2013 Q2 10-Q
Table of Contents

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
________________________________________________________
FORM 10-Q
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2013
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM              TO             
Commission file number 000-19319
____________________________________________
Vertex Pharmaceuticals Incorporated
(Exact name of registrant as specified in its charter)
Massachusetts
04-3039129
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
130 Waverly Street, Cambridge, Massachusetts
02139-4242
(Address of principal executive offices)
(Zip Code)
Registrant’s telephone number, including area code (617) 341-6100
____________________________________________

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o 
Smaller reporting company o
 
                                       (Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
Common Stock, par value $0.01 per share
232,812,301
Class
Outstanding at July 26, 2013

 


Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2013

TABLE OF CONTENTS
 
 
Page
 
 
 
 
 
 
 
 
 
 
“We,” “us,” “Vertex” and the “Company” as used in this Quarterly Report on Form 10-Q refer to Vertex Pharmaceuticals Incorporated, a Massachusetts corporation, and its subsidiaries.
“Vertex,” “INCIVEK®” and “KALYDECO™” are registered trademarks of Vertex. Other brands, names and trademarks contained in this Quarterly Report on Form 10-Q, including “INCIVO™” and “TELAVIC™,” are the property of their respective owners.



Table of Contents

Part I. Financial Information
Item 1.    Financial Statements
VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Statements of Operations
(unaudited)
(in thousands, except per share amounts)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
Revenues:
 
 
 
 
 
 
 
Product revenues, net
$
254,789

 
$
373,273

 
$
522,170

 
$
748,648

Royalty revenues
49,120

 
33,480

 
92,693

 
72,461

Collaborative revenues
6,841

 
11,552

 
24,255

 
35,933

Total revenues
310,750

 
418,305

 
639,118

 
857,042

Costs and expenses:
 
 
 
 
 
 
 
Cost of product revenues (Note H)
24,695

 
104,549

 
55,650

 
130,467

Royalty expenses
13,236

 
9,874

 
25,024

 
23,167

Research and development expenses
222,455

 
196,544

 
440,550

 
392,915

Sales, general and administrative expenses
106,521

 
117,514

 
199,400

 
228,660

Restructuring expense
776

 
594

 
815

 
954

Intangible asset impairment charge (Note I)

 

 
412,900

 

Total costs and expenses
367,683

 
429,075

 
1,134,339

 
776,163

Income (loss) from operations
(56,933
)
 
(10,770
)
 
(495,221
)
 
80,879

Other income (expense), net
(6,578
)
 
(3,635
)
 
(11,230
)
 
(7,376
)
Income (loss) before provision for (benefit from) income taxes
(63,511
)
 
(14,405
)
 
(506,451
)
 
73,503

Provision for (benefit from) income taxes
(1,799
)
 
20,063

 
(132,112
)
 
20,095

Net income (loss)
(61,712
)
 
(34,468
)
 
(374,339
)
 
53,408

Net loss (income) attributable to noncontrolling interest (Alios)
4,547

 
(30,463
)
 
9,158

 
(26,749
)
Net income (loss) attributable to Vertex
$
(57,165
)
 
$
(64,931
)
 
$
(365,181
)
 
$
26,659

Net income (loss) per share attributable to Vertex common shareholders:
 
 
 
 
 
 
 
Basic
$
(0.26
)
 
$
(0.31
)
 
$
(1.67
)
 
$
0.13

Diluted
$
(0.26
)
 
$
(0.31
)
 
$
(1.67
)
 
$
0.12

Shares used in per share calculations:
 
 
 
 
 
 
 
Basic
222,053

 
211,344

 
218,795

 
209,681

Diluted
222,053

 
211,344

 
218,795

 
212,957

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


2

Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Statements of Comprehensive Income (Loss)
(unaudited)

(in thousands)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
Net income (loss)
$
(61,712
)
 
$
(34,468
)
 
$
(374,339
)
 
$
53,408

Changes in other comprehensive income (loss):
 
 
 
 
 
 
 
Unrealized holding gains (losses) on marketable securities, net of tax
(170
)
 
105

 
(159
)
 
255

Foreign currency translation adjustment
89

 
(150
)
 
(521
)
 
125

Total changes in other comprehensive income (loss)
(81
)
 
(45
)
 
(680
)
 
380

Comprehensive income (loss)
(61,793
)
 
(34,513
)
 
(375,019
)
 
53,788

Comprehensive loss (income) attributable to noncontrolling interest (Alios)
4,547

 
(30,463
)
 
9,158

 
(26,749
)
Comprehensive income (loss) attributable to Vertex
$
(57,246
)
 
$
(64,976
)
 
$
(365,861
)
 
$
27,039

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


3

Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Balance Sheets
(unaudited)
(in thousands, except share and per share amounts)
 
June 30,
 
December 31,
 
2013(1)
 
2012(1)
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
531,247

 
$
489,407

Marketable securities, available for sale
899,449

 
831,808

Restricted cash and cash equivalents (Alios)
58,288

 
69,983

Accounts receivable, net
164,866

 
143,250

Inventories
19,509

 
30,464

Prepaid expenses and other current assets
43,231

 
24,673

Total current assets
1,716,590

 
1,589,585

Restricted cash
122

 
31,934

Property and equipment, net
581,738

 
433,609

Intangible assets
250,600

 
663,500

Goodwill
30,992

 
30,992

Other assets
4,287

 
9,668

Total assets
$
2,584,329

 
$
2,759,288

Liabilities and Shareholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
48,570

 
$
101,292

Accrued expenses
260,849

 
264,884

Deferred revenues, current portion
32,900

 
27,566

Accrued restructuring expense, current portion
5,047

 
4,758

Capital lease obligations, current portion
10,664

 
13,707

Other liabilities, current portion
23,622

 
20,417

Total current liabilities
381,652

 
432,624

Deferred revenues, excluding current portion
84,066

 
96,242

Accrued restructuring expense, excluding current portion
17,005

 
18,570

Capital lease obligations, excluding current portion
28,088

 
15,170

Convertible senior subordinated notes (due 2015)

 
400,000

Deferred tax liability
149,706

 
280,367

Construction financing lease obligation
359,100

 
268,031

Other liabilities, excluding current portion
16,049

 
13,902

Total liabilities
1,035,666

 
1,524,906

Commitments and contingencies


 


Redeemable noncontrolling interest (Alios)
39,214

 
38,530

Shareholders’ equity:
 
 
 
Preferred stock, $0.01 par value; 1,000,000 shares authorized; none issued and outstanding at June 30, 2013 and December 31, 2012

 

Common stock, $0.01 par value; 300,000,000 shares authorized at June 30, 2013 and December 31, 2012; 232,176,564 and 217,286,868 shares issued and outstanding at June 30, 2013 and December 31, 2012, respectively
2,300

 
2,149

Additional paid-in capital
5,208,431

 
4,519,448

Accumulated other comprehensive loss
(1,230
)
 
(550
)
Accumulated deficit
(3,887,048
)
 
(3,521,867
)
Total Vertex shareholders’ equity
1,322,453

 
999,180

Noncontrolling interest (Alios)
186,996

 
196,672

Total shareholders’ equity
1,509,449

 
1,195,852

Total liabilities and shareholders’ equity
$
2,584,329

 
$
2,759,288

(1)
Amounts include the assets and liabilities of Vertex’s variable interest entity (“VIE”), Alios BioPharma, Inc. (“Alios”). Vertex’s interests and obligations with respect to the VIE’s assets and liabilities are limited to those accorded to Vertex in its agreement with Alios. See Note C, "Collaborative Arrangements," to these condensed consolidated financial statements for amounts.
The accompanying notes are an integral part of these condensed consolidated financial statements.


4

Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Statements of Shareholders’ Equity and Noncontrolling Interest
(unaudited)
(in thousands)
 
Common Stock
 
Additional
Paid-in Capital
 
Accumulated
Other
Comprehensive Income (Loss)
 
Accumulated Deficit
 
Total Vertex
Shareholders’ Equity
 
Noncontrolling
Interest (Alios)
 
Total
Shareholders’ Equity
 
Redeemable
Noncontrolling Interest (Alios)
 
Shares
 
Amount
 
 
 
 
 
 
 
Balance, December 31, 2011
209,304

 
$
2,072

 
$
4,200,659

 
$
(1,053
)
 
$
(3,414,835
)
 
$
786,843

 
$
141,633

 
$
928,476

 
$
37,036

Unrealized holding gains (losses) on marketable securities, net of tax
 
 
 
 
 
 
255

 
 
 
255

 
 
 
255

 
 
Foreign currency translation adjustment
 
 
 
 
 
 
125

 
 
 
125

 
 
 
125

 
 
Net income (loss)
 
 
 
 
 
 
 
 
26,659

 
26,659

 
26,749

 
53,408

 
 
Issuance of common stock under benefit plans
6,131

 
61

 
163,271

 
 
 
 
 
163,332

 
145

 
163,477

 
 
Stock-based compensation expense
 
 
 
 
59,345

 
 
 
 
 
59,345

 
271

 
59,616

 
 
Tax benefit from equity compensation
 
 
 
 
1,214

 
 
 
 
 
1,214

 

 
1,214

 
 
Change in liquidation value of noncontrolling interest
 
 
 
 
 
 
 
 
 
 
 
 
(878
)
 
(878
)
 
878

Balance, June 30, 2012
215,435

 
$
2,133

 
$
4,424,489

 
$
(673
)
 
$
(3,388,176
)
 
$
1,037,773

 
$
167,920

 
$
1,205,693

 
$
37,914

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2012
217,287

 
$
2,149

 
$
4,519,448

 
$
(550
)
 
$
(3,521,867
)
 
$
999,180

 
$
196,672

 
$
1,195,852

 
$
38,530

Unrealized holding gains (losses) on marketable securities, net of tax
 
 
 
 
 
 
(159
)
 
 
 
(159
)
 
 
 
(159
)
 
 
Foreign currency translation adjustment
 
 
 
 
 
 
(521
)
 
 
 
(521
)
 
 
 
(521
)
 
 
Net income (loss)
 
 
 
 
 
 
 
 
(365,181
)
 
(365,181
)
 
(9,158
)
 
(374,339
)
 
 
Issuance of common stock under benefit plans
6,614

 
68

 
213,733

 
 
 
 
 
213,801

 
(72
)
 
213,729

 
 
Convertible senior subordinated notes (due 2015) conversion
8,276

 
83

 
402,182

 
 
 
 
 
402,265

 

 
402,265

 
 
Stock-based compensation expense
 
 
 
 
73,068

 
 
 
 
 
73,068

 
238

 
73,306

 
 
Change in liquidation value of noncontrolling interest
 
 
 
 
 
 
 
 
 
 
 
 
(684
)
 
(684
)
 
684

Balance, June 30, 2013
232,177

 
$
2,300

 
$
5,208,431

 
$
(1,230
)
 
$
(3,887,048
)
 
$
1,322,453

 
$
186,996

 
$
1,509,449

 
$
39,214

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


5

Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Statements of Cash Flows
(unaudited)
(in thousands)
 
Six Months Ended
June 30,
 
2013
 
2012
Cash flows from operating activities:
 
 
 
Net income (loss)
$
(374,339
)
 
$
53,408

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
 
 
 
Depreciation and amortization expense
21,245

 
17,225

Stock-based compensation expense
72,625

 
59,067

Other non-cash based compensation expense
5,857

 
5,469

Intangible asset impairment charge
412,900

 

