VERTEX PHARMACEUTICALS INC / MA - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

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FORM 10-Q

(MARK ONE)

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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2002
OR

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

FOR THE TRANSITION PERIOD FROM ______________ TO ______________

COMMISSION FILE NUMBER 000-19319

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VERTEX PHARMACEUTICALS INCORPORATED

(Exact name of registrant as specified in its charter)

MASSACHUSETTS 04-3039129
(State or other jurisdiction (I.R.S. Employer
of Identification No.)
incorporation or organization)

130 WAVERLY STREET, CAMBRIDGE, 02139-4242
MASSACHUSETTS (zip code)
(Address of principal
executive offices, including
zip code)

(617) 444-6100
(Registrant's telephone number, including area code)

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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 / /

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 $.01 per 76,022,827
share ------------------------------------
- ------------------------------------ Outstanding at August 12, 2002
Class

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VERTEX PHARMACEUTICALS INCORPORATED

INDEX

Part I. Financial Information

Item 1. Condensed Consolidated Financial Statements

Condensed Consolidated Balance Sheets--
June 30, 2002 and December 31, 2001....................... 3

Condensed Consolidated Statements of Operations--
Three and Six Months Ended June 30, 2002 and 2001......... 4

Condensed Consolidated Statements of Cash Flows--
Six Months Ended June 30, 2002 and 2001................... 5

Notes to Condensed Consolidated Financial Statements........ 6

Item 2. Management's Discussion and Analysis of Financial Condition
and
Results of Operations..................................... 12

Item 3. Quantitative and Qualitative Disclosures about Market
Risk...................................................... 21

Part II. Other Information

Item 4. Submission of Matters to a Vote of Security Holders......... 22

Item 6. Exhibits and Reports on Form 8-K............................ 22

Signature........................................................................ 23

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VERTEX PHARMACEUTICALS INCORPORATED

CONDENSED CONSOLIDATED BALANCE SHEETS

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

3

VERTEX PHARMACEUTICALS INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

* Results have been adjusted to reflect the adoption of the Substantive
Milestone method of revenue recognition in the third quarter of 2001,
retroactive to January 1, 2001. See Note 3, "Change in Accounting
Principle--Revenue Recognition," for more information.

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

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VERTEX PHARMACEUTICALS INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

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

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VERTEX PHARMACEUTICALS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. 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 generally accepted accounting principles.

The condensed consolidated financial statements reflect the operations of
the Company and its wholly owned subsidiaries. All significant intercompany
balances and transactions have been eliminated.

Certain information and footnote disclosures normally included in the
Company's annual financial statements have been condensed or omitted. Certain
prior year amounts have been reclassified to conform with current year
presentation. The interim financial statements, in the opinion of management,
reflect all adjustments (including normal recurring accruals) necessary for a
fair statement of the results of operations for the interim periods ended
June 30, 2002 and 2001.

The results of operations for the interim periods are not necessarily
indicative of the results of operations to be expected for the fiscal year,
although the Company expects to incur a substantial loss for the year ended
December 31, 2002. These interim financial statements should be read in
conjunction with the audited financial statements for the year ended
December 31, 2001, which are contained in the Company's 2001 Annual Report to
its stockholders and in its Form 10-K filed with the Securities and Exchange
Commission.

2. ACCOUNTING POLICIES

BASIC AND DILUTED LOSS PER COMMON SHARE

Basic loss per share is based upon the weighted average number of common
shares outstanding during the period. Diluted loss per share is based upon the
weighted average number of common shares outstanding during the period plus
additional weighted average common equivalent shares outstanding during the
period when the effect is not anti-dilutive. Common equivalent shares result
from the assumed exercise of outstanding stock options, the proceeds of which
are then assumed to have been used to repurchase outstanding stock using the
treasury stock method, and the assumed conversion of convertible notes. Common
equivalent shares have not been included in the net loss per share calculations
as their effect would be anti-dilutive.

The following table sets forth the computation of basic and diluted loss per
common share (in thousands, except per share amounts):

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VERTEX PHARMACEUTICALS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2. ACCOUNTING POLICIES (CONTINUED)
SEGMENT INFORMATION

On July 18, 2001, the Company completed a merger with Aurora Biosciences
Corporation ("Aurora"). Aurora specialized in assay development, screening and
cell biology services and instrumentation.

On March 1, 2001, Aurora completed a merger with PanVera Corporation
("PanVera"). PanVera is a biotechnology company engaged in the development,
manufacture and worldwide supply of proteins and reagents for evaluation as
targets and drug screening assays for high-throughput screening.

In the first quarter of 2002, following the acquisitions, the Company
aligned its business into two operating segments: (i) Pharmaceuticals and
(ii) Discovery Tools and Services, in an effort to further leverage the
strengths of the acquired business.

The Company's Pharmaceuticals business seeks to discover, develop and
commercialize major pharmaceutical products independently and with partners. The
Company's Discovery Tools and Services business specializes in assay
development, screening services, instrumentation and the manufacture and sale of
proteins and reagents.

As of July 1, 2002, the Company began to commercialize the Aurora
instruments and services business, along with PanVera's reagents and probes
business, under the name PanVera LLC. PanVera LLC's core business will include
the manufacture and sale of proteins, reagents, probes and instruments as well
as assay development and screening services to life sciences customers. The
former Aurora San Diego site operations will mainly focus on pharmaceutical drug
discovery and will operate under the name Vertex Pharmaceuticals (San Diego)
LLC. These changes align with the operating segments of the business.

