenced upon the commercial launch of the product and continues until the later of (1) the expiration of the period in which the manufacture, use or sale of the products by an unlicensed third party would constitute an infringement on the patent covering the product or (2) 10 years from commercial launch. Thereafter, the licenses granted to us shall continue as irrevocable royalty-free paid-up licenses. However, we would remain obligated to pay a net sales based royalty for use of the product trademark if we choose to continue using it after the other licenses expired. Since launch, the license agreement provides that Salix must pay Alfa Wassermann, on a quarterly basis, a percentage royalty payment based on Salix’s net sales of Xifaxan. With no minimum royalty amount, Salix is unable to prospectively disclose the absolute amount of such royalty payments, and royalties are only incurred if there are sales, in which case they are included in “Cost of products sold”.

Alfa Wassermann has agreed separately to supply us with bulk active ingredient rifaximin at a fixed price. Salix is committed to purchase a percentage of its rolling 12-month forecast that is updated monthly, and these amounts are included in the “Purchase Commitments” line of its contractual commitments table in its Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The license agreement does not have a set term and continues until terminated in accordance with its terms. Either party to the agreement may terminate it following a material breach by the other party and the failure of the breaching party to remedy the breach within 60 days. In addition, Alfa Wassermann has the right to terminate the agreement on three months’ written notice in the event that we fail to sell the product for a period of six consecutive months after commercial launch. In addition, Alfa Wassermann may terminate the agreement if we become involved in bankruptcy, liquidation or similar proceedings. We may terminate the agreement in respect of any indication or any part of the territory covered on 90 days’ notice, at which point our rights with respect to that indication or territory shall cease.

ALW Partnership

In connection with Salix’s acquisition of InKine Pharmaceutical Company, Inc. in September 2005, Salix assumed a license agreement with ALW Partnership for the worldwide rights, in perpetuity, to develop, use, market, sell, manufacture, have manufactured and sub-license Visicol and improvements, including OsmoPrep, in the field of colonic purgatives, along with ALW Partnership’s body of proprietary technical information, trade secrets and related know-how. Pursuant to this license agreement, Salix pays to ALW, on a quarterly basis, a percentage royalty payment based on Salix’s net sales of these products. As the amounts of the royalty payments are based on net sales during a quarter Salix is unable to prospectively disclose the amount of such royalty payments. The agreement does provide a minimum annual royalty payment of $0.1 million. In December 2005, ALW sold the royalty stream to Clinical Development Capital.

Biorex Laboratories Limited

Biorex, a private, independent drug company headquartered in England, developed the new chemical entity balsalazide and completed limited Phase III clinical trials. We in-licensed balsalazide and all of its salts, including our first product, balsalazide disodium, from Biorex. Under its agreements with us, Biorex will participate in future milestone revenues, royalties and profits from balsalazide.

Pursuant to an agreement entered into between us and Biorex in 1992, Biorex granted us the exclusive worldwide right (other than Japan, Taiwan, Korea and the United States) to develop, manufacture and sell balsalazide for all disease indications for a period of 15 years from the date of commercial launch, subject to early termination in certain circumstances, including upon the material breach by either party and, in the case of Biorex, in the event of our bankruptcy or if a sub-licensee of ours terminates or becomes entitled to terminate its sublicense as a result of actions by us. Pursuant to this agreement, Salix must pay to Biorex a percentage of any gross profits realized by Salix, plus a percentage of fees payable to Salix in connection with any sublicense by Salix of the rights under the agreement. This agreement was effectively amended in May 2000 to specifically provide that Salix is required to make payments to Biorex as a result of Salix sublicensing the rights to balsalazide to Shire Pharmaceuticals Group plc. The payments are based on amounts received by Salix from Shire. Salix does not anticipate any future revenues from its agreement with Shire. Accordingly, Salix does not anticipate any future payments to Biorex under this May 2000 agreement. Under a separate agreement, Biorex granted us the exclusive right to develop, manufacture and sell balsalazide for all disease indications in the United States for a period of nine years from the date of commercial launch or the term of the applicable patent, whichever is longer. Under these agreements, we paid Biorex fees upon entering into the agreements and are obligated to make additional milestone and royalty payments for the drug. The royalty payments to be made by us pursuant to the agreement governing the United States market are based on net sales, subject to minimum royalty payments for the first five years following commercial launch. Under the agreement governing territories other than the United States, we are obligated to pay to Biorex a portion of any gross profit on sales of balsalazide outside the United States. Under these agreements, we undertook to complete preclinical testing, perform clinical trials and obtain regulatory approvals for balsalazide. During 2001, we acquired from Biorex the exclusive right and license to develop, manufacture and sell balsalazide in Japan, Korea and Taiwan. There were no fees paid to Biorex upon entering into this agreement, but we are obligated to pay Biorex a portion of any upfront payments, milestone payments and gross profit on sales of balsalazide in Japan, Korea and Taiwan as well. With no minimum royalty amount, Salix is unable to prospectively disclose the absolute amount of such royalty payments, and royalties are only incurred if there are sales, in which case they are included in “Cost of products sold”.

Cedars-Sinai Medical Center

On June 28, 2006, Salix entered into a license agreement with Cedars-Sinai Medical Center, or CSMC, for the right to use a patent and a patent application relating to methods of diagnosing and treating irritable bowel syndrome and other disorders caused by small intestinal bacterial overgrowth. Under the agreement, CSMC grants Salix an exclusive worldwide license to make, have made, use, sell and have sold and import licensed products related to the use of rifaximin, with a right to sublicense. CSMC also grants Salix a nonexclusive license to use any unpublished research and development information, know-how and technical data of CSMC as necessary to exploit all rights granted to Salix with respect to rifaximin, with a right to sublicense. Salix will pay CSMC a license fee of an aggregate $1.2 million, payable over time. As of December 31, 2006, $0.6 million of the license fee had been paid. The remaining $0.6 million of the license fee is payable on a periodic basis prior to September 30, 2007 based on the license agreement. A portion of the $1.2 million is considered an up-front, non-refundable and irrevocable licensing fee. The balance is considered a prepaid, non-refundable and irrevocable royalty applicable as credit towards royalty amounts due and payable to CSMC, if any, under the agreement. At such time as the use of rifaximin is approved by the U.S. Food and Drug Administration as a treatment for irritable bowel syndrome, Salix will be required to pay CSMC low single digit percentage royalties on net sales of licensed products. An additional term of the license agreement with CSMC provides that Salix will expend a minimum amount per calendar year to seek and obtain regulatory approval and develop and commercialize licensed products. Please note that because the license agreement provides the ability for Salix to terminate the agreement upon giving written notice of not less than 90 days, Salix does not include amounts payable under the license agreement as a purchase obligation in its contractual commitments table in its Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Debiopharm Group

The Debiopharm Group is a global biopharmaceutical development company headquartered in Lausanne, Switzerland. Debiopharm developed Sanvar ® for the treatment of acute esophageal variceal bleeding. In September 2006 we acquired the exclusive right to sell, market and distribute Sanvar in the United States. The agreement provides that Salix make milestone payments in an aggregate amount of up to $7.5 million to Debiopharm upon certain events prior to the commercial launch of the product and quarterly royalty payments thereafter. As of December 31, 2006, $0.5 million of milestone payments had been made. The remaining milestone payment is contingent upon achievement of regulatory approval. Because the milestone payment is conditioned upon events that might never occur, the Company does not consider the potential milestone payment as a purchase obligation nor a commitment to be reported in our contractual commitments table in its Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Dr. Falk Pharma GmbH

Pursuant to Salix’s license agreement, as amended, with Dr. Falk Pharma GmbH, Salix acquired the rights to develop and market a granulated formulation of mesalamine. The agreement provides that Salix make milestone payments in an aggregate amount of up to $11.0 million to Dr. Falk upon certain events prior to the commercial launch of the product and quarterly royalty payments thereafter. As of December 31, 2006, $3.0 million of milestone payments had been made. The majority of the milestone payments are contingent upon patient enrollment in clinical trials, filing a new drug application and achievement of regulatory approval. Because the milestone payments are conditioned upon events that might never occur, the Company does not consider the potential milestone payments as purchase obligations nor a commitment to be reported in our contractual commitments table in its Management’s Discussion and Analysis of Financial Condition and Results of Operations.