Deferred income taxes
(130,661
)
 
19,310

Write-down of inventories to net realizable value
5,083

 
78,000

Other non-cash items, net
755

 
130

Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net
(18,462
)
 
(2,483
)
Inventories
6,620

 
(34,288
)
Prepaid expenses and other current assets
(18,152
)
 
(40,053
)
Accounts payable
(53,374
)
 
(15,313
)
Accrued expenses and other liabilities
11,316

 
9,310

Excess tax benefit from share-based payment arrangements

 
(1,214
)
Accrued restructuring expense
(1,276
)
 
(1,483
)
Deferred revenues
(6,842
)
 
(25,764
)
Net cash provided by (used in) operating activities
(66,705
)
 
121,321

Cash flows from investing activities:
 
 
 
Purchases of marketable securities
(898,706
)
 
(777,604
)
Sales and maturities of marketable securities
830,906

 
502,188

Expenditures for property and equipment
(18,408
)
 
(21,698
)
Decrease (increase) in restricted cash
31,812

 

Decrease (increase) in restricted cash and cash equivalents (Alios)
11,695

 
(4,146
)
Decrease (increase) in other assets
414

 
(485
)
Net cash used in investing activities
(42,287
)
 
(301,745
)
Cash flows from financing activities:
 
 
 
Excess tax benefit from share-based payment arrangements

 
1,214

Issuances of common stock from employee benefit plans
207,872

 
158,003

Payments to redeem secured notes (due 2015)
(158
)
 

Payments on capital lease obligations
(12,246
)
 

Payments on construction financing lease obligation
(44,115
)
 

Net cash provided by financing activities
151,353

 
159,217

Effect of changes in exchange rates on cash
(521
)
 
(52
)
Net increase (decrease) in cash and cash equivalents
41,840

 
(21,259
)
Cash and cash equivalents—beginning of period
489,407

 
475,320

Cash and cash equivalents—end of period
$
531,247

 
$
454,061

Supplemental disclosure of cash flow information:
 
 
 
Cash paid for interest
$
6,700

 
$
6,700

Conversion of convertible senior subordinated notes (due 2015) for common stock
399,842

 

Interest on converted convertible senior subordinated notes (due 2015) offset to additional paid-in capital
6,700

 

Unamortized debt issuance costs of converted convertible subordinated notes (due 2015) offset to additional paid-in capital
4,230

 

Capitalization of construction in-process related to construction financing lease obligation
130,222

 
104,341

Assets acquired under capital lease
21,576

 
29,072

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


6

Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)
A.
Basis of Presentation and Accounting Policies
Basis of Presentation
The accompanying condensed consolidated financial statements are unaudited and have been prepared by Vertex Pharmaceuticals Incorporated ("Vertex" or the "Company") in accordance with accounting principles generally accepted in the United States of America ("GAAP").
The condensed consolidated financial statements reflect the operations of (i) the Company, (ii) its wholly-owned subsidiaries and (iii) Alios BioPharma, Inc. (“Alios”), a collaborator that is a variable interest entity (a “VIE”) for which the Company is deemed under applicable accounting guidance to be the primary beneficiary. All material intercompany balances and transactions have been eliminated. The Company operates in one segment, pharmaceuticals.
Certain information and footnote disclosures normally included in the Company's annual financial statements have been condensed or omitted. These interim financial statements, in the opinion of management, reflect all normal recurring adjustments (including accruals) necessary for a fair presentation of the financial position and results of operations for the interim periods ended June 30, 2013 and 2012.
The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full fiscal year. These interim financial statements should be read in conjunction with the audited financial statements for the year ended December 31, 2012, which are contained in the Company's Annual Report on Form 10-K for the year ended December 31, 2012 that was filed with the Securities and Exchange Commission (the "SEC") on March 1, 2013 (the "2012 Annual Report on Form 10-K").
Use of Estimates and Summary of Significant Accounting Policies
The preparation of condensed consolidated financial statements in accordance with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements, and the amounts of revenues and expenses during the reported periods. Significant estimates in these condensed consolidated financial statements have been made in connection with the calculation of revenues, inventories, research and development expenses, stock-based compensation expense, restructuring expense, the fair value of intangible assets, noncontrolling interest (Alios) and the income tax provision. The Company bases its estimates on historical experience and various other assumptions, including in certain circumstances future projections, that management believes to be reasonable under the circumstances. Actual results could differ from those estimates. Changes in estimates are reflected in reported results in the period in which they become known.
The Company's significant accounting policies are described in Note A, "Nature of Business and Accounting Policies," in the 2012 Annual Report on Form 10-K.
Recent Accounting Pronouncements
For a discussion of recent accounting pronouncements please refer to Note A, "Nature of Business and Accounting Policies—Recent Accounting Pronouncements," in the 2012 Annual Report on Form 10-K. The Company did not adopt any new accounting pronouncements during the six months ended June 30, 2013 that had a material effect on the Company's condensed consolidated financial statements.
B.
Product Revenues, Net
The Company sells its products principally to a limited number of major and selected regional wholesalers and specialty pharmacy providers in North America that subsequently resell the products to patients and health care providers, as well as government-owned and supported customers in Europe (collectively, its “Customers”). The Company recognizes net revenues from product sales upon delivery as long as (i) there is persuasive evidence that an arrangement exists between the Company and the Customer, (ii) collectibility is reasonably assured and (iii) the price is fixed or determinable.


7

Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

In order to conclude that the price is fixed or determinable, the Company must be able to (i) calculate its gross product revenues from sales to Customers and (ii) reasonably estimate its net product revenues upon delivery to its Customer's locations. The Company calculates gross product revenues based on the price that the Company charges its Customers. The Company estimates its net product revenues by deducting from its gross product revenues (a) trade allowances, such as invoice discounts for prompt payment and customer fees, (b) estimated government and private payor rebates, chargebacks and discounts, (c) estimated reserves for expected product returns and (d) estimated costs of incentives offered to certain indirect customers, including patients.
The following table summarizes activity in each of the product revenue allowance and reserve categories for the six months ended June 30, 2013:
 
Trade
Allowances
 
Rebates,
Chargebacks
and Discounts
 
Product
Returns
 
Other
Incentives
 
Total
 
(in thousands)
Balance at December 31, 2012
$
5,416

 
$
63,560

 
$
2,852

 
$
3,565

 
$
75,393

Provision related to current period sales
19,880

 
99,540

 
2,029

 
6,394

 
127,843

Adjustments related to prior period sales
348

 
3,380

 
8,247

 
(136
)
 
11,839

Credits/payments made
(22,404
)
 
(103,142
)
 
(2,116
)
 
(6,831
)
 
(134,493
)
Balance at June 30, 2013
$
3,240

 
$
63,338

 
$
11,012

 
$
2,992

 
$
80,582

C.
Collaborative Arrangements
Janssen Pharmaceutica, N.V.
In 2006, the Company entered into a collaboration agreement with Janssen Pharmaceutica, N.V. ("Janssen") for the development, manufacture and commercialization of telaprevir, which Janssen began marketing under the brand name INCIVO in certain of its territories in September 2011. Under the collaboration agreement, Janssen agreed to be responsible for 50% of the drug development costs incurred under the development program for the parties’ territories (North America for the Company, and the rest of the world, other than specified countries in Asia, for Janssen) and has exclusive rights to commercialize telaprevir in its territories including Europe, South America, the Middle East, Africa and Australia.
Janssen pays the Company a tiered royalty averaging in the mid-20% range as a percentage of net sales of INCIVO in Janssen’s territories. Janssen is required under the agreement to use diligent efforts to maximize net sales of INCIVO in its territories through its commercial marketing, pricing and contracting strategies. Janssen is responsible for certain third-party royalties on net sales of INCIVO in its territories.
Janssen made a $165.0 million up-front license payment to the Company in 2006. The up-front license payment is being amortized over the Company’s estimated period of performance under the collaboration agreement. As of June 30, 2013, there were $37.3 million in deferred revenues related to this up-front license payment that the Company expects to recognize over the remaining estimated period of performance. The Company's estimates regarding the period of performance under the Janssen agreement have changed in the past, and due to the evolving nature of the landscape for treatments for HCV infection, the estimated period of performance may change in the future.
Under the collaboration agreement, Janssen agreed to make contingent milestone payments for successful development, approval and launch of telaprevir as a product in its territories. At the inception of the agreement, the Company determined that all of these contingent milestones were substantive and would result in revenues in the period in which the milestone was achieved. The Company has earned $350.0 million of these contingent milestone payments and does not expect to receive any further milestone payments under this agreement.
Under the Janssen collaboration agreement, each party incurs internal and external reimbursable expenses related to the telaprevir development program and is reimbursed by the other party for 50% of these expenses. The Company recognizes the full amount of the reimbursable costs it incurs as research and development expenses on its condensed consolidated


8

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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

statements of operations. The Company recognizes the amounts that Janssen is obligated to pay the Company with respect to reimbursable expenses, net of reimbursable expenses incurred by Janssen, as collaborative revenues. In the three and six months ended June 30, 2012, Janssen incurred more reimbursable costs than the Company, and the net amounts payable by the Company to reimburse Janssen were recorded as a reduction of collaborative revenues.
Each of the parties is responsible for drug supply in its territories. During the six months ended June 30, 2013 and 2012, the Company provided Janssen certain services through the Company’s third-party manufacturing network for telaprevir. Reimbursements from Janssen for these manufacturing services were recorded as collaborative revenues.
Janssen may terminate the collaboration agreement upon the later of (i) one year’s advance notice and (ii) such period as may be required to assign and transfer to the Company specified filings and approvals. The agreement also may be terminated by either party for a material breach by the other, subject to notice and cure provisions. Unless earlier terminated, the agreement will continue in effect until the expiration of Janssen’s royalty obligations, which expire on a country-by-country basis on the later of (a) the last-to-expire patent covering INCIVO or (b) ten years after the first commercial sale in the country. In the European Union, the Company has a patent covering the composition-of-matter of INCIVO that expires in 2026.
During the three and six months ended June 30, 2013 and 2012, the Company recognized the following revenues attributable to the Janssen collaboration:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
 
(in thousands)
Royalty revenues (INCIVO)
$
44,070

 
$
27,970

 
$
83,114

 
$
60,854

Collaborative revenues:
 
 
 
 
 
 
 
Amortized portion of up-front payment
$
3,107

 
$
3,107

 
$
6,214

 
$
6,214

Net reimbursement (payment) for telaprevir development costs
37

 
(927
)
 
9

 
(2,066
)
Reimbursement for manufacturing services

 

 
10,299

 
4,449

        Total collaborative revenues attributable to the Janssen collaboration
$
3,144

 
$
2,180

 
$
16,522

 
$
8,597

Total revenues attributable to the Janssen collaboration
$
47,214

 
$
30,150

 
$
99,636

 
$
69,451

Mitsubishi Tanabe Pharma Corporation
The Company has a collaboration agreement (the “MTPC Agreement”) with Mitsubishi Tanabe Pharma Corporation ("Mitsubishi Tanabe") pursuant to which Mitsubishi Tanabe has a fully-paid license to manufacture and commercialize TELAVIC (the brand name under which Mitsubishi Tanabe is marketing telaprevir) in Japan and other specified countries in Asia.
The parties entered into the MTPC Agreement in 2004 and amended it in 2009. Pursuant to the MTPC Agreement, Mitsubishi Tanabe provided financial and other support for the development and commercialization of telaprevir, made a $105.0 million payment in connection with the 2009 amendment of the collaboration agreement and made a $65.0 million commercial milestone payment recognized as collaborative revenues in 2011. There are no further payments under this collaboration agreement. Mitsubishi Tanabe is responsible for its own development and manufacturing costs in its territory.
Mitsubishi Tanabe may terminate the MTPC Agreement at any time without cause upon 60 days’ prior written notice to the Company. The MTPC Agreement also may be terminated by either party for a material breach by the other, subject to notice and cure provisions. Unless earlier terminated, the MTPC Agreement will continue in effect until the expiration of the last-to-expire patent covering telaprevir in Mitsubishi Tanabe's territories. In Japan, the Company has a patent covering the composition-of-matter of telaprevir that expires in 2021.