3. CHANGE IN ACCOUNTING PRINCIPLE--REVENUE RECOGNITION

In the third quarter of 2001, in connection with an overall review of
accounting policies concurrent with the merger with Aurora, Vertex elected to
change its revenue recognition policy for collaborative and other research and
development revenues from the EITF 91-6 method to the substantive milestone
method. Vertex believes this method is preferable because it is more reflective
of the Company's on going business operations and because it is consistent with
industry practices following the prior year implementation of SAB 101, "Revenue
Recognition in Financial Statements," throughout the biotechnology industry.
Under the new accounting method, adopted retroactively to January 1, 2001, the
Company recognizes revenue from non-refundable, up-front, license and milestone
payments, not specifically tied to a separate earnings process, ratably over the
period of performance. Research funding is recognized as earned ratably over the
period of effort. Milestones, based on designated achievement points that are
considered at risk and substantive at the inception of the contract, are
recognized as earned when the corresponding payment is reasonably assured. The
Company evaluates whether milestones are at risk and substantive based on the
contingent nature of the milestone, specifically reviewing factors such as the
technological and commercial risk that needs to be overcome and the level of
investment required.

Previously, the Company had recognized revenue from collaborative research
and development arrangements in a manner similar to that prescribed by EITF
91-6. Under that model, revenue was recognized for non-refundable license fees,
milestones, and collaborative research and development funding using the lesser
of the non-refundable cash received or the result achieved using percentage of

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VERTEX PHARMACEUTICALS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

3. CHANGE IN ACCOUNTING PRINCIPLE--REVENUE RECOGNITION (CONTINUED)
completion accounting. Where the Company had no continuing involvement,
non-refundable license fees were recorded as revenue upon receipt and milestones
were recorded as revenue upon achievement of the milestone by the collaborative
partner.

Pursuant to this change in accounting principle, Vertex recorded a one-time
non-cash charge of $25,901,000 in the first quarter of 2001. The impact of the
adoption of this new accounting policy for revenue recognition for collaborative
research and development revenues was to defer revenue recognition for certain
portions of revenue previously recognized in prior accounting periods under our
collaborative agreements into future accounting periods. The results for the
three and six months ended June 30, 2001 have been restated in accordance with
the new revenue recognition policy.

4. SEGMENT INFORMATION

The Company has aligned its business into two operating segments:
(i) Pharmaceuticals and (ii) Discovery Tools and Services. The Company's
Pharmaceuticals business seeks to discover, develop and commercialize major
pharmaceutical products independently and with partners. The Company's Discovery
Tools and Services business specializes in assay development, screening
services, instrumentation and the manufacture and sale of proteins and reagents.
The Company evaluates segment performance based on the loss before
merger-related charges and the cumulative effect of the change in accounting
principle. The Company does not evaluate segment performance based on the
segment's total assets and therefore the Company's assets are not reported by
segment. The following table presents, by segment, the results of operations for
the three and six months ended June 30, 2002 and 2001. For the three and six
months ended June 30, 2001, the Company was unable to restate the results of
operations into the new operating segments: Pharmaceuticals and Discovery Tools
and Services. Thus, for comparative purposes, the table also presents results of
operations information for

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VERTEX PHARMACEUTICALS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

4. SEGMENT INFORMATION (CONTINUED)
the three and six month periods ended June 31, 2002 and 2001 by the former
segments: Vertex and Aurora.

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VERTEX PHARMACEUTICALS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

5. COMPREHENSIVE LOSS

For the three and six months ended June 30, 2002 and 2001, respectively,
comprehensive loss was as follows (in thousands):

6. LEGAL PROCEEDINGS

Chiron Corporation (Chiron) filed suit on July 30, 1998 against Vertex and
Eli Lilly and Company in the United States District Court for the Northern
District of California, alleging infringement by the defendants of three U.S.
patents issued to Chiron. The infringement action relates to research activities
by the defendants in the hepatitis C viral protease field and the alleged use of
inventions claimed by Chiron in connection with that research. Chiron has
requested damages in an unspecified amount, as well as an order permanently
enjoining the defendants from unlicensed use of the claimed Chiron inventions.
During 1999, Chiron requested and was granted a reexamination by the U.S. Patent
and Trademark Office of all three of the patents involved in the suit. Chiron
also requested and, over the opposition of Vertex and Eli Lilly, was granted a
stay in the infringement lawsuit, pending the outcome of the patent
reexamination. That reexamination proceeding is still on-going and the stay is
still in effect. However, a Reexamination Certificate has been issued in two of
the three Chiron patents in suit. While the length of the stay and the final
outcome of the lawsuit cannot be determined, Vertex maintains that Chiron's
claims are without merit and intends to defend the lawsuit, if and when it
resumes, vigorously.

On December 7, 2001 Oregon Health Sciences University filed suit against
Vertex in the District Court of Oregon. The complaint in the suit seeks to name
Dr. Bruce Gold, an employee of Oregon Health Sciences University, as an inventor
and Oregon Health Sciences University as part owner of five of Vertex's
neurophilin patents and associated damages. The suit stems from assays run on
Vertex compounds by Dr. Gold under a sponsored research agreement in 1996.
Vertex has investigated the inventorship on these patents and believes that
Dr. Gold is not an inventor, Oregon Health Sciences has no ownership interest in
any of these patents, and that the claims made in this complaint are without
merit. Vertex intends to contest this claim vigorously. We believe, based on
information currently available, that the ultimate outcome of the action will
not have a material impact on the Company's consolidated financial position.