King Pharmaceuticals, Inc.

In June 2004, we acquired the exclusive right to sell Anusol-HC ® 2.5% (hydrocortisone USP) cream, Anusol-HC ® 25 mg (hydrocortisone acetate) rectal suppositories, Proctocort ® 1% (hydrocortisone USP) cream and Proctocort ® 30 mg (hydrocortisone acetate) rectal suppositories from King Pharmaceuticals, Inc. (NYSE:KG). We paid $13.0 million cash for the four products, and entered into a supply agreement for the suppository products and the Anusol-HC cream product with King Pharmaceuticals; an alternate supply arrangement with a contract manufacturer was put in place for the Proctocort cream product. Once payment amounts under this and other supply agreements are known and are non-cancelable, Salix includes them in its contractual commitments table in its Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Menarini Pharmaceutical Industries S.R.L.

Menarini, headquartered in Italy, is the largest manufacturer and distributor of pharmaceuticals in Southern Europe. Menarini also has extensive experience developing and marketing therapies for gastrointestinal disease in its markets. Under our agreements with Menarini, we granted Menarini certain manufacturing rights and exclusive distribution rights with respect to balsalazide in Italy, Spain, Portugal and Greece. Through December 31, 2001, we had received revenues as partial contribution to research and development costs borne by us of approximately $1.2 million. The agreement calls for additional milestone revenues to be paid to us relating to European marketing approvals in the Menarini territories. During 2001, Menarini paid a $0.3 million milestone payment to us related to receipt of marketing approval in Italy. Under the terms of the agreements, we will sell the bulk active ingredient balsalazide to Menarini for marketing and distribution in its territories at cost plus a sales-based royalty. During 2001, Menarini paid us approximately $1.2 million for bulk active ingredient balsalazide. Menarini did not purchase any bulk active ingredient balsalazide from us during 2002, 2003, 2005 or 2006. During 2004, Menarini paid us approximately $0.1 million related to balsalazide purchases.

Unless terminated sooner in accordance with its terms, the agreement with Menarini continues until the earlier of the expiration of (1) the patents relating to the product or (2) 15 years from the date of the agreement, provided however that in any case the agreement shall continue for a period of 10 years from the date of first launch. Either party may terminate the agreement upon a material breach by the other party and the failure to remedy such breach within 30 days in the case of a payment breach or 90 days in the case of any other material breach or if a party enters liquidation, bankruptcy or similar proceedings.

Merck & Co., Inc.

In February 2007, we entered into a Master Purchase and Sale and License Agreement with Merck & Co., Inc., to purchase the U.S. prescription pharmaceutical product rights to Pepcid Oral Suspension and Diuril Oral Suspension from Merck. The Master Purchase and Sale and License Agreement will be filed as an exhibit to our quarterly report on Form 10-Q for the period ended March 31, 2007.

Pursuant to the Master Purchase and Sale and License Agreement, Salix paid Merck $55.0 million at the closing of the transaction. In addition, Salix will make additional payments to Merck up to an aggregate of $6.0 million upon the achievement of certain annual gross sales targets for the acquired Pepcid Oral Suspension and Diuril Oral Suspension products during any of the five calendar years beginning in 2007 and ending in 2011.

In return for these payments, Salix obtained (1) all rights to the U.S. regulatory approvals and related data, open purchase orders, inventory and customer lists related to the acquired oral suspension products, (2) an exclusive license to the Pepcid Oral Suspension and Diuril Oral Suspension trademarks for the use of prescription sale of the acquired oral suspension products in the U.S., and (3) an exclusive license to certain know-how related to the manufacture of the acquired oral suspension products in the U.S. Merck also agreed to manufacture and supply the acquired oral suspension products to Salix through December 31, 2008. In the event that Salix is acquired by another party or if Salix sells all or substantially all of the rights to the acquired oral suspension products, and Merck determines in its reasonable judgment that such transaction will result in material harm to the Pepcid Oral Suspension name or the licensed trademark, Merck shall have the right to terminate one or more of the above licenses and the supply obligation.

In the event that a prescription or over-the-counter product with the same active ingredient and strength as Pepcid Oral Suspension is first sold by any party other than Salix prior to December 2008, Merck shall pay Salix up to $15.0 million depending on the date of such first sale.

Norgine B.V.

In December 2005, we acquired the exclusive rights to sell NRL944 (now marketed by us under the trade name MoviPrep), a proprietary, liquid PEG bowel cleansing product in the United States from Norgine B.V. The agreement gives us the exclusive rights to develop and market the product in the United States. In return we will make upfront and milestone payments to Norgine that could total up to $37.0 million over the term of the agreement. As of December 31, 2006, $17.0 million of milestone payments had been made. The remaining milestone payments are contingent upon reaching sales thresholds. Because milestone payments are conditioned upon events that might never occur, the Company does not consider the potential milestone payments as purchase obligations nor a commitment to be reported in our contractual commitments table in its Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Shire Pharmaceuticals Group plc

In May 2000, we signed an agreement with Shire Pharmaceuticals Group under which Shire purchased from us the exclusive rights to balsalazide, for use as a treatment for ulcerative colitis for Austria, Belgium, Denmark, Finland, France, Germany, Iceland, Republic of Ireland, Luxembourg, Norway, The Netherlands, Switzerland, Sweden and the United Kingdom. Under the agreement, Shire agreed to pay us up to a total of approximately $24.0 million, including approximately $12.1 million in up-front fees and up to $12.0 million upon the achievement of certain milestones. In accordance with our license arrangement with Biorex Laboratories Limited, our licensor, we share a portion of these payments with Biorex. In May 2000, Shire paid us $9.6 million of cash and $2.5 million by way of the issue of 160,546 new Shire ordinary shares which we subsequently sold. In August 2000 Shire paid us $4.4 million in connection with the transfer to Shire of the United Kingdom product license for balsalazide. No such additional payments have been made to us by Shire since August 2000. During 2004, we recognized $3.5 million of revenue from collaborative agreements related to this agreement which had previously been deferred. We do not anticipate any future revenues under this agreement.

MANUFACTURING

We own no manufacturing facilities. We have in the past used and plan to continue to use third-party manufacturers to produce material for use in clinical trials and for commercial product. This manufacturing strategy enables us to direct our financial resources to product in-licensing and acquisition, product development, and sales and marketing efforts, without devoting resources to the time and cost associated with building manufacturing plants.

Currently, we are using active pharmaceutical ingredient balsalazide manufactured for us by Omnichem s.a., a subsidiary of Ajinomoto in Belgium, and Pharmazell (formerly Noveon Pharma, GmbH) in Raubling, Germany. Balsalazide is being encapsulated as Colazal drug product for us by Nexgen Pharma, inc. (formerly Anabolic Laboratories) in Irvine, California. For Colazal bottling operations, we provide bulk Colazal capsules to Carton Service in Norris, Tennessee for production of finished Colazal bottles.