9

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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The $105.0 million payment that the Company received in 2009 in connection with the amendment to the MTPC Agreement was a nonrefundable, up-front license fee, and revenues related to the 2009 payment were recognized on a straight-line basis over the period of performance of the Company’s obligations under the amended agreement. The final deferred revenues related to the 2009 up-front license payment were recognized in April 2012. In connection with the amendment to the MTPC Agreement, the Company supplied manufacturing services to Mitsubishi Tanabe, until April 2012, through the Company’s third-party manufacturing network for telaprevir.
The Company recognized no collaborative revenues attributable to the Mitsubishi Tanabe collaboration in 2013 and $4.8 million and $18.9 million in collaborative revenues attributable to the Mitsubishi Tanabe collaboration in the three and six months ended June 30, 2012, respectively.
Cystic Fibrosis Foundation Therapeutics Incorporated
In April 2011, the Company entered into an amendment (the “April 2011 Amendment”) to its existing collaboration agreement with Cystic Fibrosis Foundation Therapeutics Incorporated (“CFFT”) pursuant to which CFFT agreed to provide financial support for (i) development activities for VX-661, a corrector compound discovered under the collaboration, and (ii) additional research and development activities directed at discovering new corrector compounds.
The Company entered into the original collaboration agreement with CFFT in 2004 and amended it several times prior to 2011 to, among other things, provide partial funding for its cystic fibrosis drug discovery and development efforts. In 2006, the Company received a $1.5 million milestone payment from CFFT. There are no additional milestones payable by CFFT to the Company pursuant to the collaboration agreement, as amended. Under the April 2011 Amendment, CFFT agreed to provide the Company with up to $75.0 million in funding over approximately five years for corrector-compound research and development activities. The Company retains the right to develop and commercialize KALYDECO (ivacaftor), VX-809, VX-661 and any other compounds discovered during the course of the research collaboration with CFFT.
During the three and six months ended June 30, 2013 and 2012, the Company recognized the following revenues attributable to the CFFT collaboration:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
 
(in thousands)
Collaborative revenues attributable to the CFFT collaboration
$
4,244

 
$
4,527

 
$
7,803

 
$
8,457

In the original agreement, as amended prior to the April 2011 Amendment, the Company agreed to pay CFFT tiered royalties calculated as a percentage, ranging from single digits to sub-teens, of annual net sales of any approved drugs discovered during the research term that ended in 2008, including KALYDECO, VX-809 and VX-661. The April 2011 Amendment provides for a tiered royalty in the same range on net sales of corrector compounds discovered during the research term that began in 2011. In each of the third quarter of 2012 and first quarter of 2013, CFFT earned a commercial milestone payment of $9.3 million from the Company upon achievement of certain sales levels for KALYDECO. These milestones were reflected in the Company's cost of product revenues. There are no additional commercial milestone payments payable by the Company to CFFT related to sales levels for KALYDECO. The Company also is obligated to make up to two one-time commercial milestone payments to CFFT upon achievement of certain sales levels for corrector compounds such as VX-809 or VX-661.
The Company began marketing KALYDECO in the United States in the first quarter of 2012 and began marketing KALYDECO in certain countries in the European Union in the third quarter of 2012. The Company has royalty obligations to CFFT for each compound commercialized pursuant to this collaboration until the expiration of patents covering that compound. The Company has patents in the United States and European Union covering the composition-of-matter of ivacaftor that expire in 2027 and 2025, respectively, subject to potential patent life extensions. CFFT may terminate its funding obligations under the collaboration, as amended, in certain circumstances, in which case there will be a proportional


10

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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

adjustment to the royalty rates and commercial milestone payments for certain corrector compounds. The collaboration also may be terminated by either party for a material breach by the other, subject to notice and cure provisions.
Alios BioPharma, Inc.
License and Collaboration Agreement
In June 2011, the Company entered into a license and collaboration agreement (the “Alios Agreement”) with Alios, a privately-held biotechnology company. The Company and Alios are collaborating on the research, development and commercialization of an HCV nucleotide analogue discovered by Alios, ALS-2200 (now formulated as VX-135), which is designed to act on the HCV polymerase.
Under the terms of the Alios Agreement, the Company received exclusive worldwide rights to ALS-2200 (VX-135) and ALS-2158, a second HCV nucleotide analogue discovered by Alios that was only developed pursuant to the Alios Agreement through the third quarter of 2012. Upon entering into the Alios Agreement, the Company paid Alios a $60.0 million up-front payment. As of June 30, 2013, Alios had earned an aggregate of $60.0 million in development milestone payments pursuant to the Alios Agreement. The Alios Agreement provides for development milestone payments to Alios of up to an additional $312.5 million if VX-135 is approved and commercialized. In addition, Alios is eligible to receive commercial milestone payments of up to $750.0 million, as well as tiered royalties on net sales of approved drugs.
Alios and the Company began clinical development of ALS-2200 (VX-135) in December 2011. The Company is responsible for all costs related to development, commercialization and manufacturing of compounds licensed to the Company pursuant to the Alios Agreement, provided funding to Alios to conduct the Phase 1 clinical trials associated with the Alios Agreement and provided funding for a research program that was directed to the discovery of additional HCV nucleotide analogues that act on the HCV polymerase.
The Company may terminate the Alios Agreement (i) upon 30 days’ notice to Alios if the Company ceases development after VX-135 has experienced a technical failure and/or (ii) upon 60 days’ notice to Alios at any time after the Company completes specified Phase 2a clinical trials. The Alios Agreement also may be terminated by either party for a material breach by the other, and by Alios for the Company’s inactivity or if the Company challenges certain Alios patents, in each case subject to notice and cure provisions. Unless earlier terminated, the Alios Agreement will continue in effect until the expiration of the Company’s royalty obligations, which expire on a country-by-country basis on the later of (a) the date the last-to-expire patent covering a licensed product expires or (b) ten years after the first commercial sale in the country.
Alios is continuing to operate as a separate entity, is engaged in other programs directed at developing novel drugs that are not covered by the Alios Agreement and maintains ownership of the underlying patent rights that are licensed to the Company pursuant to the Alios Agreement. Under applicable accounting guidance, the Company has determined that Alios is a VIE, that Alios is a business and that the Company is Alios’ primary beneficiary. The Company based these determinations on, among other factors, the significance to Alios of the licensed compounds and on the Company’s power, through the joint steering committee for the licensed compounds established under the Alios Agreement, to direct the activities that most significantly affect the economic performance of Alios.
Accordingly, the Company consolidated Alios’ statements of operations and balance sheet with the Company’s consolidated financial statements beginning on June 13, 2011. However, the Company’s interests in Alios are limited to those accorded to the Company in the Alios Agreement. In particular, the Company did not acquire any equity interest in Alios, any interest in Alios’ cash and cash equivalents or any control over Alios’ activities that do not relate to the Alios Agreement. Alios does not have any rights to the Company’s assets except as provided in the Alios Agreement.
Noncontrolling Interest (Alios)
The Company records noncontrolling interest (Alios) on two lines on its condensed consolidated balance sheets. The noncontrolling interest (Alios) is reflected on two separate lines because Alios has both common shareholders and preferred shareholders that are entitled to redemption rights in certain circumstances. The Company records net loss (income) attributable to noncontrolling interest (Alios) on its condensed consolidated statements of operations, reflecting Alios' net loss


11

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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

(income) for the reporting period, adjusted for changes in the fair value of contingent milestone and royalty payments, which is evaluated each reporting period. A summary of net loss (income) attributable to noncontrolling interest (Alios) for the three and six months ended June 30, 2013 and 2012 is as follows:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
 
(in thousands)
Loss (income) before provision for (benefit from) income taxes
$
6,824

 
$
4,467

 
$
12,121

 
$
9,491

Decrease (increase) in fair value of contingent milestone and royalty payments
80

 
(56,170
)
 
2,820

 
(55,200
)
Provision for (benefit from) income taxes
(2,357
)
 
21,240

 
(5,783
)
 
18,960

Net loss (income) attributable to noncontrolling interest (Alios)
$
4,547

 
$
(30,463
)
 
$
9,158

 
$
(26,749
)
The Company uses present-value models to determine the estimated fair value of the contingent milestone and royalty payments, based on assumptions regarding the probability of achieving the relevant milestones, estimates regarding the time to develop drug candidates, estimates of future product sales and the appropriate discount rates. The Company bases its estimate of the probability of achieving the relevant milestones on industry data for similar assets and its own experience. The discount rates used in the valuation model represent a measure of credit risk and market risk associated with settling the liability. Significant judgment is used in determining the appropriateness of these assumptions at each reporting period. Changes in these assumptions could have a material effect on the fair value of the contingent milestone and royalty payments.
In the three and six months ended June 30, 2013, the fair value of the contingent milestone payments and royalties payable by the Company to Alios related to the HCV nucleotide analogue program decreased by $0.1 million and $2.8 million, respectively, which decreased net loss attributable to Vertex by a corresponding amount.
In the three and six months ended June 30, 2012, the fair value of contingent milestone and royalty payments increased by $56.2 million and $55.2 million, respectively, primarily because the Company received positive clinical data from a Phase 1 clinical trial evaluating ALS-2200 (VX-135), which increased the probability that Alios would earn future payments from the Company under the Alios Agreement.
If VX-135 continues to advance in clinical development, the Company expects it will record increases in the fair value of the contingent milestone and royalty payments in future periods. Changes in the fair value of these contingent milestone and royalty payments, and the effects of these changes on net income (loss) attributable to Vertex, may be material in future periods.


12

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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Alios Balance Sheet Information
The following table summarizes items related to Alios included in the Company’s condensed consolidated balance sheets:
 
As of
June 30, 2013
 
As of
December 31, 2012
 
(in thousands)
Restricted cash and cash equivalents (Alios)
$
58,288

 
$
69,983

Prepaid expenses and other current assets
4,115

 
672

Property and equipment, net
1,478

 
1,728

Intangible assets
250,600

 
250,600

Goodwill
4,890

 
4,890

Other assets
861

 
861

Accounts payable
1,666

 
1,054

Accrued expenses
5,294

 
6,099

Deferred tax liability
149,706

 
152,781

Other liabilities, excluding current portion
1,078

 
1,625

Redeemable noncontrolling interest (Alios)
39,214

 
38,530

Noncontrolling interest (Alios)
186,996

 
196,672

The Company has recorded Alios’ cash and cash equivalents as restricted cash and cash equivalents (Alios) because (i) the Company does not have any interest in or control over Alios’ cash and cash equivalents and (ii) the Alios Agreement does not provide for these assets to be used for the development of the assets that the Company licensed from Alios pursuant to the Alios Agreement. Assets recorded as a result of consolidating Alios’ financial condition into the Company’s condensed consolidated balance sheets do not represent additional assets that could be used to satisfy claims against the Company’s general assets.