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7. RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets," which requires that ratable amortization of goodwill be replaced with
periodic tests of the goodwill's impairment and that intangible assets other
than goodwill be amortized over their useful lives. The provisions of SFAS
No. 142 are effective for fiscal years beginning after December 15, 2001. The
Company adopted the provisions of SFAS 142 on January 1, 2002 as required; the
adoption did not have a material effect on the Company's financial position and
results of operations.

In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment of Long-Lived Assets." SFAS No. 144 supercedes SFAS No. 121
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of" and provides a single accounting model for long-lived assets to
be disposed of. The provisions of SFAS No. 144 are effective for fiscal years
beginning after December 15, 2001. The Company adopted the provisions of
SFAS 144 on January 1, 2002 as required; the adoption did not have a material
effect on the Company's financial position and results of operations.

In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Nos. 4, 44
and 64, Amendment of FASB Statement No. 13, and Technical Corrections as of
April 2002." This Statement rescinds FASB No. 4, "Reporting Gains and Losses
from Extinguishment of Debt," and an amendment of that Statement and FASB
Statement No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements" and SFAS No. 44, "Accounting for Intangible Assets of Motor
Carriers." SFAS No. 145 also amends SFAS No. 13, "Accounting for Leases," to
eliminate an inconsistency between the required accounting for sale-leaseback
transactions and the required accounting for certain lease modifications that
have the same economic effect as a sale-leaseback transaction. SFAS No. 145 also
amends other existing authoritative pronouncements to make various technical
corrections, clarify meanings, or describe their applicability under changed
conditions. Adoption of certain provisions of this standard was required after
May 15, 2002, while other provisions must be adopted within financial statements
issued after May 15, 2002 or the year beginning after May 15, 2002. The Company
is currently evaluating the potential impact of SFAS No. 145 on its financial
position and results of operations.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities," which supersedes EITF 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a Restructuring)." The standard
affects the accounting for restructuring charges and related activities. The
provisions of this statement are required to be adopted for exit or disposal
activities that are initiated after December 31, 2002.

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

We are a global biotechnology company with more than 1,000 employees located
in Cambridge, MA, Madison, WI, San Diego, CA and Abingdon, UK. We have two
operating segments: Pharmaceuticals and Discovery Tools and Services.

Our Pharmaceuticals business seeks to discover, develop, and commercialize
major pharmaceutical products independently and with collaborators.
Chemogenomics, our proprietary, systematic, genomics-based platform, is designed
to accelerate the discovery of new drugs and to expand intellectual property
coverage of drug candidate compounds and classes of related compounds. We
believe this approach, which targets gene families, has formed the basis for
successful drug discovery and for the advancement of drug candidates by Vertex
and its collaborators.

Our first approved product is Agenerase-Registered Trademark- (amprenavir),
an HIV protease inhibitor, which we co-promote with GlaxoSmithKline. We earn a
royalty from GlaxoSmithKline on sales of Agenerase. Agenerase has received
approval in 34 countries worldwide, including the United States, the 15 member
states of the European Union (E.U.), and Japan, where the drug is sold under the
trade name Prozei-TM-. We have more than twelve drug candidates in development
to treat viral diseases, cancer, autoimmune and inflammatory diseases,
neurological disorders and genetic disorders. We have significant collaborations
with large pharmaceutical companies including Aventis, Eli Lilly,
GlaxoSmithKline, Novartis, and Serono. We are developing several drug candidates
in commercial collaborations in which we retain rights to downstream product
revenue.

Our Discovery Tools and Services business specializes in assay development,
screening services, instruments and products, and the manufacture and sale of
proteins and reagents. This business has collaborations with large
pharmaceutical companies for assay development, screening services and the
development of specialized screening platforms, as well as the sale of proteins
and reagents to the pharmaceuticals industry.

Our Discovery Tools and Services business has contracts in place that
require the delivery of products, licenses and services throughout 2002. These
contracts account for more than $65 million of actual plus potential 2002
revenue of which approximately $12 million relates to one specific contract.

Our collaborations and contracts in the Pharmaceuticals and Discovery Tools
and Services businesses provide us with financial support and other valuable
resources for our research programs, development of our clinical drug
candidates, and marketing and sales of our products. We believe that we are
positioned to commercialize multiple products in the coming years, which we
expect will generate increased milestone payments, product revenues and royalty
payments.

We have incurred operating losses since our inception and expect to incur
losses for the foreseeable future. We plan to make significant investments in
research and development for our other potential products. We expect that losses
will fluctuate from year to year and that such fluctuations may be substantial.

In the third quarter of 2001, in connection with our overall review of
accounting policies concurrent with our merger with Aurora, we elected to change
our revenue recognition policy for collaborative and other research and
development revenues from the Emerging Issues Task Force No. 91-6 (EITF 91-6)
method to the Substantive Milestone Method. We believe this method is preferable
because it is reflective of the Company's on-going business operations and is
more consistent with industry practices following the prior year implementation
of SAB 101 throughout the biotechnology industry.