Under our supply agreement with Alfa Wassermann, Alfa Wassermann is obligated to supply us with bulk active ingredient rifaximin until July 2014 or introduction of a generic product, whichever occurs first. Currently, our supply of rifaximin drug substance, as provided by Alfa Wassermann, is manufactured by Zambon in Lonigo, Italy; a secondary site for rifaximin drug substance production (Aventis in Brindisi, Italy) is in the process of final qualifications for use in the U.S. Currently, Alfa Wassermann manufactures rifaximin tablets for the Italian and other European markets. Under our long-term supply agreement with Patheon, Inc., in Whitby, Ontario, Patheon uses our bulk rifaximin drug substance as provided by Alfa Wassermann and produces our commercial supply of Xifaxan finished product. For Xifaxan blister packaging operations, we provide bulk Xifaxan tablets as produced by Patheon to Carton Service in Norris, Tennessee for final blister packaging and secondary packaging of the finished product.

With respect to our products currently under development, namely granulated mesalamine, our 1100 mg balsalazide tablet formulation and our 550 mg rifaximin tablet formulation, we plan to negotiate with the same manufacturers who supplied the drug substance and drug product for the Phase III clinical trial material for eventual commercial supply.

Under our long-term supply agreement with aaiPharma, aaiPharma produces our commercial supply of 25 mg, 75 mg and 100 mg Azasan finished product. We are in the process of qualifying an additional Azasan drug product manufacturer.

Under our long-term supply agreement with Paddock Laboratories in Minneapolis, Minnesota, Paddock produces our commercial supply of finished product of Anusol-HC Cream, Anusol-HC Suppositories, and Proctocort Suppositories. In addition, through prior supply arrangements between King Pharmaceuticals and Crown Laboratories in Johnson City, Tennessee, Crown will also be supplying us with commercial finished product of Proctocort Cream.

Under our long-term supply agreement with WellSpring Pharmaceuticals in Oakville, Ontario, WellSpring produces our commercial supply of OsmoPrep finished product.

Under our long-term supply agreement with Norgine in Hengoed, Wales, Norgine produces our commercial supply of MoviPrep pouches. We then supply Carton Services in Norris, Tennessee with these MoviPrep pouches for secondary packaging into finished commercial MoviPrep kits.

Merck has agreed to manufacture our commercial supply of Pepcid Oral Suspension and Diuril Oral Suspension through December 2008.

SALES AND MARKETING

We currently market our products and intend, if approved by the FDA, to market future products to U.S. gastroenterologists through our own direct sales force. We enter into distribution relationships outside the United States and in markets where a larger sales organization is appropriate. Currently, our sales and marketing staff consists of approximately 150 people. We believe our sales force should also position us to sell additional products, if and when acquired and/or approved for U.S. marketing.

CEO BACKGROUND

John F. Chappell has served as a member of our Board of Directors since December 1993 and has been the Chairman of the Board since September 2003. From 1990 until his retirement in 2000, he served as founder and Chairman of Plexus Ventures, which specializes in business development and strategic transactions for clients in the biotechnology, pharmaceutical and drug delivery industries. Prior to founding Plexus Ventures, Mr. Chappell served as Chairman, Worldwide Pharmaceuticals for SmithKline Beecham plc, now GlaxoSmithKline plc, where he was responsible for the multi-billion dollar ethical pharmaceutical business with 30,000 employees worldwide. During his 28 years at SmithKline Beecham, Mr. Chappell also headed the International Consumer Products (OTC) operations and the Corporate Development Center. He has served as a director of SmithKline Beecham, the Pharmaceutical Manufacturers Association, now PhRMA, and the Industrial Biotechnology Association, now BIO. Mr. Chappell holds a B.A. degree from Harvard University and attended the Wharton School of the University of Pennsylvania.

Thomas W. D’Alonzo joined our Board of Directors in May 2000. From 1996 to 1999, Mr. D’Alonzo served as President and Chief Operating Officer of Pharmaceutical Product Development, Inc., or PPD, a global provider of discovery and development services to pharmaceutical and biotechnology companies. Before joining PPD, from 1993 to 1996, he served as President and Chief Executive Officer of GENVEC, Inc., a clinical-stage biopharmaceutical company. From 1983 to 1993, Mr. D’Alonzo held positions of increasing responsibility within Glaxo, Inc., including President. He is currently on the Board of Directors of BioDelivery Sciences International, Inc. and Amarillo Biosciences, Inc. Mr. D’Alonzo received his B.S. in Business Administration from the University of Delaware, and his J.D. from the University of Denver College of Law.

Richard A. Franco, Sr. joined our Board of Directors in May 2000. Mr. Franco is President and a director of the Richards Group Ltd., a healthcare consulting firm, and DARA BioSciences, Inc., a private pharmaceutical company. Mr. Franco served as the Chairman of the Board for LipoScience, Inc. from May 1997 to October 2002, as well as Chief Executive Officer and President from November 1997 to September 2001. Prior to co-founding LipoScience, he was President, Chief Executive Officer and a director of Trimeris Inc., a biopharmaceutical company. Prior to joining Trimeris, Mr. Franco held several senior positions and served on the Executive Committee of Glaxo, Inc. from 1983 to 1994, including Vice President and General Manager of Glaxo Dermatology, Vice President and General Manager of the Cerenex Division, Vice President of Commercial Development and Vice President of Marketing. Prior to joining Glaxo, Mr. Franco worked in various positions over a 16-year period with Eli Lilly and Company. Mr. Franco served on the Board of Directors of TriPath Imaging, Inc., a wholly owned subsidiary of Becton, Dickinson and Company, and NeoMatrix, Inc. He received a B.S. in Pharmacy from St. John’s University and did his graduate work in pharmaceutical marketing and management at Long Island University. Mr. Franco has completed executive training at the Wharton School of the University of Pennsylvania, Duke University Fuqua School of Business, School of Business at the University of Michigan, Tuck School at Dartmouth College, and the Kellogg School of Management at Northwestern University.

William Harral III joined our Board of Directors in September 2005. He is the President of the Barra Foundation and Chairman of the Board of Directors of C&D Technologies, Inc., an electronics and industrial battery manufacturer. Mr. Harral served as a director of InKine Pharmaceutical Company, Inc. from July 2004 until September 2005, when it was acquired by Salix. He also held positions of increasing responsibility with Bell Atlantic-Pennsylvania, now Verizon Communications, serving most recently as its President and Chief Executive Officer. Mr. Harral serves on the Board of Directors of the Recording for the Blind and Dyslexic organization. From June 2000 until June 2001, Mr. Harral served as the Dean at Drexel University’s Bennett S. LeBow College of Business. Mr. Harral holds a B.A. degree from Gettysburg College and received an M.S. degree from the Massachusetts Institute of Technology.

William P. Keane joined our Board of Directors in January 2004. From October 2002 until September 2005, Mr. Keane was the Chief Financial Officer and Corporate Secretary for Genta Incorporated, a biopharmaceutical company focused on the identification, development and commercialization of drugs for the treatment of patients with cancer. Prior to that, Mr. Keane was the Vice President – Sourcing, Strategy and Operations Effectiveness for Bristol-Myers Squibb Company from April 2001 until October 2002. From August 2000 until April 2001, Mr. Keane was the Chief Financial Officer for Covance Biotechnology Services, a drug development services company. From September 1997 until July 2000, Mr. Keane was the Vice President, Finance – Global Pharmaceutical Manufacturing for Warner-Lambert Company, a pharmaceutical company subsequently acquired by Pfizer Inc. Mr. Keane received a B.A. in Microbiology and an M.B.A. from Rutgers University.

Carolyn J. Logan has served as our President and Chief Executive Officer and as a member of our Board of Directors since July 2002. She previously served as Senior Vice President, Sales and Marketing from June 2000 to July 2002. Prior to joining Salix, Ms. Logan served as Vice President, Sales and Marketing of the Oclassen Dermatologics Division of Watson Pharmaceuticals, Inc. from May 1997 to June 2000, and as its Vice President, Sales from February 1997 to May 1997. Prior to that date, she served as Director, Sales of Oclassen Pharmaceuticals, Inc. from January 1993 to February 1997. Prior to joining Oclassen, Ms. Logan held various sales and marketing positions with Galderma Laboratories, Ulmer Pharmacal and Westwood Pharmaceuticals. Ms. Logan received a B.S. degree in Biology and Dental Hygiene from the University of North Carolina at Chapel Hill.