13

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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

D.
Net Income (Loss) Per Share Attributable to Vertex Common Shareholders
The following table sets forth the computation of basic and diluted net income (loss) attributable to Vertex per common share in conformity with the two-class method for the three and six months ended June 30, 2013 and 2012:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands, except per share amounts)
Basic net income (loss) attributable to Vertex per common share calculation:
 
 
 
 
 
 
 
Net income (loss) attributable to Vertex common shareholders
$
(57,165
)
 
$
(64,931
)
 
$
(365,181
)
 
$
26,659

Less: Undistributed earnings allocated to participating securities

 

 

 
(260
)
Net income (loss) attributable to Vertex common shareholders—basic
$
(57,165
)
 
$
(64,931
)
 
$
(365,181
)
 
$
26,399

Basic weighted-average common shares outstanding
222,053

 
211,344

 
218,795

 
209,681

Basic net income (loss) attributable to Vertex per common share
$
(0.26
)
 
$
(0.31
)
 
$
(1.67
)
 
$
0.13

 
 
 
 
 
 
 
 
Diluted net income (loss) attributable to Vertex per common share calculation:
 
 
 
 
 
 
 
Net income (loss) attributable to Vertex common shareholders
$
(57,165
)
 
$
(64,931
)
 
$
(365,181
)
 
$
26,659

Less: Undistributed earnings allocated to participating securities

 

 

 
(256
)
Net income (loss) attributable to Vertex common shareholders—diluted
$
(57,165
)
 
$
(64,931
)
 
$
(365,181
)
 
$
26,403

Weighted-average shares used to compute basic net income (loss) per common share
222,053

 
211,344

 
218,795

 
209,681

Effect of potentially dilutive securities:
 
 
 
 
 
 
 
Stock options

 

 

 
3,188

Other

 

 

 
88

Weighted-average shares used to compute diluted net income (loss) per common share
222,053

 
211,344

 
218,795

 
212,957

Diluted net income (loss) attributable to Vertex per common share
$
(0.26
)
 
$
(0.31
)
 
$
(1.67
)
 
$
0.12

The Company did not include the securities described in the following table in the computation of the diluted net income (loss) attributable to Vertex per common share calculations because the effect would have been anti-dilutive during each such period:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
 
(in thousands)
Stock options
16,802

 
18,771

 
16,802

 
10,624

Convertible senior subordinated notes

 
8,192

 

 
8,192

Unvested restricted stock and restricted stock units
2,600

 
2,087

 
2,600

 
8

E.
Fair Value Measurements
The fair value of the Company’s financial assets and liabilities reflects the Company’s estimate of amounts that it would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from sources independent from the Company) and to minimize the use of unobservable inputs (the Company’s assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:


14

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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Level 1:
Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.
Level 2:
Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active.
Level 3:
Unobservable inputs based on the Company’s assessment of the assumptions that market participants would use in pricing the asset or liability.
The Company’s investment strategy is focused on capital preservation. The Company invests in instruments that meet the credit quality standards outlined in the Company’s investment policy. This policy also limits the amount of credit exposure to any one issue or type of instrument. As of June 30, 2013, the Company’s investments were in money market funds, short-term U.S. Treasury securities, short-term government-sponsored enterprise securities, corporate debt securities and commercial paper.
As of June 30, 2013, all of the Company’s financial assets that were subject to fair value measurements were valued using observable inputs. The Company’s financial assets valued based on Level 1 inputs consisted of money market funds, U.S. Treasury securities and government-sponsored enterprise securities. The Company’s financial assets valued based on Level 2 inputs consisted of corporate debt securities and commercial paper, which consist of investments in highly-rated investment-grade corporations. During the three and six months ended June 30, 2013 and 2012, the Company did not record an other-than-temporary impairment charge related to its financial assets. The Company’s noncontrolling interest (Alios) includes the fair value of the contingent milestone and royalty payments, which is valued based on Level 3 inputs. Please refer to Note C, "Collaborative Arrangements," for further information.
The following table sets forth the Company’s financial assets (excluding Alios’ cash equivalents) subject to fair value measurements:
 
Fair Value Measurements
as of June 30, 2013
 
 
 
Fair Value Hierarchy
 
Total
 
Level 1
 
Level 2
 
Level 3
 
(in thousands)
Financial assets carried at fair value:
 
 
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
300,472

 
$
300,472

 
$

 
$

U.S. Treasury securities
680

 
680

 

 

Marketable securities:
 
 
 
 
 
 
 
U.S. Treasury securities
3,050

 
3,050

 

 

Government-sponsored enterprise securities
598,411

 
598,411

 

 

Commercial paper
192,878

 

 
192,878

 

Corporate debt securities
105,110

 

 
105,110

 

Total
$
1,200,601

 
$
902,613

 
$
297,988

 
$

Alios’ cash equivalents of $56.5 million as of June 30, 2013 consisted of money market funds, which were valued based on Level 1 inputs.


15

Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

F.
Marketable Securities
A summary of the Company’s cash, cash equivalents and marketable securities is shown below:
 
Amortized Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
 
(in thousands)
As of June 30, 2013
 
 
 
 
 
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash and money market funds
$
530,567

 
$

 
$

 
$
530,567

U.S. Treasury securities
680

 

 

 
680

Total cash and cash equivalents
$
531,247

 
$

 
$

 
$
531,247

Marketable securities:
 
 
 
 
 
 
 
U.S. Treasury securities (due within 1 year)
$
3,050

 
$

 
$

 
$
3,050

Government-sponsored enterprise securities (due within 1 year)
598,440

 
17

 
(46
)
 
598,411

Commercial paper (due within 1 year)
192,702

 
176

 

 
192,878

Corporate debt securities (due within 1 year)
105,220

 

 
(110
)
 
105,110

Total marketable securities
$
899,412

 
$
193

 
$
(156
)
 
$
899,449

Total cash, cash equivalents and marketable securities
$
1,430,659

 
$
193

 
$
(156
)
 
$
1,430,696

 
 
 
 
 
 
 
 
As of December 31, 2012
 
 
 
 
 
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash and money market funds
$
489,407

 
$

 
$

 
$
489,407

Total cash and cash equivalents
$
489,407

 
$

 
$

 
$
489,407

Marketable securities:
 
 
 
 
 
 
 
U.S. Treasury securities (due within 1 year)
$
111,350

 
$
2

 
$
(2
)
 
$
111,350

Government-sponsored enterprise securities (due within 1 year)
440,181

 
49

 
(5
)
 
440,225

Commercial paper (due within 1 year)
225,294

 
155

 

 
225,449

Corporate debt securities (due within 1 year)
15,429

 
1

 
(1
)
 
15,429

Corporate debt securities (due after 1 year through 5 years)
39,358

 
10

 
(13
)
 
39,355

Total marketable securities
$
831,612

 
$
217

 
$
(21
)
 
$
831,808

Total cash, cash equivalents and marketable securities
$
1,321,019

 
$
217

 
$
(21
)
 
$
1,321,215

Alios’ $58.3 million and $70.0 million, respectively, of cash and money market funds as of June 30, 2013 and December 31, 2012, recorded on the Company’s condensed consolidated balance sheets in “Restricted cash and cash equivalents (Alios),” are not included in the above table.


16

Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

G.
Accumulated Other Comprehensive Income (Loss)
The following table summarizes the changes in accumulated other comprehensive income (loss) by component, net of tax:
 
 
Foreign Currency Translation Adjustment
 
Unrealized Holding Gains (Losses) on Marketable Securities, Net of Tax
 
Total
 
 
(in thousands)
Balance at December 31, 2012
 
$
(746
)
 
$
196

 
$
(550
)
Other comprehensive income (loss) before reclassifications
 
(521
)
 
(159
)
 
(680
)
Amounts reclassified from accumulated other comprehensive income (loss)
 

 

 

Net current period other comprehensive income (loss)
 
(521
)
 
(159
)
 
(680
)
Balance at June 30, 2013
 
$
(1,267
)
 
$
37

 
$
(1,230
)
For the six months ended June 30, 2013, amounts reclassified from accumulated other comprehensive income (loss) were not significant. Amounts reclassified for unrealized gains (losses) on available-for-sale securities are recorded as part of other income (expense), net on the Company's condensed consolidated statements of income.
H.
Inventories
The following table sets forth the Company’s inventories by type:
 
As of
June 30, 2013
 
As of
December 31, 2012
 
(in thousands)
Raw materials
$
3,103

 
$
3,754

Work-in-process
4,655

 
11,317

Finished goods
11,751

 
15,393

Total
$
19,509

 
$
30,464

In the three months ended June 30, 2013 and 2012, the Company recorded within cost of product revenues $5.1 million and $78.0 million, respectively, of write-offs for excess and obsolete inventories.
I.
Intangible Assets and Goodwill
Intangible Assets
As of December 31, 2012, the Company's intangible assets consisted of indefinite-lived in-process research and development assets of (i) $250.6 million related to its HCV nucleotide analogue program, which includes the HCV nucleotide analogue VX-135, and (ii) $412.9 million related to VX-222, which also was being developed for the treatment of HCV infection. The Company acquired VX-222 when it acquired ViroChem Pharma Inc. ("ViroChem") in 2009.
The Company tests intangible assets for impairment on an annual basis as of October 1, and more frequently if indicators are present or changes in circumstance suggest that impairment may exist. In connection with each annual impairment assessment and any interim impairment assessment in which indicators of impairment have been identified, the Company compares the fair value of the asset as of the date of the assessment with the carrying value of the asset on the Company's condensed consolidated balance sheet.