The cumulative effect of the 2001 change in accounting principle related to
revenue recognition recorded in the third quarter of 2001, retroactive to
January 1, 2001, resulted in a non-cash charge to income of $25,901,000 in the
first quarter of 2001. Included in the charge to income was $1,591,000 and

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$3,182,000 of revenue recognized in the three and six months ended June 30, 2002
and $1,889,000 and $3,714,000 of revenue recognized in the three and six months
ended June 30, 2001, respectively.

CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of our financial condition and results of
operations is based upon our condensed consolidated financial statements that
are unaudited and have been prepared in accordance with generally accepted
accounting principles in the United States of America. The preparation of these
financial statements requires us to make certain estimates and assumptions that
affect the reported amounts of assets and liabilities, the disclosure of
contingent assets and liabilities at the date of the condensed consolidated
financial statements and the reported amounts of revenue and expense during the
reported periods. These items are constantly monitored and analyzed by
management for changes in facts and circumstances, and material changes in these
estimates could occur in the future. Changes in estimates are recorded in the
period in which they become known. We base our estimates on historical
experience and various other assumptions that we believe to be reasonable under
the circumstances. Actual results may differ from our estimates if past
experience or other assumptions do not turn out to be substantially accurate.

In December 2001, the SEC requested that all registrants discuss their
"critical accounting policies" in management's discussion and analysis of
financial condition and results of operations. The SEC indicated that a
"critical accounting policy" is one that is both important to the portrayal of
the company's financial conditions and results, and requires management's most
difficult, subjective or complex judgments, often as a result of the need to
makes estimates about the effect of matters that are inherently uncertain. While
our significant accounting polices are more fully described in Note B to our
consolidated financial statements included in our Form 10-K, we believe our
revenue recognition policy to be critical and have outlined this policy below.

Our revenue recognition policies are in accordance with the SEC's Staff
Accounting Bulletin No. 101 (SAB 101), "Revenue Recognition in Financial
Statements". We generate revenue through collaborative research and development
agreements, product sales, assay development and screening services and royalty
agreements.

Our collaborative research and development revenue is primarily generated
through collaborative research and development agreements with strategic
partners for the development of small molecule drugs that address major unmet
medical needs. The terms of the agreements typically include non-refundable
up-front license fees, funding of research and development efforts, payments
based upon achievement of certain at-risk and substantive milestones and
royalties on product sales.

Under the Substantive Milestone Method, adopted retroactively to January 1,
2001, we recognize revenue from non-refundable, up-front license fees and
milestones, not specifically tied to a separate earnings process, ratably over
the contracted or estimated period of performance. Changes in estimates could
impact revenue in the period the estimate is changed. Research funding is
recognized as earned, ratably over the period of effort. Milestones that are
based on designated achievement points and that are considered at risk and
substantive at the inception of the collaborative contract, are recognized as
earned, when the corresponding payment is considered reasonably assured. We
evaluate whether milestones are at risk and substantive based on the contingent
nature of the milestone, specifically reviewing factors such as the
technological and commercial risk that must be overcome and the level of
investment required.

Product sales include instrumentation system sales, technology licensing and
biotechnology product sales as well as commercial drug substance sales. Revenue
from licenses where we have continuing obligations is recognized over the period
of the license. Revenue from perpetual licenses is recognized when the license
is issued, provided that there are no significant continuing obligations and the
payment is non-refundable and non-creditable.

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Revenue from sales of commercial drug substance, biotechnology products and
certain instrumentation system sales, is recognized upon shipment, when the
title to the product and associated risk of loss has passed to the customer,
collectibility is reasonably assured and upon acceptance when acceptance
criteria are specified or upon expiration of the acceptance period, if
applicable. Sales under long-term production contracts are recognized using
percentage of completion accounting, based on actual costs incurred to date
compared to total estimated costs to complete. Funding for prototype
instrumentation systems was recognized ratably over the terms of the agreements,
which approximated costs incurred. Milestones related to delivery of the
components of the prototype systems were recognized when earned, as evidenced by
written acknowledgement of acceptance from the customer.

Service revenues include assay development, screening services and
contracted product development. Service revenue is recognized as the services
are performed or ratably over the service period if we believe such method will
approximate the expense being incurred. Revenue from upfront fees is deferred
and recognized over the service period.

Our subsidiary has certain contracts under which it agrees to sell
instrumentation systems and technology licenses in addition to providing assay
development and screening services. Each of these separable elements may be
individually delivered and is not considered essential to the functionality of
the others. We allocate revenue under such contracts to each of the separable
elements based on the relative fair value of each element, which under most of
our agreements approximates the stated price in the contract.

Royalty revenue is recognized based upon actual and estimated net sales of
licensed products in licensed territories, as provided by our collaborative
partner, and is generally recognized in the period the sales occur. Differences
between actual royalty revenues and estimated royalty revenues, which have not
been historically significant, are reconciled and any resulting adjustments are
made in the quarter they become known.

THREE MONTHS ENDED JUNE 30, 2002 COMPARED WITH THREE MONTHS ENDED JUNE 30, 2001

Our net loss for the three months ended June 30, 2002 was $21,019,000 or
$0.28 per basic and diluted common share compared to a loss before merger
related costs of $9,015,000, or $0.12 per basic and diluted common share, for
the three months ended June 30, 2001. The net loss for the three months ended
June 30, 2001, including merger related costs of $4,363,000, was $13,378,000 or
$0.18 per basic and diluted common share.