MANAGEMENT DISCUSSION FROM LATEST 10K

OVERVIEW

We are a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, 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 use our 150 member specialty sales and marketing team focused on high-prescribing U.S. gastroenterologists to sell our products.

In September 2006 we acquired exclusive marketing rights for Sanvar ® from Debiovision Inc. and paid an up-front payment of $0.5 million. Sanvar is currently undergoing a confirmatory Phase III trial for the treatment of acute esophageal variceal bleeding secondary to portal hypertension. Esophageal variceal bleeding, or EVB, is a life-threatening and frequent complication of late-stage liver cirrhosis. Sanvar, if approved, will be the only approved treatment for EVB in the United States. In February 2007, we purchased the U.S. prescription pharmaceutical product rights to Pepcid Oral Suspension and Diuril Oral Suspension from Merck & Co., Inc. Pepcid Oral Suspension is a widely-known prescription pharmaceutical product indicated for several gastrointestinal indications including the treatment of duodenal ulcer, benign gastric ulcer and gastro esophageal reflux disease. The acquisition reflects the ongoing execution of the Company’s strategy to expand and diversify revenue. Pepcid Oral Suspension achieved net product sales in the U.S. of approximately $20 million in 2006. Pepcid Oral Suspension and Diuril Oral Suspension, both liquid formulations of their solid dosage form counterparts, compete in an approximately $150 million market that is concentrated in pediatric and hospitalized patient populations. We anticipate launching a hospital sales force at the time of the Sanvar approval. In addition to selling Sanvar, Pepcid Oral Suspension and Diuril Oral Suspension, this focused sales force will work with our office-based representatives to ensure that prescribers, managed care groups, hospital formulary committees and all other relevant parties are fully apprised of the utility and availability of Xifaxan and our other drugs.

We generate revenue primarily by selling our products, prescription drugs, to pharmaceutical wholesalers. These direct customers resell and distribute our products to and through pharmacies to patients who have had our products prescribed by doctors. Because demand for our products originates with doctors, our sales force calls on high-prescribing specialists, primarily gastroenterologists, and we monitor new and total prescriptions for our products as key performance indicators for our business.

Prescriptions result in our products being used by patients, requiring our direct customers to purchase more products to replenish their inventory. However, our revenue might fluctuate from quarter to quarter due to other factors, such as increased buying by wholesalers in anticipation of a price increase or because of the introduction of new products. Revenue could be less than anticipated in subsequent quarters as wholesalers’ increased inventory is used up. For example, wholesalers made initial stocking purchases of OsmoPrep when it was launched in second quarter 2006 and MoviPrep when it was launched in the third quarter of 2006. Also, 2006 Colazal revenue was slightly lower than in the comparable periods in 2005 even though prescriptions increased in 2006.

In December 2000, we established our own field sales force to market Colazal in the United States. Currently, this sales force has approximately 100 sales representatives in the field. Although the creation of an independent sales organization involved substantial costs, we believe that the financial returns from our direct product sales have been and will continue to be more favorable to us than those from the indirect sale of products through marketing partners. In addition, we intend to enter into distribution relationships outside the United States and in markets where a larger sales organization is appropriate.

CRITICAL ACCOUNTING POLICIES

General

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to sales of our products, bad debts, inventories, investments, intangible assets and legal issues. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results might differ materially from these estimates under different assumptions or conditions.

Methodologies used and assumptions selected by management in making these estimates, as well as the related disclosures, have been reviewed by and discussed with the Audit Committee of our Board of Directors.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue in accordance with the SEC’s Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” as amended by Staff Accounting Bulletin No. 104 (together, “SAB 101”), and FASB Statement No. 48 “Revenue Recognition When Right of Return Exists” (“SFAS 48”). SAB 101 states that revenue should not be recognized until it is realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: (a) persuasive evidence of an arrangement exists; (b) delivery has occurred or services have been rendered; (c) the seller’s price to the buyer is fixed and determinable; and (d) collectibility is reasonably assured.

SFAS 48 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if (1) the seller’s price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to the seller 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 that provided by the seller, (5) the seller does 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, and the other criteria of SAB 101 and SFAS 48 are satisfied, 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 qualitative and quantitative factors, including:


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


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estimated levels of inventory in the distribution channel;


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historical rebates, chargebacks and returns of products;


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direct communication with customers;


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anticipated introduction of competitive products or generics;


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anticipated pricing strategy changes by Salix and/or its competitors;


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


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the impact of changes in state and federal regulations; and


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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 which may 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.

Consistent with industry practice, we periodically offer promotional discounts to our existing customer base. These discounts are calculated as a percentage of the current published list price and are treated as off-invoice allowances. Accordingly, the discounts are recorded as a reduction of revenue in the period that the program is offered. In addition to promotional discounts, at the time that we implement a price increase, we generally offer our existing customer base 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 and chargebacks were $8.0 million and $7.3 million as of December 31, 2006 and 2005, 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 continues to be appropriate. 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 in 2006, we would have recorded an adjustment to revenues of approximately $2.1 million, or 1.0%, for the year.

Allowances for product returns were $6.1 million and $2.1 million as of December 31, 2006 and 2005, 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 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. A change in assumptions that resulted in a 10% change in forecasted return rates would have resulted in a change in total product returns liability at December 31, 2006 of approximately $0.6 million and a corresponding change in 2006 net product revenue of less than 1%.

For the years ended December 31, 2006 and 2005, our absolute exposure for rebates, chargebacks and product returns has grown 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 provision for these revenue-reducing items as a percentage of gross product revenue in the year ended December 31, 2006 and 2005 was 8.8% and 8.3% for rebates, chargebacks and discounts and was 3.4% and 1.0% for product returns, respectively.

Inventories

Inventory at December 31, 2006 consisted of $14.4 million of raw materials, $2.5 million of work-in-process, and $8.2 million of finished goods. Inventory at December 31, 2005 consisted of $15.8 million of raw materials, $4.6 million of work in process and $2.8 million of finished goods. Inventories are stated at the lower of cost (which approximates actual cost on a first-in, first-out cost method) or market. In evaluating whether inventory is stated at the lower of cost or market, management considers such factors as the amount of inventory on hand and in the distribution channel, estimated time required to sell such inventory, remaining shelf life, and current and expected market conditions, including levels of competition. As of December 31, 2006, we had recorded inventory reserves totaling $0.7 million, compared to $2.8 million as of December 31, 2005, to reduce inventories to their net realizable value. The decrease in inventory reserves from 2006 to 2005 is primarily the result of a one-time write-off of $2.7 million of obsolete inventories in 2005 associated with the initial launch of Xifaxan. Refer to “Schedule II – Valuation and Qualifying Accounts” for a roll-forward of the inventory allowance.

Intangible Assets and Goodwill

Our intangible assets consist of license agreements, product rights and other identifiable intangible assets, which result from product and business acquisitions. Goodwill represents the excess purchase price over the fair value of assets acquired and liabilities assumed in a business combination.

When we make product acquisitions that include license agreements, product rights and other identifiable intangible assets, we record the purchase price of such intangibles, along with the value of the product-related liabilities that we assume, as intangible assets. We allocate the aggregate purchase price to the fair value of the various tangible and intangible assets in order to determine the appropriate carrying value of the acquired assets and then amortize the cost of the intangible assets as an expense in the consolidated statements of operations over the estimated economic useful life of the related assets. We assess the impairment of identifiable intangible assets whenever events or changes in circumstances indicate that the carrying value might not be recoverable. Some factors that we consider important which could trigger an impairment review include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for our overall business, and significant negative industry or economic trends.