17

Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

In connection with its preparation of its financial statements for the three months ended March 31, 2013, the Company determined that there were indicators that the value of the VX-222 intangible asset had become impaired.  This determination was based on (a) preliminary safety, tolerability and efficacy data from a Phase 2 clinical trial of VX-222, telaprevir and ribavirin, which was received in March 2013 and analyzed through April 2013 and (b) a review of the existing and emerging data regarding all-oral regimens for HCV infection being developed by the Company's competitors that appear to be generally well tolerated with high sustained viral response ("SVR") rates for treatment-naïve patients with genotype 1 HCV infection. After evaluating the data from this Phase 2 clinical trial, the Company determined that regimens containing VX-222 were unlikely to be competitive with the treatment regimens being developed by the Company's competitors. The Company evaluated the fair value of VX-222 from the perspective of a market participant and based on this analysis determined that the fair value of VX-222 was zero as of March 31, 2013. Accordingly, the Company recorded a $412.9 million impairment charge in the six months ended June 30, 2013. The Company continues to monitor the development of competitive all-oral regimens and other direct antivirals and does not plan to initiate any new clinical trials of VX-222.  In connection with this impairment charge, the Company recorded a credit of $127.6 million in its provision for income taxes. In the six months ended June 30, 2013, the increase to the Company's net loss attributable to Vertex related to this impairment charge, net of the tax credit, was $285.3 million, and the net increase to the Company's net loss per share attributable to Vertex common shareholders was $1.30 per share.
The field of HCV infection treatment is highly competitive and characterized by rapid technological advances and the development of drug candidates for the treatment of HCV infection is subject to numerous risks. Two of the Company's competitors have filed applications seeking approval for potentially competitive treatment regimens that include pegylated-interferon and ribavirin, and several of the Company's competitors are conducting Phase 3 clinical trials evaluating all-oral combinations of their drug candidates for the treatment of genotype 1 HCV infection.
In July 2013, U.S. Food and Drug Administration ("FDA") placed a partial clinical hold on the Company's Phase 2 clinical trial evaluating VX-135 in combination with ribavirin. The partial clinical hold prevents the Company from evaluating a 200 mg dose of VX-135 in the United States following observation of reversible elevated liver enzymes in patients who received 400 mg of VX-135 in combination with ribavirin in a Phase 2 clinical trial in Europe. Evaluation of a 100 mg dose of VX-135 in combination with ribavirin as part of the 12-week Phase 2 clinical trial in the United States is continuing as planned. The Company recently completed dosing of 100 mg and 200 mg of VX-135 in combination with ribavirin as part of the 12-week Phase 2 clinical trial in Europe, and both doses were well tolerated with no discontinuations. No serious adverse events have been reported and no liver or cardiac safety issues have been identified in the 100 mg or 200 mg dose arms of this clinical trial in Europe. Vertex also recently initiated dosing of 100 mg and 200 mg of VX-135 in combination with daclatasvir, an NS5A replication complex inhibitor being developed by Bristol-Myers Squibb, in a Phase 2 clinical trial in New Zealand. The Company evaluated this data and the related partial clinical hold and has concluded that it does not represent an indicator of impairment.  The Company will continue to evaluate VX-135 for impairment each reporting period.
If the fair value of the HCV nucleotide analogue program becomes impaired as the result of unfavorable safety or efficacy data from any ongoing or future clinical trial or because of any other information regarding the prospects of successfully developing or commercializing VX-135, the Company would incur significant charges in the period in which the impairment occurs.
Goodwill
As of June 30, 2013 and December 31, 2012, goodwill of $31.0 million was recorded on the Company's condensed consolidated balance sheets. There was no change to goodwill recorded during the three and six months ended June 30, 2013 or 2012.
J.
Convertible Senior Subordinated Notes
In 2010, the Company completed an offering of $400.0 million in aggregate principal amount of 3.35% convertible senior subordinated notes due 2015 (the "2015 Notes"). This offering resulted in $391.6 million of net proceeds to the


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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Company. The underwriting discount and other expenses of $8.4 million were recorded as debt issuance costs and were included in other assets on the Company’s condensed consolidated balance sheets.
The 2015 Notes were convertible at any time, at the option of the holder, into common stock at a price equal to approximately $48.83 per share, or 20.4794 shares of common stock per $1,000 principal amount of the 2015 Notes. If the closing price of the Company’s common stock exceeded 130% of the conversion price for at least 20 trading days within a period of 30 consecutive trading days, the Company had the right to redeem the 2015 Notes at its option at a redemption price equal to 100% of the principal amount of the 2015 Notes to be redeemed.
In the second quarter of 2013, the Company's common stock exceeded 130% of the conversion price of the 2015 Notes for at least 20 trading days within a period of 30 consecutive trading days, and the Company notified the holders of the 2015 Notes that it would redeem the 2015 Notes on June 17, 2013. In response to the Company's call of the 2015 Notes for redemption, in accordance with the provisions of the 2015 Notes, the holders of $399.8 million in aggregate principal amount of 2015 Notes elected to convert their 2015 Notes into the Company's common stock at the conversion price of approximately $48.83 per share. As a result of these conversions, the Company issued 8,188,448 shares of common stock. The remaining $0.2 million in aggregate principal amount of 2015 Notes was redeemed on June 17, 2013.
Pursuant to the terms of the 2015 Notes, the Company made an additional payment of $16.75 per $1,000 principal amount, payable in shares of the Company’s common stock, to the holders of the 2015 Notes that converted or redeemed their 2015 Notes after the Company called the 2015 Notes for redemption. These payments resulted in the issuance of an additional 87,109 shares of the Company's common stock. In the second quarter of 2013, the Company recognized an aggregate of $6.7 million in interest expense related to the 2015 Notes. Unamortized debt issuance costs for the 2015 Notes of $4.2 million were recorded as an offset to additional paid-in capital.
K.
Long-term Obligations
Fan Pier Leases
In 2011, the Company entered into two leases, pursuant to which the Company agreed to lease approximately 1.1 million square feet of office and laboratory space in two buildings (the "Buildings") that the landlord is building at Fan Pier in Boston, Massachusetts (the “Fan Pier Leases”). The Company expects to commence lease payments in December 2013 and to make payments for the period ending 15 years from the commencement date. The Company has an option to extend the term of the Fan Pier Leases for an additional ten years.
Because the Company is involved in the construction project, including having responsibility to pay for a portion of the costs of finish work and structural elements of the Buildings, the Company is deemed for accounting purposes to be the owner of the Buildings during the construction period. Accordingly, the Company has recorded project construction costs incurred by the landlord as an asset and a related financing obligation in “Property and equipment, net” and “Construction financing lease obligation,” respectively, on the Company’s condensed consolidated balance sheets. The Company bifurcates its future lease payments pursuant to the Fan Pier Leases into (i) a portion that is allocated to the Buildings and (ii) a portion that is allocated to the land on which the Buildings are being constructed, which is recorded as rental expense. Although the Company will not begin making lease payments pursuant to the Fan Pier Leases until the commencement date, the portion of the lease obligations allocated to the land is treated for accounting purposes as an operating lease that commenced in 2011.
Property and equipment, net, included $421.3 million and $290.7 million as of June 30, 2013 and December 31, 2012, respectively, related to construction costs for the Buildings at Fan Pier in Boston, Massachusetts. The construction financing lease obligation related to the Buildings at Fan Pier was $359.1 million and $268.0 million as of June 30, 2013 and December 31, 2012, respectively. As of June 30, 2013 and December 31, 2012, the primary difference between the amounts recorded in property and equipment, net and the construction financing lease obligation represented the cost of finish work and structural elements of the Buildings that the Company was responsible for paying to date.
Once the landlord completes the construction of the Buildings, the Company will evaluate the Fan Pier Leases in order to determine whether or not the Fan Pier Leases meet the criteria for “sale-leaseback” treatment. If the Fan Pier Leases meet the


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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

“sale-leaseback” criteria, the Company will remove the asset and the related liability from its consolidated balance sheet and treat the Fan Pier Leases as either operating or capital leases based on the Company’s assessment of the accounting guidance. The Company expects that upon completion of construction of the Buildings the Fan Pier Leases will not meet the “sale-leaseback” criteria. If the Fan Pier Leases do not meet “sale-leaseback” criteria, the Company will treat the Fan Pier Leases as a financing obligation and will depreciate the asset over its estimated useful life.
Capital Leases
The Company has outstanding capital leases for equipment, leasehold improvements and software licenses with terms through 2018. The capital leases bear interest at rates ranging from 4% to 7% per year. The following table sets forth the Company’s future minimum payments due under capital leases as of June 30, 2013:
Year
 
(in thousands)
2013
 
$
3,468

2014
 
14,053

2015
 
11,585

2016
 
5,048

2017
 
5,048

2018
 
4,627

Total payments
 
43,829

Less: amount representing interest
 
(5,077
)
Present value of payments
 
$
38,752

Financing Arrangements
In the first half of 2013, the Company began supporting $31.9 million in irrevocable stand-by letters of credit issued in support of property leases and other similar agreements with an unsecured credit facility with a one-year term. The Company previously had cash-collateralized these stand-by letters of credit. As a result of this credit facility, the restricted cash reflected on the Company's condensed consolidated balance sheets decreased by $31.8 million net of other activity recorded during the period and the Company's cash and cash equivalents increased by a corresponding amount.
L.
Stock-based Compensation Expense
The Company issues stock options, restricted stock and restricted stock units with service conditions, which are generally the vesting periods of the awards. The Company also has issued, to certain members of senior management, restricted stock and restricted stock units that vest upon the earlier of the satisfaction of (i) a performance condition or (ii) a service condition, and stock options that vest upon the earlier of the satisfaction of (a) performance conditions or (b) a service condition. In addition, the Company issues shares pursuant to an employee stock purchase plan ("ESPP").


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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The effect of stock-based compensation expense during the three and six months ended June 30, 2013 and 2012 was as follows:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
 
(in thousands)
Stock-based compensation expense by type of award:
 
 
 
 
 
 
 
Stock options
$
29,949

 
$
22,683

 
$
49,623

 
$
40,905

Restricted stock and restricted stock units
9,732

 
7,253

 
19,110

 
14,539

ESPP share issuances
2,051

 
1,742

 
4,573

 
4,172

Less stock-based compensation expense capitalized to inventories
(382
)
 
(299
)
 
(681
)
 
(549
)
Total stock-based compensation expense included in costs and expenses
$
41,350

 
$
31,379

 
$
72,625

 
$
59,067

 
 
 
 
 
 
 
 
Stock-based compensation expense by line item:
 
 
 
 
 
 
 
Research and development expenses
$
25,740

 
$
19,777

 
$
45,089

 
$
36,981

Sales, general and administrative expenses
15,610

 
11,602

 
27,536

 
22,086

Total stock-based compensation expense included in costs and expenses
$
41,350

 
$
31,379

 
$
72,625

 
$
59,067

The following table sets forth the Company's unrecognized stock-based compensation expense, net of estimated forfeitures, by type of award and the weighted-average period over which that expense is expected to be recognized:
 
As of June 30, 2013
 
Unrecognized Expense,
Net of
Estimated Forfeitures
 
Weighted-average
Recognition
Period
 
(in thousands)
 
(in years)
Type of award:
 
 
 
Stock options
$
162,669

 
2.75
Restricted stock and restricted stock units
78,790

 
2.44
ESPP share issuances
2,298

 
0.48


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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The following table summarizes information about stock options outstanding and exercisable at June 30, 2013:
 
 
Options Outstanding
 
Options Exercisable
Range of Exercise Prices
 
Number
Outstanding
Weighted-average
Remaining
Contractual Life
Weighted-average
Exercise Price
 
Number
Exercisable
Weighted-average
Exercise Price
 
 
(in thousands)
(in years)
(per share)
 