Total revenues increased to $42,330,000 for the three months ended June 30,
2002 compared to $40,641,000 for the three months ended June 30, 2001. In the
second quarter of 2002, Pharmaceuticals revenue was comprised of $2,384,000 in
royalties and $18,859,000 in collaborative research and development revenue, as
compared with $2,862,000 in royalties and $16,273,000 in collaborative research
and development revenue in the second quarter of 2001. In the second quarter of
2002, Discovery Tools and Services revenue was comprised of $15,587,000 in
product sales and royalties and $5,500,000 in service revenue, as compared with
$15,423,000 in product sales and royalties and $6,083,000 in service revenue in
the second quarter of 2001.

Pharmaceuticals royalties consist primarily of Agenerase royalty revenue.
Agenerase royalty revenue is based on actual and estimated worldwide net sales
of Agenerase.

Collaborative research and development revenue consists of research support
payments, development reimbursements, milestones and amortization of previously
received up-front or license payments.

Collaborative research and development revenue increased in the second
quarter of 2002 by 16%, or $2,586,000, as compared with the second quarter of
2001 due primarily to additional revenue earned under the Novartis
collaboration. In the second quarter of 2002, we recognized $10,434,000 of
revenue

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under the Novartis collaboration compared with $8,512,000 in the second quarter
of 2001. Effort related to our kinase research program increased significantly
in the first and second quarters of 2002 compared to 2001. Also, during the
second quarter of 2002 development reimbursements from certain collaborators
increased.

Product sales and royalties include instrumentation sales, technology
licensing and biotechnology product sales.

Product sales increased $164,000, or 1%, to $15,587,000 in the second
quarter of 2002 from $15,423,000 in the second quarter of 2001. The increase in
product sales is due primarily to increased technology licensing during the
quarter offset by decreased instrumentation revenue and biotechnology product
revenue.

Service revenue includes assay development, screening services and
contracted product development.

Service revenue decreased $583,000, or 10%, to $5,500,000 in the second
quarter of 2002 from $6,083,000 in the second quarter of 2001. The decrease is a
result of the completion of several significant screening agreements in late
2001.

Pharmaceutical royalty costs of $828,000 and $972,000 in the second quarter
of 2002 and 2001, respectively, consist primarily of royalty payments on the
sales of Agenerase.

Product costs decreased $4,166,000, or 61%, to $2,662,000 in the second
quarter of 2002 from $6,828,000 in the second quarter of 2001. The decrease in
product costs is attributable to a strategic shift in focus of the Discovery
Tools and Services business towards technology licensing and discovery tools
which have higher gross margins, and away from product sales. Product gross
margins will fluctuate from period to period based upon the product mix.

Cost of service revenue in our Discovery Tools and Services business
increased $576,000, or 24%, to $2,972,000 in the second quarter of 2002 from
$2,396,000 in the second quarter of 2001. The increase is primarily due to
increased overhead related to these service agreements.

Research and development expenses increased $11,969,000, or 35%, to
$46,546,000 in the second quarter of 2002 from $34,577,000 in the second quarter
2001 primarily due to our continued investment in advancing our broad clinical
pipeline and fueling our drug discovery engine. Our clinical investment was
primarily focused on the advancement of our second generation p38 MAP kinase,
caspase and IMPDH inhibitors. We currently are focusing these oral drugs on
large market opportunities such as inflammatory, autoimmune and viral diseases.
We continued to expand our multi-target gene family research programs, of which
kinases is our most advanced, along with investments in target families such as
proteases and ion channels. As a result of our continued expansion, personnel
and facilities expenses also increased.

Sales, general and administrative expenses increased $1,968,000, or 17%, to
$13,348,000 for the three months ended June 30, 2002 from $11,380,000 for the
three months ended June 30, 2001. This increase is primarily attributable to
increased personnel and professional expenses as well as the write-off of
certain land development costs. We believe we have a solid infrastructure
necessary to support our growth and will continue to manage our investments
prudently. In addition, legal and patent expenses have increased in the period
as we continue to protect our intellectual property and contest a suit filed by
Oregon Health Sciences University. We believe, based on information currently
available, that the ultimate outcome of the action will not have a material
impact on our consolidated financial position.

Interest income decreased approximately $4,301,000 to approximately
$7,467,000 in the second quarter of 2002 from $11,768,000 in the second quarter
of 2001. This reflects a lower interest rate environment as well as a lower
level of invested funds compared to the prior year.

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Interest expense decreased $811,000 to approximately $4,460,000 in the
second quarter of 2002 from $5,271,000 in the second quarter of 2001. The
decrease in interest expense is a result of the reduction in principal amount of
our convertible notes from $345,000,000 at June 30, 2001 to $315,000,000 at
June 30, 2002. In October 2001, we repurchased $30,000,000 in principal amount
of our 5% convertible subordinated notes due September 2007.

SIX MONTHS ENDED JUNE 30, 2002 COMPARED WITH SIX MONTHS ENDED JUNE 30, 2001

The net loss for the six months ended June 30, 2002 was $43,086,000 or $0.57
per basic and diluted share, compared to a loss before our change in accounting
principle and merger related costs of $20,050,000, or $0.27 per basic and
diluted common share, for the six months ended June 30, 2001. The net loss for
the six months ended June 30, 2001, including merger related costs of $5,542,000
and the cumulative effect of the change in accounting principle of $25,901,000,
was $51,493,000 or $0.69 per basic and diluted common share.