In assessing the recoverability of its intangible assets, we must make assumptions regarding estimated future cash flows and other factors. If the estimated undiscounted future cash flows do not exceed the carrying value of the intangible assets we must determine the fair value of the intangible assets. If the fair value of the intangible assets is less than the carrying value, an impairment loss will be recognized in an amount equal to the difference.

We review goodwill for impairment in accordance Statement of Financial Accounting Standard No. 142, “Goodwill and Other Intangible Assets” at least annually, and we review all long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.

In November 2003, we acquired from aaiPharma LLC the exclusive right to sell 25, 75 and 100 milligram dosage strengths of azathioprine tablets in North America under the name Azasan for $2.0 million. The purchase price was fully allocated to product rights and related intangibles and is being amortized over a period of ten years. Although Azasan does not have any patent protection, we believe ten years is an appropriate amortization period based on established product history and management’s experience. At December 31, 2006 and 2005, accumulated amortization for the Azasan intangible was $0.6 million and $0.4 million, respectively.

In June 2004, we acquired the exclusive U.S. rights to Anusol-HC 2.5% (hydrocortisone Cream USP), Anusol-HC 25 mg Suppository (Hydrocortisone Acetate), Proctocort Cream (Hydrocortisone Cream USP) 1% and Proctocort Suppositories (Hydrocortisone Acetate Rectal Suppositories, 30 mg) from King Pharmaceuticals, Inc. for $13.0 million. The purchase price was fully allocated to product rights and related intangibles and is being amortized over a period of ten years. Although Anusol-HC and Proctocort do not have any patent protection, we believe ten years is an appropriate amortization period based on established product history and management’s experience. At December 31, 2006 and 2005, accumulated amortization for the King product intangibles was $3.3 million and $2.0 million, respectively.

In September 2005, we acquired InKine Pharmaceutical Company, Inc. for $210.0 million. We allocated $74.0 million of the purchase price to in-process research and development, $9.3 million to net assets acquired and $37.0 million to specifically identifiable product rights and related intangibles with an ongoing economic benefit to us. We allocated the remaining $89.7 million to goodwill, which is not being amortized. The InKine product rights and related intangibles are being amortized over an average period of 14 years, which we believe is an appropriate amortization period due to the product’s patent protections and the estimated economic lives of the product rights and related intangibles. At December 31, 2006 and 2005, accumulated amortization for the InKine intangibles was $3.8 million and $0.8 million, respectively.

In December 2005, we entered into a License and Supply Agreement with Norgine B.V., granting Salix the exclusive right to sell a patented-protected, liquid PEG bowel cleansing product, NRL 944, in the United States. In August 2006, we received Food and Drug Administration marketing approval for NRL 944 under the branded name of MoviPrep. In January 2007 the United States Patent Office issued a patent providing coverage to September 1, 2024. In August 2006, pursuant to the terms of the Agreement, Salix made a $15.1 million payment to Norgine. We are amortizing the milestone payment over a period of 17.3 years, which we believe is an appropriate amortization period due to the product’s patent protection and the estimated economic life of the related intangible. At December 31, 2006, accumulated amortization for the MoviPrep intangible was $0.4 million.

Allowance for Uncollectible Accounts

Based on a review of specific customer balances, industry experience and the current economic environment, we currently reserve for specific past due accounts that may represent collection concerns plus a percentage of our outstanding trade accounts receivable balance as an allowance for uncollectible accounts, which at December 31, 2006 and 2005 was approximately $2.7 million and $2.0 million, respectively. Refer to “Schedule II – Valuation and Qualifying Accounts” for a roll-forward of the allowance for uncollectible accounts.

Investments

We consider all investments that have a maturity of greater than three months and less than one year to be short-term investments. All securities with maturities beyond one year are considered long-term investments. Our investments as of December 31, 2005 consist of government agency and high-grade corporate bonds and are classified as available-for-sale. All available-for-sale investments are classified as current, as we have the ability to use them for current operations and investing purposes. As of December 31, 2006, all of our investments have matured.

Research and Development

In accordance with its policy, we expense research and development costs, both internal and externally contracted, as incurred. Due to increased development activity levels and the way in which many of our long-term development contracts are structured, we conducted a review of our process of estimating research and development expenses during the first quarter of 2006. Based on that review, we refined our process of estimating certain externally contracted development activities to more closely align the related expense with the level of progress achieved and services received during the period. In accordance with Statement of Financial Accounting Standard No. 154, “Accounting Changes and Error Corrections”, the refined estimation process was implemented in the first quarter of 2006. As of December 31, 2006, the prepaid amount related to on-going research and development activities was $2.1 million. This prepaid amount, which will be charged to expense in future periods as the related research and development activities are performed under the contracts, resulted in a reduction of research and development expense for the year-ended December 31, 2006 and a corresponding increase in income from operations of $2.1 million, and net income of $2.0 million, or $0.04 per diluted share. The refined estimation process will continue to be applied on the same basis in future periods.

RESULTS OF OPERATIONS

Years Ended December 31, 2006, 2005 and 2004

Revenues totaled $208.5 million, $154.9 million and $105.5 million for 2006, 2005 and 2004, respectively. Revenues for the year ended December 31, 2006 consisted solely of net product revenues. Revenues for the year ended December 31, 2005 included net product revenues of $154.7 million and revenues from collaborative agreements of $0.2 million. Revenues for the years ended December 31, 2004 included net product revenues of $101.7 million and revenues from collaborative agreements of $3.8 million. We expect that future revenues will consist solely or primarily of net product revenue.

Net product revenue increases from 2005 to 2006 were due to increased sales of Xifaxan and Visicol, and the launch of OsmoPrep and MoviPrep during the second and fourth quarters of 2006, respectively, offset by decreased Colazal sales. Net product revenue increases from 2004 to 2005 were due to increased sales of Colazal, Xifaxan, Azasan, Anusol-HC and Proctocort, and the addition of Visicol during the fourth quarter of 2005. Increased sales from 2005 to 2006 were primarily driven by prescription growth for Xifaxan of 118%, respectively, as well as price increases for all of our products. Colazal prescriptions increased 10% year-over-year from 2005 to 2006, thus the decrease in Colazal revenue reflects a draw-down of wholesaler inventories in 2006, offset by price increases of 9%. As planned, Colazal’s contribution as a percentage of total product revenue incrementally decreased during 2006 due to the expansion of our product portfolio with the launch of our bowel cleansing products and as Xifaxan sales continued to ramp up. Colazal sales contributed 50% of total product revenue for 2006 compared to 71% for 2005 and 84% for 2004. We expect Colazal’s contribution as a percentage of total product revenue will continue to moderate going forward. Increases in revenue-reducing items from 2005 to 2006 were due primarily to increases in allowances for managed care agreements as a result of increased product sales and the allowance for product returns associated with Colazal, Visicol, Anusol and Proctocort. Increased sales from 2004 to 2005 were primarily driven by prescription growth for Colazal and Xifaxan of 7% and 489%, respectively, as well as price increases for all of our products and the introduction of the Colazal 500-count and Xifaxan 100-count bottles. Increases in revenue-reducing items from 2004 to 2005 were due primarily to increases in allowances for managed care agreements as a result of increased product sales and the allowance for product returns associated with the commercial launch of Xifaxan.

Total costs and expenses were $178.2 million, $216.0 million, and $98.8 million for 2006, 2005 and 2004, respectively. Excluding the September 2005 one-time charge of $74.0 million for the write-off of in-process research and development associated with the acquisition of InKine, our higher operating expenses in absolute terms from 2005 to 2006 were due primarily to increased research and development activities, increased cost of products sold related to the corresponding increase in product revenues, and increased selling, general and administrative expenses due to the expansion of our sales force in connection with the InKine merger and the launches of OsmoPrep and MoviPrep. Higher operating expenses from 2004 to 2005, excluding the one-time charge of $74.0 million write-off of in-process research and development, were due to on-going studies pursuing additional indications for rifaximin and on-going Phase III studies for granulated mesalamine and commercial development activities.