(in thousands)
(per share)
$ 9.07–$20.00
 
547
2.91
$15.39
 
547
$15.39
$20.01–$30.00
 
1,149
6.18
$29.38
 
839
$29.21
$30.01–$40.00
 
8,026
5.87
$36.48
 
4,684
$35.71
$40.01–$50.00
 
4,860
9.18
$46.32
 
361
$47.01
$50.01–$60.00
 
1,916
7.82
$53.68
 
733
$54.65
$60.01–$70.00
 
47
8.86
$63.29
 
9
$63.23
$70.01-$80.00
 
72
9.88
$77.73
 
$—
$80.01-$84.18
 
186
9.92
$81.55
 
165
$81.54
M.
Sale of HIV Protease Inhibitor Royalty Stream
In 2008, the Company sold to a third party its rights to receive royalty payments from GlaxoSmithKline plc, net of royalty amounts to be earned by and due to a third party, for a one-time cash payment of $160.0 million. These royalty payments relate to net sales of HIV protease inhibitors, which had been developed pursuant to a collaboration agreement between the Company and GlaxoSmithKline plc. As of June 30, 2013, the Company had $75.2 million in deferred revenues related to the one-time cash payment, which it is recognizing over the life of the collaboration agreement with GlaxoSmithKline plc based on the units-of-revenue method. In addition, the Company continues to recognize royalty revenues equal to the amount of the third-party subroyalty and an offsetting royalty expense for the third-party subroyalty payment.
N.
Income Taxes
For the three months ended June 30, 2013, the Company recorded a net benefit from income taxes of $1.8 million. This benefit from income taxes was due to a benefit from income taxes of $2.4 million attributable to noncontrolling interest (Alios) offset by a provision for income taxes of $0.6 million attributable to Vertex. In the first quarter of 2013, the Company determined that the fair value of VX-222 was zero, which resulted in an impairment charge of $412.9 million in the six months ended June 30, 2013. In connection with this impairment charge, the Company wrote-off the associated deferred tax liability of $127.6 million resulting in a benefit from income in its condensed consolidated statements of operations for the six months ended June 30, 2013. Please refer to Note I, "Intangible Assets and Goodwill," for further information regarding the impairment charge.
For the three months ended June 30, 2012, the Company recorded a benefit from income taxes attributable to Vertex of $1.2 million. For the six months ended June 30, 2012, the Company recorded a provision for income taxes attributable to Vertex of $1.1 million. These were due to state income taxes. For the three and six months ended June 30, 2012, the Company recorded a provision for income taxes attributable to noncontrolling interest (Alios) of $21.2 million and $19.0 million, respectively.
The Company has no liability for taxes payable by Alios. As such, the portion of the income tax provision (benefit) related to Alios has been allocated to noncontrolling interest (Alios). As of June 30, 2013 and December 31, 2012, Alios had a deferred tax liability of $149.7 million and $152.8 million reflected on the Company's condensed consolidated balance sheets, respectively.


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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

As of June 30, 2013 and December 31, 2012, the Company had no material unrecognized tax benefits and no adjustments to liabilities or operations were required. The Company does not expect that its unrecognized tax benefits will materially increase within the next twelve months. The Company did not recognize any material interest or penalties related to uncertain tax positions as of June 30, 2013 and December 31, 2012.
The Company maintains a valuation allowance on its net operating losses and other deferred tax assets because of its extended history of annual losses. As of December 31, 2012, the Company had U.S. federal net operating loss carryforwards of approximately $2.6 billion and tax credits of $98.0 million, which may be used to offset future federal income tax liability. For state income tax purposes, the Company had net operating loss carryforwards of approximately $1.5 billion and tax credits of $60.3 million at December 31, 2012, which may be used to offset future state income tax liability. On a quarterly basis, the Company reassesses the valuation allowance for deferred income tax assets. In future periods, if management determines that it is more likely than not that the deferred tax asset will be realized, (i) the valuation allowance would be decreased, (ii) a portion or all of the deferred tax asset would be reflected on the Company’s consolidated balance sheet and (iii) the Company would record non-cash benefits in its consolidated statements of operations related to the reflection of the deferred tax asset on its consolidated balance sheet.
The Company files U.S. federal income tax returns and income tax returns in various state, local and foreign jurisdictions. The Company is no longer subject to any tax assessment from an income tax examination in the United States before 2007 and any other major taxing jurisdiction for years before 2005, except where the Company has net operating losses or tax credit carryforwards that originated before 2005. The Company is currently under examination by Revenue Quebec for the year ended March 11, 2009 and the year ended December 31, 2007. No adjustments have been reported. The Company is not under examination by any other jurisdictions for any tax year.
The Company currently intends to reinvest the total amount of its unremitted earnings, which have not been significant to date, in the local international jurisdiction or to repatriate the earnings only when tax-effective. As a result, the Company has not provided for U.S. federal income taxes on the unremitted earnings of its international subsidiaries. Upon repatriation of those earnings, in the form of dividends or otherwise, the Company would be subject to U.S. federal income taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to the various foreign countries. At June 30, 2013, foreign earnings, which were not significant, have been retained indefinitely by foreign subsidiary companies for reinvestment; therefore, no provision has been made for income taxes that would be payable upon the distribution of such earnings, and it would not be practicable to determine the amount of the related unrecognized deferred income tax liability.
O.
Restructuring Liability
In 2003, the Company adopted a plan to restructure its operations to coincide with its increasing internal emphasis on advancing drug candidates through clinical development to commercialization. The restructuring liability relates to specialized laboratory and office space that is leased to the Company pursuant to a 15-year lease that terminates in 2018, and that the Company has not used since it adopted the plan to restructure its operations in 2003. This laboratory and office space currently is subleased to third parties.
In estimating the expense and liability under its lease obligations, the Company estimated (i) the costs to be incurred to satisfy rental and build-out commitments under the lease (including operating costs), (ii) the lead-time necessary to sublease the space, (iii) the projected sublease rental rates and (iv) the anticipated durations of subleases. The Company uses a credit-adjusted risk-free rate of approximately 10% to discount the estimated cash flows. The Company reviews its estimates and assumptions on at least a quarterly basis, intends to continue such reviews until the termination of the applicable lease, and will make whatever modifications the Company believes necessary, based on the Company’s best judgment, to reflect any changed circumstances.


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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The activities related to the restructuring liability for the three and six months ended June 30, 2013 and 2012 were as follows:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2013
 
2012
 
2013
 
2012
 
(in thousands)
Liability, beginning of the period
$
22,459

 
$
25,473

 
$
23,328

 
$
26,313

Cash payments
(3,849
)
 
(3,725
)
 
(7,422
)
 
(7,411
)
Cash received from subleases
2,666

 
2,488

 
5,331

 
4,974

Restructuring expense
776

 
594

 
815

 
954

Liability, end of the period
$
22,052

 
$
24,830

 
$
22,052

 
$
24,830

P.
Legal Proceedings
On September 6, 2012, a purported shareholder class action, City of Bristol Pension Fund v. Vertex Pharmaceuticals Incorporated, et al., was filed in the United States District Court for the District of Massachusetts, naming the Company and certain of the Company's current and former officers and directors as defendants. The lawsuit alleges that the Company made material misrepresentations and/or omissions of material fact in the Company's disclosures during the period from May 7, 2012 through June 28, 2012, all in violation of Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder. By order dated December 12, 2012, the court appointed the City of Bristol lead plaintiff and appointed the City of Bristol's attorneys lead counsel. The plaintiffs filed an amended complaint on February 11, 2013. The Company filed a motion to dismiss the complaint on April 12, 2013. On May 28, 2013, the plaintiffs filed an opposition to the Company's motion to dismiss the complaint. On June 27, 2013, the Company filed a reply in further support of the Company's motion to dismiss the plaintiffs' complaint. The plaintiffs seek unspecified monetary damages on behalf of the putative class and an award of costs and expenses, including attorney's fees, as well as disgorgement of the proceeds from certain individual defendants' sales of the Company's common stock. The Company believes that this action is without merit and intends to defend it vigorously. As of June 30, 2013, the Company has not recorded any reserves for this purported class action.
Q.
Contingencies
The Company has certain contingent liabilities that arise in the ordinary course of its business activities. The Company accrues a reserve for contingent liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. There were no material contingent liabilities accrued as of June 30, 2013 or December 31, 2012.
R.
Guarantees
As permitted under Massachusetts law, the Company’s Articles of Organization and By-laws provide that the Company will indemnify certain of its officers and directors for certain claims asserted against them in connection with their service as an officer or director. The maximum potential amount of future payments that the Company could be required to make under these indemnification provisions is unlimited. However, the Company has purchased directors’ and officers’ liability insurance policies that could reduce its monetary exposure and enable it to recover a portion of any future amounts paid. No indemnification claims currently are outstanding, and the Company believes the estimated fair value of these indemnification arrangements is minimal.
The Company customarily agrees in the ordinary course of its business to indemnification provisions in agreements with clinical trial investigators and sites in its drug development programs, sponsored research agreements with academic and not-for-profit institutions, various comparable agreements involving parties performing services for the Company, and its real estate leases. The Company also customarily agrees to certain indemnification provisions in its drug discovery, development and commercialization collaboration agreements. With respect to the Company’s clinical trials and sponsored research agreements, these indemnification provisions typically apply to any claim asserted against the investigator or the


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VERTEX PHARMACEUTICALS INCORPORATED

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

investigator’s institution relating to personal injury or property damage, violations of law or certain breaches of the Company’s contractual obligations arising out of the research or clinical testing of the Company’s compounds or drug candidates. With respect to lease agreements, the indemnification provisions typically apply to claims asserted against the landlord relating to personal injury or property damage caused by the Company, to violations of law by the Company or to certain breaches of the Company’s contractual obligations. The indemnification provisions appearing in the Company’s collaboration agreements are similar to those for the other agreements discussed above, but in addition provide some limited indemnification for its collaborator in the event of third-party claims alleging infringement of intellectual property rights. In each of the cases above, the indemnification obligation generally survives the termination of the agreement for some extended period, although the Company believes the obligation typically has the most relevance during the contract term and for a short period of time thereafter. The maximum potential amount of future payments that the Company could be required to make under these provisions is generally unlimited. The Company has purchased insurance policies covering personal injury, property damage and general liability that reduce its exposure for indemnification and would enable it in many cases to recover all or a portion of any future amounts paid. The Company has never paid any material amounts to defend lawsuits or settle claims related to these indemnification provisions. Accordingly, the Company believes the estimated fair value of these indemnification arrangements is minimal.
The Company entered into an underwriting agreement with Merrill Lynch, Pierce, Fenner & Smith Incorporated dated September 23, 2010 (the “Underwriting Agreement”), relating to the public offering and sale of the 2015 Notes. The Underwriting Agreement requires the Company to indemnify the underwriter against any loss it may suffer by reason of the Company’s breach of any representation or warranty relating to the public offering, the Company’s failure to perform certain covenants in the Underwriting Agreement, the inclusion of any untrue statement of material fact in the prospectus used in connection with the offering, the omission of any material fact needed to make those materials not misleading, and any actions taken by the Company or its representatives in connection with the offering. The representations, warranties, covenants and indemnification provisions in the Underwriting Agreement are of a type customary in agreements of this sort. The Company believes the estimated fair value of this indemnification arrangement is minimal.