Total revenues increased to $83,025,000 for the six months ended June 30,
2002 from $75,597,000 for the six months ended June 30, 2001.

Collaborative research and development revenue increased $5,090,000, or 16%,
to $36,936,000 for the six months ended June 30, 2002 as compared with
$31,846,000 for the six months ended June 30, 2001 primarily due to additional
revenue earned under the Novartis collaboration. For the six months ended
June 30, 2002, we recognized $20,466,000 of revenue under the Novartis
collaboration compared with $15,623,000 for the six months ended June 30, 2001.
Effort related to our kinase research program increased significantly in the
first and second quarters of 2002 compared to 2001.

Product sales and royalties increased $3,845,000, or 14%, to $30,797,000 for
the six months ended June 30, 2002 from $26,952,000 for the six months ended
June 30, 2001. The increase in product sales is due primarily to increased
technology licensing revenue offset by decreased instrumentation revenue and
biotechnology product revenue.

Services revenue decreased $907,000, or 8%, to $10,434,000 for the six
months ended June 30, 2002 from $11,341,000 for the six months ended June 30,
2001. The decrease is a result of the completion of several screening agreements
in late 2001.

Product costs decreased $6,444,000, or 47%, to $7,252,000 for the six months
ended June 30, 2002 from $13,696,000 for the six months ended June 30, 2001. The
decrease in product costs is attributable to a strategic shift in focus of the
Discovery Tools and Services business toward technology licensing and discovery
tools which have higher gross margins, and away from product sales.

Cost of service revenue in our Discovery Tools and Services business
increased $1,020,000, or 20%, to $6,206,000 for the six months ended June 30,
2002 from $5,186,000 for the six months ended June 30, 2001. Cost of services
increased as a result of increased personnel and professional expenses.

Research and development costs increased $26,451,000, or 39%, to $93,568,000
for the six months ended June 30, 2002 from $67,117,000 for the six months ended
June 30, 2001 primarily due to our continued investment in advancing our broad
clinical pipeline and fueling our drug discovery engine.

We have more than 12 drug candidates in development targeting a range of
major diseases. Our collaborative partners have agreed to fund portions of our
research and development programs and/or to conduct certain research and
development related to specified drug candidates. The following table

16

details our Collaborator and Company-sponsored research and development expenses
for the three and six months ended June 30 (in thousands):

To date we have incurred in excess of $724,000,000 in research and
development costs associated with drug discovery and development. These costs
include discovery costs associated with our kinase, protease and ion channel
gene family programs and our other discovery programs, as well as development
costs incurred in advancing drug candidates that were products of these
discovery programs. Our major development investments relate to the drug
candidates identified on the table appearing on the following page. We
anticipate research and development expenses will continue to increase as we add
personnel and expand research and development activities to accommodate our
existing collaborations and additional commitments we may make.

We estimate that it takes from 10 to 15 years (industry average is
12 years) to discover, develop and bring to market a pharmaceutical product.
Drug development in the United States is a process that includes several steps
defined by the FDA as outlined below:

The successful development of our products is highly uncertain and subject
to a number of risk factors. The duration of clinical trials may vary
substantially according to the type, complexity and novelty of the
pharmaceutical product. The FDA and comparable agencies in foreign countries
impose substantial requirements on the introduction of therapeutic
pharmaceutical products through lengthy and detailed laboratory and clinical
testing procedures, sampling activities and other costly and time-consuming
procedures. Data obtained from pre-clinical and clinical activities are
susceptible to varying interpretations, which could delay, limit or prevent
regulatory approval. The duration and the cost related to discovery,
pre-clinical and clinical trials may vary significantly over the life of a
project and are difficult to predict. The most significant costs associated with
drug discovery and development are those costs associated with Phase II and
Phase III clinical trials. Due to the variables described above, we are not able
to estimate precisely the costs to complete these research and development
programs.

17

Below is a summary of our drug candidates currently in pre-clinical and
clinical development:

Currently, our discovery operations are focused significantly on the kinase
research program with Novartis. Other significant discovery programs include ion
channels, proteases, caspases and gyrase. Our development investment is
primarily focused on the advancement of our second-generation p38 MAP kinase
program (VX-702 and VX-850), IMPDH program (VX-148, VX-497 and VX-944) and ICE
program (VX-765). Our collaborative partners are advancing other significant
late stage drug candidates such as VX-175, targeted at HIV, and Pralnacasan
(VX-740), currently targeting rheumatoid arthritis and osteoarthritis. Our
partners bear the costs of the continued development of these drugs.

We organize our research and development efforts based on the drug target or
target gene family. The programs detailed above identify the targets for
therapeutic intervention.

Sales, general and administrative expenses increased $2,114,000, or 9%, to
$24,443,000 for the six months ended June 30, 2002 from $22,329,000 for the six
months ended June 30, 2001. The increase is primarily related to increased
personnel and professional expenses as well as increased legal expenses as we
continue to protect our intellectual property and contest a suit filed by Oregon
Health Sciences University.

Interest income decreased $8,913,000 to approximately $15,925,000 for the
six months ended June 30, 2002 from $24,838,000 for the six months ended
June 30, 2001. The decrease is a result of lower funds invested and lower
portfolio yields.