We recognized cost of products sold of $41.4 million, $34.2 million and $21.8 million for 2006, 2005 and 2004, respectively. Gross margin on total product revenue was 80%, 78% and 79% in 2006, 2005 and 2004, respectively. The increase in cost of products sold from 2005 to 2006 was due primarily to increased sales of Xifaxan and Visicol and the additions of OsmoPrep and MoviPrep during the second and third quarters, respectively. The increases in cost of products sold and decreased gross margin from 2004 to 2005 was due primarily to increased sales of Colazal and Xifaxan and a one-time write-off of $2.7 million of obsolete inventories associated with the initial launch of Xifaxan. Cost of products sold does not include amortization of product rights and intangibles. Refer to “Critical Accounting Policies—Intangible Assets and Goodwill” above.

License fees and costs related to collaborative agreements were $1.3 million, $0.1 million and $1.8 million in 2006, 2005 and 2004, respectively, and relate primarily to payments made to Debiovision, Cedars-Sinai, Biorex and Alfa Wassermann under the terms of their license agreements.

Research and development expense was $47.9 million, $34.6 million and $20.4 million for 2006, 2005 and 2004, respectively. The increase in research and development expenses from 2005 to 2006 was due primarily to the expansion of our Colazal life cycle management program through initiatives to strengthen and support our 1100mg balsalazide tablet submission, our Colazal pediatric exclusivity filing and the costs associated with ongoing late-stage studies to expand the Xifaxan label. The increase in research and development expense from 2004 to 2005 was primarily due to on-going studies pursuing additional indications for rifaximin, on-going Phase III studies for granulated mesalamine and expenses associated with licensing fees. To date, we have incurred research and development expense of approximately $37.0 million for balsalazide, $51.4 million for rifaximin and $20.6 million for granulated mesalamine. Due to the risks and uncertainties of the drug development and regulatory approval process, research and development expenditures are difficult to forecast and subject to unexpected increases. As disclosed in Note 2 in the Notes to Condensed Consolidated Financial Statements, due to increased development activities and the way in which many of our long-term development contracts are structured, we have refined our process of estimating development activities to more closely align expenses with the level of progress achieved. We expect research and development costs to increase in absolute terms as we pursue additional indications and formulations for balsalazide and rifaximin, and continue to develop granulated mesalamine, and if and when we acquire new products.

Selling, general and administrative expenses were $82.6 million, $70.8 million and $54.1 million for 2006, 2005 and 2004, respectively. In absolute terms, the increase from 2005 to 2006 was primarily due to launch and training activities associated with our two new purgative products, OsmoPrep and MoviPrep, and the expansion of our sales force and infrastructure subsequent to the InKine merger. The increase from 2004 to 2005 was primarily due to increased commercial development activities which include expansion of the sales force and InKine merger related expenses.

Interest and other income, net was $2.6 million, $1.2 million and $0.6 million in 2006, 2005 and 2004, respectively. The increase from 2005 to 2006 and from 2004 to 2005 was primarily due to higher average daily cash balances and increased short-term interest rates.

Income tax expense was $1.4 million, $0.7 million and $0.4 million in 2006, 2005 and 2004, respectively. Our effective tax rate was 4.2%, (1.2)% and 5.6% in 2006, 2005 and 2004, respectively, due to the utilization of net operating loss carryforwards.

At December 31, 2006, 2005 and 2004, we had U.S. federal net operating loss carryforwards of approximately $111.1 million, $128.7 million and $87.3 million, respectively. These carryforwards will expire on various dates beginning in 2007 through 2024 if not utilized. Utilization of the federal net operating loss and credit carryforwards may be subject to a substantial annual limitation due to the “change in ownership” provisions of the Internal Revenue Code. The annual limitation might result in the expiration of net operating losses and credits before utilization.

See Note 13 of Notes to Consolidated Financial Statements for a presentation of our quarterly results of operations for the years ended December 31, 2006 and 2005.

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 collaborative partners. Since launching Colazal in January 2001, net product revenue has been a growing source of cash, a trend that we expect to continue. As of December 31, 2006, we had $76.5 million in cash, cash equivalents and short-term investments compared to $68.2 million as of December 31, 2005.

Net cash provided by operating activities was $17.8 million and $3.0 million in 2006 and 2005, respectively, and cash used in operating activities was $5.0 million in 2004. Positive operating cash flows in 2006 was primarily attributable to increased earnings, partially offset by increased accounts receivable balances due to increased sales in December 2006 and decreased accounts payable and accrued liability balances. Positive operating cash flows in 2005 were primarily attributable to increased earnings, excluding the impact of non-cash flow items including in-process research and development and depreciation and amortization, partially offset by increased accounts receivable and other current assets. Negative operating cash flows during 2004 were primarily attributable to increases in accounts receivable, inventory and other asset balances attributed to our business growth.

Net cash used in investing activities was $12.8 million in 2006 and was primarily attributable to the acquisition of MoviPrep and the purchase of property and equipment, partially offset by $1.0 million of investments that matured or were called by the issuers. Net cash provided by investing activities was $9.5 million in 2005 and was primarily attributable to proceeds from the maturity of investments and net cash acquired in the InKine acquisition, partially offset by the purchase of property and equipment. Net cash used in investing activities was $7.4 million in 2004 and was primarily attributable to the acquisition of the U.S. rights to Anusol and Proctocort from King Pharmaceuticals, Inc., partially offset by $6.0 million of investments that matured or were called by the issuers.

Net cash provided by financing activities was $4.3 million, $6.5 million and $5.7 million in 2006, 2005, and 2004, respectively, and was attributable to the exercise of stock options.

As of December 31, 2006, we had non-cancelable purchase order commitments for inventory purchases of approximately $18.2 million. We anticipate significant expenditures related to our on-going sales, marketing, product launch and development efforts associated with Colazal, Xifaxan, Visicol, Azasan, Anusol-HC, Proctocort, OsmoPrep, MoviPrep, Pepcid Oral Suspension and granulated mesalamine. To the extent we acquire rights to additional products, we will incur additional expenditures.

In February 2007, Salix also entered into a Credit Agreement (the “Credit Facility”) with the lenders from time to time parties to the Credit Agreement (the “Lenders”), Bank of America, N.A., as Administrative Agent, Swing Line Lender and L/C Issuer, Wachovia Bank, National Association, as Syndication Agent, and RBC Centura Bank, as Documentation Agent. Salix borrowed $15.0 million under the Credit Facility at closing. The Credit Facility is a $100.0 million revolving credit facility that matures in February 2012. The Credit Facility includes a $5.0 million swing line commitment and may be fully utilized for the issuance of letters of credit. Amounts outstanding under the Credit Facility are guaranteed by our subsidiaries pursuant to a Subsidiary Guaranty. Virtually all of our assets and those of our subsidiaries, including our ownership interest in the equity securities of our subsidiaries, secure our obligations under the Credit Facility.

The Credit Facility bears interest at a rate per annum equal to, at our option, either (a) a base rate equal to the higher of (i) the Federal Funds Rate plus 1/2 of 1% and (ii) the Bank of America prime rate, or (b) a Eurodollar rate (based on LIBOR), plus, in each case, a percentage rate that fluctuates, based on the ratio of our funded debt to EBITDA (income before income taxes plus interest expense and depreciation and amortization), from 0.00% to 0.75% for base rate borrowings and 1.00% to 1.75% for Eurodollar rate borrowings.