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Item 2.     Management's Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
We are in the business of discovering, developing, manufacturing and commercializing small molecule drugs for patients with serious diseases. Our two products are: INCIVEK (telaprevir), which we market in the United States and Canada for the treatment of adults with genotype 1 hepatitis C virus, or HCV, infection; and KALYDECO (ivacaftor), which we market in the United States, Australia, Canada and Europe for the treatment of patients six years of age and older with cystic fibrosis, or CF, who have a specific genetic mutation that is referred to as the G551D mutation. We receive royalties from sales in Europe and other countries for telaprevir, where it is marketed as INCIVO, by our collaborator, Janssen Pharmaceutica, N.V.
We invest in scientific innovation to create transformative medicines for patients with serious diseases, with a focus on specialty markets. Our strategy is to make focused investments to invent and develop innovative drugs, while we continue to market INCIVEK and KALYDECO to eligible patients to generate revenues and maintain a strong financial position.
Our second quarter 2013 revenues included INCIVEK net product revenues of $155.8 million and KALYDECO net product revenues of $99.0 million. As of June 30, 2013, we had cash, cash equivalents and marketable securities of $1.4 billion. Our net product revenues from sales of INCIVEK declined over the course of 2012 and in the first half of 2013, and we expect this trend to continue due to reduced demand for current therapies for HCV infection, as new competitive therapies approach commercialization. In the future, we expect that our ability to increase net product revenues will be dependent on the outcomes of ongoing label-expansion programs for KALYDECO monotherapy and on introducing one or more of our drug candidates in late-stage development to the market.
We are focusing most of our drug development investment on the following key programs:
Cystic Fibrosis - Our goal is to develop treatment regimens that will provide benefits to as many patients with CF as possible and to maximize those benefits. We are conducting Phase 3 label-expansion clinical trials and a proof-of-concept clinical trial of ivacaftor monotherapy in patients with certain mutations in their cystic fibrosis transmembrane conductance regulator, or CFTR, gene that were not studied in prior Phase 3 clinical trials. In the first quarter of 2013, we initiated an international pivotal Phase 3 development program to evaluate combinations of ivacaftor and our investigational CFTR corrector VX-809 (lumacaftor) for patients with two copies of the most prevalent genetic mutation that causes CF.
HCV - We are seeking to develop all-oral, interferon-free treatment regimens that are 12 weeks or less in duration with a goal of providing high viral cure rates and improved tolerability, in order to be commercially competitive in the HCV market of the future. We are conducting multiple Phase 2 clinical trials to evaluate all-oral combination treatment regimens that include our HCV nucleotide analogue VX-135 together with molecules that have potentially complementary mechanisms, such as ribavirin, or RBV, an HCV protease inhibitor and an HCV NS5A inhibitor.
Autoimmune Diseases - We are evaluating our JAK3 inhibitor, VX-509, in a fully-enrolled Phase 2 clinical trial. The primary endpoints of this clinical trial will be measured after 12 weeks of treatment, and we expect data from this clinical trial in the second half of 2013.
We may seek collaborators for some of our drug candidates in order to diversify risk, broaden or accelerate or otherwise benefit a development program in an effort to fully realize the value of a drug candidate.
We plan to continue investing in our research programs and supporting scientific innovation in order to identify and develop transformative medicines. We believe that pursuing research in diverse areas allows us to balance the risks inherent in drug development and may provide the drug candidates that will form our pipeline in future years. We have on-going research programs, including in the areas of CF, Huntington's disease, multiple sclerosis and cancer.


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Table of Contents

CF
KALYDECO (ivacaftor) is approved in the United States, Australia, Canada and the European Union for the treatment of patients with CF six years of age and older who have the G551D mutation on at least one allele of the CFTR gene. We are continuing our work in CF to identify and develop treatment regimens that will provide benefits to as many patients with CF as possible and to maximize those benefits. We have multiple ongoing clinical development programs to evaluate our CF treatment regimens, and our research group is working to identify additional corrector compounds that could be included in future dual-corrector regimens in combination with ivacaftor in patients with one or two copies of the F508del mutation.
Ivacaftor (monotherapy)
We are conducting Phase 3 label-expansion clinical trials and a Phase 2 proof-of-concept clinical trial of ivacaftor monotherapy:
We are conducting a Phase 3 clinical trial evaluating ivacaftor in patients six years of age and older with CF with gating mutations other than the G551D mutation. In July 2013, we reported that patients in this clinical trial had statistically significant improvements in their lung function. We plan to submit a supplemental New Drug Application, or sNDA, to the U.S. Food and Drug Administration, or FDA, and a Marketing Authorization Application, or MAA, variation in the European Union in the second half of 2013 for the use of ivacaftor monotherapy in patients six years of age and older with gating mutations other than the G551D mutation.
We are conducting a Phase 3 clinical trial evaluating ivacaftor in patients six years of age and older with CF who have the R117H mutation in the CFTR gene on at least one allele. We expect data from this clinical trial in the second half of 2013. If this clinical trial is successful, we plan to submit an sNDA to the FDA in early 2014 for the use of ivacaftor monotherapy in patients with CF who are six years of age and older who have the R117H mutation in the CFTR gene on at least one allele.
We are conducting a Phase 3 clinical trial in which we are evaluating a pediatric formulation of ivacaftor as a treatment for children two to five years of age with gating mutations in the CFTR gene, including the G551D mutation. We have completed the pharmacokinetic portion of this clinical trial and have selected a dose to evaluate for the 24-week dosing period, which is now underway. We expect data from this clinical trial in mid-2014.
We are enrolling patients in a Phase 2 clinical trial in which we are evaluating ivacaftor in patients with CF who have clinical evidence of residual CFTR function. We expect data from this clinical trial in the first half of 2014.
If we are able to establish that all of these additional patient groups will benefit from ivacaftor monotherapy, there is the potential to increase the number of patients eligible for treatment with ivacaftor monotherapy to more than ten percent of patients worldwide with CF.
VX-809 in Combination with Ivacaftor
We are enrolling patients in an international pivotal Phase 3 clinical program to evaluate combinations of VX-809 and ivacaftor in patients with CF who have two copies of the F508del mutation in their CFTR gene (homozygous). We are conducting two 24-week Phase 3 clinical trials that are designed to support approval of the combination of VX-809 and ivacaftor for patients 12 years of age and older. We expect to complete enrollment of patients in these clinical trials in the second half of 2013. Each Phase 3 clinical trial will enroll approximately 500 patients with CF who are homozygous for the F508del mutation, for a total of approximately 1,000 patients. The two clinical trials have the same design and together will be conducted at approximately 200 clinical trial sites in North America, Europe and Australia. If these trials are successful, we plan to submit a New Drug Application, or NDA, to the FDA in 2014. Almost half of the patients with CF worldwide are homozygous for the F508del mutation in their CFTR gene.
In addition to the two Phase 3 clinical trials, in the second half of 2013 we plan to begin evaluation of VX-809 in combination with ivacaftor in patients with CF who are 12 years of age and older and who have one copy of the F508del mutation in the CFTR gene in a Phase 2 clinical trial. In the second half of 2013, we also plan to begin enrollment in a Phase 2 clinical trial to evaluate VX-809 in combination with ivacaftor in children with CF six to eleven years of age who have two copies of the F508del mutation. If this Phase 2 clinical trial is successful, we plan to use the data from this clinical trial, along with data from the two Phase 3 clinical trials, for registration in the United States in patients six to eleven years of age, following registration in patients 12 years of age and older. Discussions with European regulatory agencies about plans for patients in this age group are ongoing.


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VX-661
We are preparing to evaluate a four-week regimen of VX-661 in combination with ivacaftor in patients with one copy of the F508del mutation and one copy of the G551D mutation in a Phase 2 clinical trial. The evaluation of this regimen is supported by in vitro data presented at the European Cystic Fibrosis Society Conference by our researchers that showed increased chloride transport in human bronchial epithelial cells with one copy of the F508del mutation and one copy of the G551D mutation, with the combination of a corrector compound and ivacaftor as compared to the use of ivacaftor alone. Our strategy is to evaluate multiple first-generation correctors, including VX-661 and VX-983, in combination with ivacaftor to identify regimens that may provide benefit to patients with the F508del mutation.
Dual-Correctors in Combination with Ivacaftor
We have an active research program focused on identifying additional corrector compounds that could be included in future dual-corrector regimens in combination with ivacaftor in patients with one or two copies of the F508del mutation. The potential use of a dual-corrector regimen in combination with ivacaftor is supported by in vitro data presented at the European Cystic Fibrosis Society Conference that showed a combination of two CFTR correctors and ivacaftor increased chloride transport in human bronchial epithelial cells with one or two copies of the F50del mutation, as compared to the use of a single CFTR corrector in combination with ivacaftor. Our goal is to advance a second-generation CFTR corrector compound into clinical development by the end of 2014.
HCV
Janssen and we market INCIVEK/INCIVO in direct competition with Merck & Co., Inc.'s VICTRELIS™ (boceprevir), another HCV protease inhibitor that was approved for sale in the United States and Europe in 2011. We expect that a number of new therapies for HCV infection will become available to patients over the next several years. The most advanced potentially competitive drug candidates are Gilead Sciences, Inc.'s, or Gilead's, sofosbuvir (GS-7977) and Janssen's simeprevir (TMC435). Gilead and Janssen have filed NDAs for sofosbuvir and simeprevir, respectively, and each of these drug candidates may be approved as treatments for genotype 1 HCV infection in combination with pegylated-interferon, or peg-IFN, and RBV, in 2013. The top-line results reported by Gilead and Janssen from Phase 3 clinical trials suggest that the safety and efficacy profiles of sofosbuvir and simeprevir will position them, if approved, to potentially take a significant portion of the market for HCV therapies.
We plan to compete in the HCV infection market as it shifts away from current treatment regimens (including our INCIVEK triple-combination therapy) to regimens that incorporate new drugs with improved safety, efficacy and/or tolerability, by pursuing development of all-oral, interferon-free regimens incorporating our HCV nucleotide analogue VX-135. A number of pharmaceutical companies are investigating combination regimens that incorporate one or more of an HCV protease inhibitor, an HCV nucleotide analogue, an HCV non-nucleotide polymerase inhibitor or an NS5A inhibitor. Clinical trials of these investigational combination regimens are being conducted in a wide variety of patient populations, including treatment-naïve and treatment-failure patients, and across all HCV genotypes, which respond differently to different combinations of molecules employing different mechanisms. In the future, we expect that the market for any specific HCV treatment regimen, including INCIVEK triple-combination therapy, could be affected by the introduction of new competitive drugs or drug combinations, sales from currently approved drugs, adverse information regarding the safety characteristics or efficacy of the regimen, significant new information regarding potential treatment regimens being evaluated in clinical trials and enrollment of patients in clinical trials being conducted by us or our competitors. While it is possible that a portion of patients with HCV infection would continue to benefit from treatment regimens that include peg-IFN, we expect that treatment regimens that include the administration of peg-IFN by injection will command a relatively small portion of the overall market.
We are evaluating potential all-oral treatment regimens that include our HCV nucleotide analogue VX-135 in planned and ongoing Phase 2 clinical trials in order to determine which regimen or regimens appear likely to provide benefits to patients and to advance into Phase 3 clinical development. We currently are evaluating VX-135 in combination with RBV, Janssen's HCV protease inhibitor simeprevir and Bristol-Myers Squibb's, or BMS's, NS5A replicon complex inhibitor daclatasvir.
Some of our competitors' potential all-oral treatment regimens are more advanced, including all-oral treatment regimens that are being evaluated in Phase 3 clinical trials by Gilead and Abbvie, Inc. While the development and regulatory timelines for drug candidates for the treatment of HCV infection are subject to risk and uncertainty, we believe that (i) substantial additional clinical data regarding potential all-oral treatment regimens will become available in 2013 and (ii) it is possible that one or more all-oral treatment regimens for genotype 1 HCV infection could be commercially available as soon as late 2014. As a result, if we are successful in developing all-oral treatment regimens that include VX-135, independently or with a collaborator, it is likely that our all-oral treatment regimens would compete directly with one or more previously approved all-oral treatment regimens.