Interest expense decreased $1,382,000 to approximately $8,922,000 for the
six months ended June 30, 2002 from $10,304,000 for the six months ended
June 30, 2001. The decrease is a result of the reduction in principal amount of
our convertible notes from $345,000,000 at June 30, 2001 to $315,000,000 at
June 30, 2002. In October 2001, we repurchased $30,000,000 in principal amount
of our 5% convertible subordinated notes due September 2007.

18

LIQUIDITY AND CAPITAL RESOURCES

Our operations have been funded principally through strategic collaborative
agreements, strategic technology alliances, revenues from assay development and
screening services, product sales, royalties, public offerings and private
placements of our equity and debt securities, equipment lease financing, and
investment income. With the approval and launch of Agenerase in April 1999, we
began receiving product royalty revenues. In 2000, we completed private
placements of $175,000,000 of 5% Convertible Subordinated Notes due March 2007
and $345,000,000 of 5% Convertible Subordinated Notes due September 2007.

We have continued to increase and advance products in our research and
development pipeline. Consequently, we expect to incur losses on a quarterly and
annual basis as we continue to develop existing and future compounds and to
conduct clinical trials of potential drugs. We also expect to incur substantial
administrative and commercialization expenditures in the future and additional
expenses related to filing, prosecution, defense and enforcement of patent and
other intellectual property rights.

We expect to finance these substantial cash needs with future payments under
our existing and future collaborative agreements, strategic technology
alliances, royalties from the sales of Agenerase, revenues from assay
development and screening services, product sales, existing cash and marketable
securities of $679,845,000 at June 30, 2002, together with investment income
earned thereon, and facilities and equipment financing. To the extent that funds
from these sources are not sufficient to fund our activities, it will be
necessary to raise additional funds through public offerings or private
placements of securities or other methods of financing. There can be no
assurance that such financing will be available on acceptable terms, if at all.

Our aggregate cash and marketable securities decreased $63,357,000 to
$679,845,000, which includes cash and cash equivalents of $125,268,000, at
June 30, 2002 from $743,202,000, including cash and cash equivalents of
$189,205,000, at December 31, 2001. Net cash used in operations was $47,777,000
for the six months ended June 30, 2002. Included in the cash used in operations
was the net loss of $43,086,000 and a decrease in deferred revenue of
$13,146,000, partially offset by $11,986,000 of non-cash charges and gains.
Deferred revenue decreased due to cash received for research funding and the
receipt of a milestone payment in late 2001. Such cash was based on contractual
commitments that are being fulfilled in 2002 and 2003. Cash used by investing
activities for the six months ended June 30, 2002 was $22,783,000, including net
purchases of available-for-sale securities of $4,306,000 and property and
equipment expenditures of $18,258,000 as we continue to invest in our
infrastructure and drug discovery technology. Cash provided by financing
activities during the six months ended June 30, 2002 was $6,361,000 including
$8,717,000 from the issuance of common stock under employee stock option and
benefit plans offset by $2,356,000 in principal payments on capital leases and
other obligations. The decrease in cash and marketable securities can fluctuate
from quarter to quarter.

FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements about our business,
including our expectation that (i) we are positioned to commercialize multiple
products in the coming years that we expect will generate increased revenues,
(ii) our losses will continue, (iii) our research and development expenses, our
administrative and commercialization expenses and our expenses related to
filing, prosecuting and defending our patents and intellectual property rights
will increase, and sales, general and administrative expenses will remain
consistent with current levels, and (iv) the Chiron Corporation and Oregon
Health Sciences University litigation will not have a material adverse effect on
us. While management makes its best efforts to be accurate in making
forward-looking statements, such statements are subject to risks and
uncertainties that could cause our actual results to vary materially. These
risks and uncertainties include, among other things, our inability to
successfully integrate Aurora

19

into our existing business, our inability to further identify, develop and
achieve commercial success for new products and technologies, the possibility of
delays in the research and development necessary to select drug development
candidates and delays in clinical trials, the risk that clinical trials may not
result in marketable products, the risk that we may be unable to successfully
finance and secure regulatory approval of and market our drug candidates, our
dependence upon pharmaceutical and biotechnology collaborations, the levels and
timing of payments under our collaborative agreements, uncertainties about our
ability to obtain new corporate collaborations and acquire new technologies on
satisfactory terms, if at all, the development of competing systems, our ability
to protect our proprietary technologies, patent-infringement claims, risks of
new, changing and competitive technologies and regulations in the U.S. and
internationally. Please see the "Risk Factors" appearing in our 2001 Annual
Report to Stockholders and in our Form 10-K filed with the Securities and
Exchange Commission for more details regarding these and other risks. We
disclaim any intention or obligation to update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.

LEGAL PROCEEDINGS

Chiron Corporation filed suit on July 30, 1998 against Vertex and Eli Lilly
and Company in the United States District Court for the Northern District of
California, alleging infringement by the defendants of three U.S. patents issued
to Chiron. The infringement action relates to research activities by the
defendants in the hepatitis C viral protease field and the alleged use of
inventions claimed by Chiron in connection with that research. Chiron has
requested damages in an unspecified amount, as well as an order permanently
enjoining the defendants from unlicensed use of the claimed Chiron inventions.
During 1999, Chiron requested and was granted a reexamination by the U.S. Patent
and Trademark Office of all three of the patents involved in the suit. Chiron
also requested and, over the opposition of Vertex and Eli Lilly, was granted a
stay in the infringement lawsuit, pending the outcome of the patent
re-examination. That reexamination proceeding is still on-going and the stay is
still in effect. However, a Reexamination Certificate has been issued in two of
the three Chiron patents in suit. While the length of the stay and the final
outcome of the lawsuit cannot be determined, we maintain that Chiron's claims
are without merit and we intend to defend the lawsuit, if and when it resumes,
vigorously.