The Credit Facility contains various representations, warranties and affirmative, negative and financial covenants customary for financings of this type. The affirmative covenants include requirements for Salix to deliver financial statements and other financial information; provide notification to the lenders of events of default, litigation, changes in accounting policies and other adverse changes; pay and perform its obligations; maintain its and its subsidiaries’ corporate existence; maintain its property and insurance; comply with laws and material contracts; as well as other requirements. The negative covenants include limitations on the creation of liens; investments and acquisitions; indebtedness; mergers; sales of assets and dispositions of property; dividends and distributions; changes in the nature of the business of Salix and its subsidiaries; transactions with affiliates; use of the proceeds of loans; accounting changes; prepayments of indebtedness; and other matters. The financial covenants include a leverage test and a fixed charge test.

The Credit Facility also has customary defaults, including nonpayment of principal, interest or fees; failure to perform or observe certain specified covenants when due; failure of any subsidiary to perform or observe any term, covenant or agreement contained in the Subsidiary Guaranty; failure to perform or observe any other covenants or agreements contained in any of the loan documents within 30 days after such covenants or agreements are due; material misrepresentations; cross-defaults on other indebtedness greater than $5.0 million; bankruptcy or insolvency; unstayed judgments greater than $5.0 million or non-monetary final judgments that could have a material adverse effect individually or in the aggregate; invalidity of the loan documents; loss of any material license, permit or franchise of Salix or any of its subsidiaries; a change of control; and other matters. In an event of default under the Credit Facility, the obligations of the lenders to make loans or issue letters of credit terminate and the amounts outstanding, including all accrued interest and unpaid fees, become immediately due and payable.

The Credit Facility may be used for working capital, capital expenditures, acquisitions (including the acquisition) and other general corporate purposes.

As of December 31, 2006, we had an accumulated deficit of $113.0 million and cash and cash equivalent balances of $76.5 million. We believe our cash and cash equivalent balances, plus borrowing under our credit facility, should be sufficient to satisfy our cash requirements for the foreseeable future. However, our actual cash needs might vary materially from those now planned because of a number of factors, including the status of competitive products, including potential generics, our success selling products, the results of research and development activities, FDA and foreign regulatory processes, establishment of and change in collaborative relationships, technological advances by us and other pharmaceutical companies, and whether we acquire rights to additional products. We might seek additional debt or equity financing or both to fund our operations or acquisitions. If we incur more debt, we might be restricted in our ability to raise additional capital and might be subject to financial and restrictive covenants. If we issued 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.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In June 2006, the FASB issued FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (FIN 48), which is an interpretation of SFAS 109 “Accounting for Income Taxes.” This interpretation 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 a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact of adopting FIN 48 on our consolidated financial statements.

In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (SFAS 157). The statement provides guidance for using fair value to measure assets and liabilities. SFAS 157 references fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts. The statement applies whenever other standards require (or permit) assets or liabilities to be measured at fair value. SFAS 157 does not expand the use of fair value in any new circumstances. It is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We do not believe adoption of SFAS 157 will have a material impact on our consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin 108, (SAB 108), “Financial Statements—Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 provides guidance on the consideration of prior year misstatements in determining whether the current year’s financial statements are materially misstated. The SEC staff indicates that registrants should quantify the impact of correcting all misstatements, including both the carryover and reversing effects of prior year misstatements, on the current year financial statements. SAB 108 is effective for fiscal years ending after November 15, 2006. Registrants may either restate their financials for any material misstatements arising from the application of SAB 108 or recognize a cumulative effect of applying SAB 108 within the current year opening balance in retained earnings. Our adoption of SAB 108 did not have a material impact on our consolidated financial statements.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Results of Operations

Three-month and Nine-month Periods Ended September 30, 2007 and 2006

Revenues

Net product revenues for the three-month period ended September 30, 2007 were $67.4 million, compared to $51.2 million for the corresponding three-month period in 2006, a 32% increase. This net product revenue increase was due to increased sales of Colazal and Xifaxan, a full quarter of sales for MoviPrep, which was launched during the fourth quarter of 2006, a full quarter of sales for Pepcid, which was acquired and launched during February 2007, and increased sales from OsmoPrep which was launched in June 2006.

Net product revenues for the nine-month period ended September 30, 2007 were $193.8 million, compared to $145.9 million for the corresponding nine-month period in 2006, a 33% increase. This net product revenue increase was due to increased sales of Colazal and Xifaxan, a full nine months of sales for MoviPrep, which was launched during the fourth quarter of 2006, a full nine months of sales for OsmoPrep, which was launched in June 2006, and twenty-nine weeks of sales for Pepcid, which was acquired during February 2007. These increases were partially offset by a decrease in revenue from sales of Visicol. As planned, Colazal’s contribution as a percentage of total product revenue continued to decrease during the nine-month period ended September 30, 2007 compared to the nine-month period ended September 30, 2006 due to the expansion of our product portfolio with the launch of our bowel cleansing products, the acquisition of Pepcid, and the continued increase in Xifaxan sales.

Revenues from collaborative agreements for the nine-month period ended September 30, 2007 consists of an upfront payment of $1.5 million upon execution of an agreement to license exclusive rights to market DIACOL™ in 28 territories in Europe to Dr. Falk Pharma GmbH of Freiberg, Germany; and a $1.0 million milestone payment from Zeria Pharmaceutical Co., Ltd. of Tokyo, Japan as a result of their receipt of marketing approval of Visiclear® Tablets for colon cleansing in Japan. Revenues from collaborative agreements for the three-month period and nine-month period ended September 30, 2007 include $12,000 in royalty income from the sale of Visiclear®. We did not receive any revenues from collaborative agreements during the three-month period or nine-month period ended September 30, 2006.

Costs and Expenses

Costs and expenses for the three-month periods ended September 30, 2007 and 2006 were $52.4 million and $44.8 million, respectively. Costs and expenses for the nine-month periods ended September 30, 2007 and 2006 were $167.0 million and $129.4 million, respectively. Higher operating expenses in absolute terms were due primarily to increased research and development activities; increased cost of products sold related to the corresponding increase in product revenue; increased selling, general and administrative expenses due to the expansion of our infrastructure; costs related to OsmoPrep and MoviPrep, which were launched during the second and fourth quarters of 2006, respectively; and the acquisition of Pepcid during February 2007.

Cost of Products Sold

Cost of products sold for the three-month periods ended September 30, 2007 and 2006 were $13.1 million and $11.7, respectively. Cost of products sold for the nine-month periods ended September 30, 2007 and 2006 were $38.1 million and $29.2 million, respectively. The increase in cost of products sold for the three-month and nine-month periods ended September 30, 2007 compared to the three-month and nine-month periods ended September 30, 2006 was due primarily to increased sales of Colazal and Xifaxan, a full nine months of sales for OsmoPrep and MoviPrep which were launched during the second and fourth quarters of 2006, respectively, and the acquisition of Pepcid during February 2007. Gross margin on total product revenue, excluding $2.3 million and $1.3 million in amortization of product rights and intangibles for the three-month periods ended September 30, 2007 and 2006, respectively, was 80.6% for the three-month period ended September 30, 2007 compared to 77.2% for the three-month period ended September 30, 2006. Lower margin for the three-month period ended September 30, 2006 was primarily due to increased reserves and the launch of MoviPrep. Gross margin on total product revenue, excluding $6.4 million and $3.6 million in amortization of product rights and intangibles for the nine-month periods ended September 30, 2007 and 2006, respectively, was 80.3% for the nine-month period ended September 30, 2007 compared to 80.0% for the nine-month period ended September 30, 2006.

Fees and Costs Related to License Agreements

Fees and costs related to license agreements for the three-month period and nine-month period ended September 30, 2007 relates to payments made to Cedars-Sinai Medical Center under the terms of the related license agreements and payments of $1.1 million to Clinical Development Capital, the successor licensor of DIACOL™ and Visiclear®, for its share of the German and Japanese milestone revenue of $2.5 million recognized during the nine-month period ended September 30, 2007.

Amortization of Product Rights and Intangible Assets

Amortization of product rights and intangible assets consists of amortization of the costs of license agreements, product rights and other identifiable intangible assets, which result from product and business acquisitions. The increase in this non-cash expense for the three-month period and nine-month period ended September 30, 2007 compared to the corresponding periods in 2006 is primarily a result of the acquisition of Pepcid in February 2007.

Research and Development

Research and development expenses for the three-month periods ended September 30, 2007 and 2006 were $16.0 million and $10.3 million, respectively. Research and development expenses for the nine-month periods ended September 30, 2007 and 2006 were $56.8 million and $32.1 million, respectively. The increase in research and development expenses was due primarily to the expansion of our Colazal life cycle management program through initiatives to strengthen and support our 1100mg balsalazide tablet submission completed in July 2007, studies of granulated mesalamine, and ongoing late-stage studies to expand the Xifaxan label. To date, we have incurred research and development expenditures of approximately $60.4 million for balsalazide, $66.6 million for rifaximin and $24.1 million for granulated mesalamine. Due to the risks and uncertainties of the drug development and regulatory approval process, research and development expenditures are difficult to forecast and subject to unexpected increases. As disclosed in Note 2 in the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2006, due to increased development activities and the way in which many of our long-term development contracts are structured, we have refined our process of estimating development activities to more closely align expenses with the level of progress achieved. We have recently substantially completed several clinical trials in our development programs and expect research and development costs to be lower for the remaining three months of 2007 compared to the first nine months of 2007. However, in future years we expect research and development costs to increase in absolute terms as we pursue additional indications and formulations for balsalazide and rifaximin, and continue to develop granulated mesalamine, and if and when we acquire new products.

Selling, General and Administrative

Selling, general and administrative expenses for the three-month periods ended September 30, 2007 and 2006 were $20.9 million and $20.7 million, respectively. Selling, general and administrative expenses for the nine-month periods ended September 30, 2007 and 2006 were $64.1 million and $63.5 million, respectively. These slight increases in absolute dollars were primarily due to the expansion of our infrastructure related to OsmoPrep and MoviPrep which were launched during the second and fourth quarters of 2006, respectively, and the acquisition of Pepcid during February 2007, offset by reduced spending on the launch of OsmoPrep.

Interest and Other Income, Net

Interest and other income, net for the three-month periods ended September 30, 2007 and 2006 was $1.4 million and $0.8 million, respectively. Interest and other income, net for the nine-month periods ended September 30, 2007 and 2006 was $2.6 million and $2.5 million, respectively. Interest and other income, net for the three-month period and nine-month period ended September 30, 2007 includes $1.2 million received as final settlement of a legal matter initiated by InKine prior to our acquisition of InKine. This increase in interest and other income, net is offset by a decrease in interest and other income, net primarily due to interest expense of $0.2 million and $0.9 million incurred in the three-month and nine-month periods ended September 30, 2007 on our credit facility discussed below.

Realized Loss on Foreign Currency Translation

During the nine-months ended September 30, 2006, we recorded a non-cash charge under other comprehensive loss related to deferred revenue from the Shire Pharmaceuticals Group plc purchase from us in 2000 of exclusive rights to balsalazide for northern Europe. We expect no further charges or income from Shire, nor related payments to Biorex, our licensor for balsalazide.

Provision for Income Tax

Income tax expense for the three-month periods ended September 30, 2007 and 2006 was $2.2 million and $0.2 million, respectively. Income tax expense for the nine-month periods ended September 30, 2007 and 2006 was $4.7 million and $0.7 million, respectively. Our effective tax rate was 13.4% and 14.7%, respectively for the three-month and nine-month periods ended September 30, 2007, and 2.8% and 3.6% for the comparable periods in 2006. The increased effective tax rate in 2007 is primarily due to the increased utilization of acquired net operating loss carry-forwards in 2007 compared to 2006.

Net Income

Net income for the three-month periods ended September 30, 2007 and 2006 was $14.2 million and $7.0 million, respectively. Net income for the nine-month periods ended September 30, 2007 and 2006 was $27.3 million and $17.6 million, respectively.

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 collaborative partners. Since launching Colazal in January 2001, net product revenue has been a growing source of cash, a trend that we expect to continue. As of September 30, 2007, we had approximately $70.2 million in cash, cash equivalents and investments, compared to $76.5 million as of December 31, 2006.

Cash provided by operating activities was $36.0 million for the nine-month period ended September 30, 2007, compared with $5.3 million in the corresponding period in 2006. The increase in cash provided by operations during the nine-month period ended September 30, 2007 was primarily due to increased net income.

Cash used by investing activities was $59.2 million for the nine-month period ended September 30, 2007, compared with $12.2 million in the corresponding nine-month period in 2006. Cash used in investing activities for the nine-month period ended September 30, 2007 was primarily related to the acquisition of Pepcid in February 2007. Cash used in investing activities for the nine-month period ended September 30, 2006 was primarily related to a $15.1 million milestone payment made to Norgine in August 2006 upon the receipt of marketing approval from the FDA for MoviPrep.

Cash provided by financing activities was $16.9 million for the nine-month period ended September 30, 2007, compared to $2.4 million for the corresponding nine-month period in 2006. The increase was a result of borrowings during the nine-month period ended September 30, 2007 under our credit facility entered into in February 2007.

As of September 30, 2007, we had non-cancelable purchase order commitments for inventory purchases of approximately $14.1 million over six months. We anticipate significant expenditures related to our on-going sales, marketing, product launch and development efforts associated with Colazal, Xifaxan, Visicol, Azasan, Anusol-HC, Proctocort, OsmoPrep, MoviPrep, Pepcid Oral Suspension, and granulated mesalamine. To the extent we acquire rights to additional products, we will incur additional expenditures.

In February 2007, we entered into a $100.0 million revolving credit facility that matures in February 2012. At September 30, 2007, $15.0 million was outstanding under the credit facility. Virtually all of our assets and those of our subsidiaries secure our obligations under the credit facility. The credit facility may be used for working capital, capital expenditures, acquisitions and other general corporate purposes.

The credit facility bears interest at a rate per annum equal to, at our option, either (a) a base rate equal to the higher of (i) the Federal Funds Rate plus 1/2 of 1% and (ii) the Bank of America prime rate, or (b) a Eurodollar rate (based on LIBOR), plus, in each case, a percentage rate that fluctuates, based on the ratio of our funded debt to EBITDA (income before income taxes plus interest expense and depreciation and amortization), from 0.00% to 0.75% for base rate borrowings and 1.00% to 1.75% for Eurodollar rate borrowings. The rate as of September 30, 2007 on our outstanding borrowings was 6.5%.

The credit facility contains various representations, warranties and affirmative, negative and financial covenants customary for financings of this type. The financial covenants include a leverage test and a fixed charge test. We were in compliance with these covenants at September 30, 2007.

As of September 30, 2007, we had an accumulated deficit of $85.7 million. We believe cash flow from operations and our cash and cash equivalent balances, together with amounts available under our credit facility, should be sufficient to satisfy our cash requirements for the foreseeable future. However, our actual cash needs might vary materially from those now planned because of a number of factors, including the status of competitive products, including potential generics, whether we acquire rights to additional products, our success selling products, the results of research and development activities, FDA and foreign regulatory processes, establishment of, success with, and change in collaborative relationships, and technological advances by us and other pharmaceutical companies. We might seek additional debt or equity financing or both to fund our operations or acquisitions. If we incur debt, we might be restricted in our ability to raise additional capital and might be subject to financial and restrictive covenants. If we issued 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.

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