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Recent Developments
Ivacaftor - Phase 3 Label-expansion Clinical Trial
In July 2013, we disclosed data from a Phase 3 label-expansion clinical trial that enrolled 39 patients six years of age and older with CF who have at least one non-G551D CFTR gating mutation. The clinical trial met its primary endpoint of absolute change from baseline in percent predicted forced expiratory volume in one second, or FEV1. Patients in this clinical trial received either ivacaftor or placebo for eight weeks, followed by a four-week washout period. After the washout period, patients who received placebo in the first eight weeks received ivacaftor for the final eight weeks, and patients who received ivacaftor for the first eight weeks received placebo for the final eight weeks. The primary analysis was conducted at week 20 of the clinical trial. The result of statistical testing is often defined in terms of a "p-value," with p<0.05 generally considered to represent a statistically significant difference. After the 20 week cross-over period, patients were eligible to receive ivacaftor as part of a 16 week open-label dosing period.
In this clinical trial, the mean absolute treatment difference in percent predicted FEV1 between treatment with ivacaftor and placebo was 10.7% (p<0.0001) and the mean relative treatment difference in percent predicted FEV1 was 14.2% (p<0.0001) through the 8-week treatment period. The mean absolute and relative percent predicted FEV1 improvements during ivacaftor treatment (within-group) were 7.5% (p<0.0001) and 10.8% (p<0.0001), respectively. Additionally, treatment with ivacaftor in this clinical trial resulted in statistically significant improvements in weight gain and improvements in patient-reported quality of life as measured by the respiratory domain of the Cystic Fibrosis Questionnaire Revised (CFQ-R). The safety and tolerability results observed in this clinical trial were consistent with those observed in prior Phase 3 clinical trials of ivacaftor monotherapy in patients with CF who have the G551D mutation. The most commonly observed adverse events, regardless of treatment assignment, included pulmonary exacerbation, cough, headache and abdominal pain, each occurring more frequently while patients received placebo than while patients received ivacaftor.
Based on these data, we plan to submit an sNDA in the United States and an MAA variation in the European Union in the second half of 2013 for the use of ivacaftor monotherapy in patients with CF six years of age and older who have at least one non-G551D CFTR gating mutation. We estimate that approximately 400 patients six years of age and older with CF have a non-G551D gating mutation worldwide.
VX-135
In July 2013, the FDA placed a partial clinical hold on our ongoing Phase 2 clinical trial in the United States in which we are evaluating VX-135 in combination with RBV in patients with genotype 1 HCV infection. The partial clinical hold prevents us from evaluating a 200 mg dose of VX-135 in the United States following observation of reversible elevated liver enzymes in patients who received 400 mg of VX-135 in combination with RBV in a Phase 2 clinical trial in Europe.
Multiple clinical trials to evaluate potential all-oral treatment regimens that include VX-135 are ongoing, as follows:
U.S. Clinical Trial of VX-135 in Combination with Ribavirin. Dosing of 100 mg of VX-135 in combination with RBV as part of a 12-week Phase 2 clinical trial in the United States is ongoing, and evaluation of this dose group is continuing as planned. Ten patients with genotype 1 HCV infection are enrolled in this dose group, and all patients have now completed at least ten weeks of treatment. We expect complete safety and efficacy results from the 100 mg arm of this clinical trial to be available in the second half of 2013. Under the partial clinical hold, we plan to complete evaluation of the 100 mg dose of VX-135 but will not evaluate a 200 mg dose of VX-135 in the United States without authorization from the FDA. At the request of the FDA, we expect to complete submission of additional clinical, preclinical and pharmacokinetic data in the fourth quarter of 2013.
European Clinical Trial of VX-135 in Combination with Ribavirin. Dosing of 100 mg and 200 mg of VX-135 in combination with RBV as part of a 12-week Phase 2 clinical trial in Europe is complete, and all patients are in the post-treatment follow-up period. Ten patients with genotype 1 HCV infection were enrolled in each dose group, and all 20 patients completed 12 weeks of treatment. Both the 100 mg and 200 mg doses were well tolerated, no serious adverse events have been reported and no liver or cardiac safety issues have been identified in these dose groups. All patients in these dose groups achieved undetectable HCV RNA during the 12-week dosing period, and 70 percent and 80 percent of patients in the 100 mg and 200 mg dosing arms, respectively, had undetectable HCV RNA levels within four weeks of initiating treatment. HCV RNA levels were undetectable at the end of the treatment period in all patients with available data. Complete safety and efficacy results from the 100 mg and 200 mg arms of this clinical trial are expected to be available in the second half of 2013.
Following completion of enrollment in the 100 mg and 200 mg arms of the European clinical trial, the clinical trial design was amended to add the evaluation of a 400 mg dose of VX-135 in combination with RBV in ten patients with


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genotype 1 HCV infection. Elevated liver enzymes were observed in three of the ten patients in this dose group, including one serious adverse event, and the 400 mg arm of the clinical trial was discontinued. Following the discontinuation of dosing, liver enzyme levels returned to baseline in all three patients.
Clinical Trial of 100 mg and 200 mg Doses of VX-135 in Combination with Daclatasvir. We, in collaboration with BMS, recently initiated dosing of VX-135 in combination with daclatasvir, an NS5A replication complex inhibitor being developed by BMS, in a Phase 2 clinical trial in New Zealand. The first part of this clinical trial will evaluate 100 mg and 200 mg doses of VX-135 in combination with daclatasvir for 12 weeks in approximately 20 patients who have genotype 1 HCV infection. Pending data from the first part of the clinical trial, we and BMS plan to expand this clinical trial to enroll additional patients with either genotype 1 or 3 HCV infection. Safety and efficacy data from the first part of this clinical trial are expected to be available in early 2014.
VX-135 in Combination with Simeprevir. A drug-drug interaction clinical trial of VX-135 in combination with simeprevir in healthy volunteers is complete. A clinical trial to evaluate the combination of VX-135 and simeprevir is planned for the second half of 2013 in patients who have genotype 1 HCV infection, pending availability of additional data. Simeprevir, or TMC435, is an investigational HCV protease inhibitor being jointly developed by Janssen R&D Ireland and Medivir AB.
Termination of GlaxoSmithKline Collaboration
In June 2013, we and GlaxoSmithKline plc mutually decided to cease the collaboration for a Phase 2 clinical trial of VX-135 and GSK 2336805 and prioritize other projects. The preclinical and early-stage clinical data support continued development of VX-135 and of GSK 2336805.
Regulatory Compliance
Our marketing of pharmaceutical products, which began in 2011, is subject to extensive and complex laws and regulations. We have a corporate compliance program designed to actively identify, prevent and mitigate risk through the implementation of compliance policies and systems and the promotion of a culture of compliance. Among other laws, regulations and standards, we are subject to various U.S. federal and state and comparable foreign laws pertaining to health care fraud and abuse, including anti-kickback and false claims statutes, and laws prohibiting the promotion of drugs for unapproved, or off-label, uses. Anti-kickback laws make it illegal for a prescription drug manufacturer to solicit, offer, receive or pay any remuneration in exchange for, or to induce, the referral of business, including the purchase or prescription of a particular drug. False claims laws prohibit anyone from presenting for payment to third-party payors, including Medicare and Medicaid, claims for reimbursed drugs or services that are false or fraudulent, claims for items or services not provided as claimed or claims for medically unnecessary items or services. We expect to continue to devote substantial resources to maintain, administer and expand these compliance programs globally.


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RESULTS OF OPERATIONS
 
Three Months Ended
June 30,
 
Increase/
(Decrease)
 
Increase/
(Decrease)
 
Six Months Ended
June 30,
 
Increase/
(Decrease)
 
Increase/
(Decrease)
 
2013
 
2012
 
$
 
%
 
2013
 
2012
 
$
 
%
 
(in thousands)
 
 
 
(in thousands)
 
 
Revenues
$
310,750

 
$
418,305

 
$
(107,555
)
 
(26
)%
 
$
639,118

 
$
857,042

 
$
(217,924
)
 
(25
)%
Operating costs and expenses
367,683

 
429,075

 
(61,392
)
 
(14
)%
 
1,134,339

 
776,163

 
358,176

 
46
 %
Other items, net
(4,779
)
 
(23,698
)
 
(18,919
)
 
(80
)%
 
120,882

 
(27,471
)
 
n/a

 
n/a

Net loss (income) attributable to noncontrolling interest (Alios)
4,547

 
(30,463
)
 
n/a

 
n/a

 
9,158

 
(26,749
)
 
n/a

 
n/a

Net income (loss) attributable to Vertex
$
(57,165
)
 
$
(64,931
)
 
$
(7,766
)
 
(12
)%
 
$
(365,181
)
 
$
26,659

 
n/a

 
n/a

Net Income (Loss) Attributable to Vertex
Net loss attributable to Vertex was $(57.2) million in the second quarter of 2013 compared to net loss attributable to Vertex of $(64.9) million in the second quarter of 2012. Our revenues decreased in the second quarter of 2013 as compared to the second quarter of 2012 due to decreased INCIVEK net product revenues partially offset by increased KALYDECO net product revenues and increased INCIVO royalties. Our operating expenses decreased in the second quarter of 2013 as compared to the second quarter of 2012 due to a $78.0 million write-off in the second quarter of 2012 for excess and obsolete INCIVEK inventories and decreased sales, general and administrative expenses partially offset by increased research and development expenses.
For the first half of 2013, net loss attributable to Vertex was $(365.2) million as compared to net income attributable to Vertex of $26.7 million for the first half of 2012. Our revenues decreased in the first half of 2013 as compared to the first half of 2012 due to decreased INCIVEK net product revenues partially offset by increased KALYDECO net product revenues and increased INCIVO royalties. Our operating costs and expenses increased from $776.2 million in the first half of 2012 to $1.1 billion in the first half of 2013. The increase in operating expenses from the first half of 2012 to the first half of 2013 was primarily due to a $412.9 million intangible asset impairment charge for VX-222 recorded in the first quarter of 2013 partially offset by the $78.0 million write-off in the second quarter of 2012 for excess and obsolete INCIVEK inventories.
Stock-based compensation expense was $41.4 million and $31.4 million in the second quarter of 2013 and 2012, respectively, and $72.6 million and $59.1 million in the first half of 2013 and 2012, respectively.
Net Income (Loss) Attributable to Vertex per Diluted Share
Net loss attributable to Vertex was $(0.26) per diluted share in the second quarter of 2013 as compared to net loss attributable to Vertex of $(0.31) per diluted share in the second quarter of 2012. Net loss attributable to Vertex was $(1.67) per diluted share in the first half of 2013 compared to net income attributable to Vertex of $0.12 in first half of 2012.
Common Shares Outstanding
Our shares of outstanding common stock increased by 14.9 million shares from 217.3 million shares on December 31, 2012 to 232.2 million shares on June 30, 2013 due to the approximately 8.3 million shares of common stock we issued in connection with the conversions of our 3.35% convertible senior subordinated notes due 2015, or 2015 Notes, and the approximately 6.6 million shares of common stock we issued pursuant to our employee equity programs.


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Revenues
 
Three Months Ended
June 30,
 
Increase/
(Decrease)
 
Increase/
(Decrease)
 
Six Months Ended
June 30,
 
Increase/
(Decrease)
 
Increase/
(Decrease)
 
2013
 
2012
 
$
 
%
 
2013
 
2012
 
$
 
%
 
(in thousands)
 
 
 
(in thousands)
 
 
Product revenues, net
$
254,789

 
$
373,273

 
$
(118,484
)
 
(32
)%
 
$
522,170

 
$
748,648

 
$
(226,478
)
 
(30
)%
Royalty revenues
49,120

 
33,480

 
15,640

 
47
 %
 
92,693

 
72,461

 
20,232

 
28
 %
Collaborative revenues
6,841