On December 7, 2001 Oregon Health Sciences University filed suit against
Vertex in the District Court of Oregon. The complaint in the suit seeks to name
Dr. Bruce Gold, an employee of Oregon Health Sciences University, as an inventor
and Oregon Health Sciences University as part owner of five of Vertex's
neurophilin patents, and associated damages. The suit stems from assays run on
Vertex compounds by Dr. Gold under a sponsored research agreement in 1996. We
have investigated the inventorship on these patents and believe that Dr. Gold is
not an inventor, Oregon Health Sciences has no ownership interest in any of
these patents, and that the claims made in this complaint are without merit. We
intend to contest this claim vigorously.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other Intangible
Assets," which requires that ratable amortization of goodwill be replaced with
periodic tests of the goodwill's impairment and that intangible assets other
than goodwill be amortized over their useful lives. The provisions of SFAS
No. 142 are effective for fiscal years beginning after December 15, 2001. We
adopted the provisions of SFAS 142 on January 1, 2002 as required. That adoption
did not have any effect on our financial position and results of operations.

In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment of Long-Lived Assets." SFAS No. 144 supercedes SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of" and provides a single accounting model for

20

long-lived assets to be disposed of. The provisions of SFAS No. 144 are
effective for fiscal years beginning after December 15, 2001. We adopted the
provisions of SFAS 144 on January 1, 2002 as required. That adoption did not
have any effect on our financial position and results of operations.

In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Nos. 4, 44
and 64, Amendment of FASB Statement No. 13, and Technical Corrections as of
April 2002." This Statement rescinds FASB No. 4, "Reporting Gains and Losses
from Extinguishment of Debt," and an amendment of that Statement and FASB
Statement No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements" and SFAS No. 44, "Accounting for Intangible Assets of Motor
Carriers." SFAS No. 145 also amends SFAS No. 13, "Accounting for Leases," to
eliminate an inconsistency between the required accounting for sale-leaseback
transactions and the required accounting for certain lease modifications that
have the same economic effect as a sale-leaseback transaction. SFAS No. 145 also
amends other existing authoritative pronouncements to make various technical
corrections, clarify meanings, or describe their applicability under changed
conditions. Adoption of certain provisions of this standard was required after
May 15, 2002, while other provisions must be adopted within financial statements
issued after May 15, 2002 or the year beginning after May 15, 2002. We are
currently evaluating the potential impact of SFAS No. 145 on our financial
position and results of operations.

In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities," which supersedes EITF 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a Restructuring)." The standard
affects the accounting for restructuring charges and related activities. The
provisions of this statement are required to be adopted for exit or disposal
activities that are initiated after December 31, 2002.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As part of its investment portfolio, Vertex owns financial instruments that
are sensitive to market risks. The investment portfolio is used to preserve
Vertex's capital until it is required to fund operations, including Vertex's
research and development activities. None of these market risk sensitive
instruments are held for trading purposes. Vertex does not have derivative
financial instruments in its investment portfolio.

INTEREST RATE RISK

Vertex invests its cash in a variety of financial instruments, principally
securities issued by the U.S. government and its agencies, investment grade
corporate bonds and notes and money market instruments. These investments are
denominated in U.S. dollars. All of its interest-bearing securities are subject
to interest rate risk, and could decline in value if interest rates fluctuate.
Substantially all of Vertex's investment portfolio consists of marketable
securities with active secondary or resale markets to help ensure portfolio
liquidity, and Vertex has implemented guidelines limiting the term to maturity
of its investment instruments. Due to the conservative nature of these
instruments, Vertex does not believe that it has a material exposure to interest
rate risk.

21

PART II. OTHER INFORMATION

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company's Annual Meeting of Stockholders was held on May 17, 2002.

The stockholders elected Roger W. Brimblecombe, Donald R. Conklin and Stuart
J.M. Collinson to the class of directors whose term expires in 2005. The
tabulation of votes with respect to the election of such directors is as
follows:

In addition, the stockholders approved amendments to the Vertex
Pharmaceuticals Incorporated Employee Stock Purchase Plan, including an
amendment to increase the total number of shares of common stock authorized for
issuance under that plan by 600,000, by a vote of 54,195,646 shares in favor,
5,687,763 shares against, and 252,109 shares abstaining.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits:

None

(b) Reports on Form 8-K:

On May 24, 2002, we filed a Report on Form 8-K dated May 23, 2002, Item 5,
reporting that Lynne H. Brum, the Company's Vice President of Corporate
Development and Communications, entered into a plan with Goldman, Sachs & Co.,
pursuant to which Goldman will undertake to sell, subject to a limit order, an
aggregate of 23,816 shares of the Company's stock issuable upon exercise of
options held by Ms. Brum.

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SIGNATURE

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

VERTEX PHARMACEUTICALS INCORPORATED

August 14, 2002 By: /s/ IAN F. SMITH
-----------------------------------------
Ian F. Smith
VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER