UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2003

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 0-19119

CEPHALON, INC.

(Exact Name of Registrant as Specified in its Charter)

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

145 Brandywine Parkway, West Chester, PA		19380-4245
(Address of Principal Executive Offices)		(Zip Code)

(610) 344-0200
(Registrant’s Telephone Number, Including Area Code)

Not Applicable
(Former Name, Former Address and Former Fiscal Year, If Changed Since Last Report)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o

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

Class		Outstanding as of November 7, 2003
Common Stock, par value $.01		55,651,449 Shares

CEPHALON, INC. AND SUBSIDIARIES

INDEX

PART I – FINANCIAL INFORMATION

	Item 1.	Consolidated Financial Statements

			Consolidated Balance Sheets - September 30, 2003 and December 31, 2002

			Consolidated Statements of Income - Three and nine months ended September 30, 2003 and 2002

			Consolidated Statements of Stockholders’ Equity - September 30, 2003 and December 31, 2002

			Consolidated Statements of Cash Flows - Nine months ended September 30, 2003 and 2002

			Notes to Consolidated Financial Statements

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

	Item 3.	Quantitative and Qualitative Disclosure about Market Risk

	Item 4.	Controls and Procedures

PART II – OTHER INFORMATION

	Item 1.	Legal Proceedings

	Item 6.	Exhibits and Reports on Form 8-K

SIGNATURES

CEPHALON, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)	September 30, 2003			December 31, 2002
	(Unaudited)
ASSETS

CURRENT ASSETS:
Cash and cash equivalents	$	1,032,141		$	486,097
Investments	46,750			96,591
Receivables, net	99,881			83,130
Inventory, net	59,460			54,299
Deferred tax asset	56,023			56,070
Other current assets	11,897			9,793
Total current assets	1,306,152			785,980

PROPERTY AND EQUIPMENT, net	115,571			90,066
GOODWILL	298,769			298,769
OTHER INTANGIBLE ASSETS, net	331,451			351,719
DEBT ISSUANCE COSTS, net	37,454			21,406
DEFERRED TAX ASSET, net	188,464			114,002
OTHER ASSETS	58,643			27,148
	$	2,336,504		$	1,689,090

LIABILITIES AND STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES:
Current portion of long-term debt	$	14,133		$	15,402
Accounts payable	30,767			23,089
Accrued expenses	82,712			80,444
Current portion of deferred revenues	621			712
Total current liabilities	128,233			119,647

LONG-TERM DEBT	1,416,646			860,897
DEFERRED REVENUES	1,820			1,968
DEFERRED TAX LIABILITIES	48,140			52,666
OTHER LIABILITIES	14,181			11,327
Total liabilities	1,609,020			1,046,505

COMMITMENTS AND CONTINGENCIES (Note 8)	—			—

STOCKHOLDERS’ EQUITY:
Preferred stock, $.01 par value, 5,000,000 shares authorized, 2,500,000 shares issued, and none outstanding	—			—
Common stock, $.01 par value, 200,000,000 shares authorized, 55,687,495 and 55,425,841 shares issued, and 55,411,855 and 55,152,984 shares outstanding	557			554
Additional paid-in capital	1,052,621			1,034,137
Treasury stock, 275,640 and 272,857 shares outstanding, at cost	(12,114		)	(11,989		)
Accumulated deficit	(352,530		)	(405,163		)
Accumulated other comprehensive income	38,950			25,046
Total stockholders’ equity	727,484			642,585
	$	2,336,504		$	1,689,090

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

CEPHALON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
(In thousands, except per share data)	2003			2002			2003			2002

REVENUES:
Sales	$	184,877		$	122,364		$	482,745		$	326,934
Other revenues	5,166			7,999			20,822			35,657
	190,043			130,363			503,567			362,591

COSTS AND EXPENSES:
Cost of sales	22,584			19,502			65,283			48,819
Research and development	44,541			30,725			117,336			91,925
Selling, general and administrative	63,533			45,215			183,685			130,430
Depreciation and amortization	10,991			8,715			32,558			25,051
	141,649			104,157			398,862			296,225

INCOME FROM OPERATIONS	48,394			26,206			104,705			66,366

OTHER INCOME AND EXPENSE
Interest income	2,962			3,940			8,137			10,580
Interest expense	(6,218		)	(8,126		)	(22,574		)	(29,405		)
Charge on early extinguishment of debt	(9,816		)	—			(9,816		)	(7,142		)
Other income (expense)	(522		)	(544		)	1,789			(1,846		)
	(13,594		)	(4,730		)	(22,464		)	(27,813		)

INCOME BEFORE INCOME TAXES	34,800			21,476			82,241			38,553

INCOME TAX EXPENSE	(12,528		)	(1,500		)	(29,608		)	(3,485		)

INCOME BEFORE CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE	22,272			19,976			52,633			35,068

CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE	—			—			—			(3,534		)

NET INCOME APPLICABLE TO COMMON SHARES	$	22,272		$	19,976		$	52,633		$	31,534

BASIC INCOME PER COMMON SHARE:
Income per common share before cumulative effect of a change in accounting principle	$	0.40		$	0.36		$	0.95		$	0.63
Cumulative effect of a change in accounting principle	—			—			—			(0.06		)
	$	0.40		$	0.36		$	0.95		$	0.57

DILUTED INCOME PER COMMON SHARE:
Income per common share before cumulative effect of a change in accounting principle	$	0.38		$	0.35		$	0.91		$	0.61
Cumulative effect of a change in accounting principle	—			—			—			(0.06		)
	$	0.38		$	0.35		$	0.91		$	0.55

WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING	55,573			55,128			55,510			55,044

WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING-ASSUMING DILUTION	64,552			56,730			64,497			56,971

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

CEPHALON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

																				Accumulated Other Comprehensive Income
										Additional Paid-in Capital
	Comprehensive Income (Loss)						Common Stock						Treasury Stock				Accumulated Deficit
(In thousands, except share data)				Total			Shares	Amount					Shares	Amount

BALANCE, JANUARY 1, 2002				$	398,731		54,909,533	$	549	$	982,123		223,741	$	(9,523	)	$	(576,691	)	$	2,273

Net income	$	171,528		171,528				—		—				—			171,528			—

Foreign currency translation gain	20,367
Unrealized investment gains	2,406
Other comprehensive income	22,773			22,773				—		—				—			—			22,773
Comprehensive income	$	194,301

Stock options exercised				5,940			347,686	4		6,056			2,055	(120		)	—			—

Tax benefit from the exercise of stock options				40,998				—		40,998				—			—			—

Restricted stock award plan				2,828			129,900	1		2,827				—			—			—

Employer contributions to employee benefit plan				2,133			38,722	—		2,133				—			—			—

Treasury stock acquired				(2,346		)		—		—			47,061	(2,346		)	—			—

BALANCE, DECEMBER 31, 2002				642,585			55,425,841	554		1,034,137			272,857	(11,989		)	(405,163		)	25,046

Net income	$	52,633		52,633				—		—				—			52,633			—

Foreign currency translation gain	14,907
Unrealized investment losses	(1,003		)
Other comprehensive income	13,904			13,904				—		—				—			—			13,904
Comprehensive income	$	66,537

Sale of warrants associated with convertible subordinated notes				178,315				—		178,315				—			—			—

Purchase of Convertible Hedge associated with convertible subordinated notes				(258,584		)				(258,584		)

Tax benefit from the purchase of Convertible Hedge				90,500						90,500

Stock options exercised				3,391			236,891	3		3,388				—			—			—

Tax benefit from the exercise of stock options				3,100				—		3,100				—			—			—

Restricted stock award plan				936			6,175	—		936				—			—			—

Employer contributions to employee benefit plan				829			18,588	—		829				—			—			—

Treasury stock acquired				(125		)		—		—			2,783	(125		)	—			—

BALANCE, SEPTEMBER 30, 2003 (Unaudited)				$	727,484		55,687,495	$	557	$	1,052,621		275,640	$	(12,114	)	$	(352,530	)	$	38,950

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

CEPHALON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Nine Months Ended September 30,
(In thousands)	2003			2002

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	52,633		$	31,534
Adjustments to reconcile net income to net cash provided by operating activities:
Deferred income taxes	15,227			—
Tax benefit from exercise of stock options	3,100			—
Depreciation and amortization	32,558			25,051
Amortization of debt issuance costs	6,837			9,082
Cumulative effect of changing inventory costing method from FIFO to LIFO	—			3,534
Stock-based compensation expense	1,765			3,511
Non-cash charge on early extinguishment of debt	3,615			7,142
Increase (decrease) in cash due to changes in assets and liabilities:
Receivables	(12,394		)	9,696
Inventory	(2,328		)	(2,646		)
Other assets	1,193			(3,956		)
Accounts payable, accrued expenses and deferred revenues	6,339			2,369
Other liabilities	(2,784		)	(738		)

Net cash provided by operating activities	105,761			84,579

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment	(28,983		)	(20,492		)
Investments in non-marketable securities	(32,975		)	—
Acquisition of intangible assets	—			(23,480		)
Sales and maturities (purchases) of investments, net	48,838			(86,752		)

Net cash used for investing activities	(13,120		)	(130,724		)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercises of common stock options	3,391			3,762
Payments to acquire treasury stock	(125		)	(171		)
Principal payments on and retirements of long-term debt	(200,757		)	(17,944		)
Net proceeds from issuance of convertible subordinated notes	727,085			—
Proceeds from sale of warrants	178,315			—
Purchase of convertible hedge	(258,584		)	—

Net cash provided by (used for) financing activities	449,325			(14,353		)

EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS	4,078			3,036

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS	546,044			(57,462		)

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD	486,097			548,727

CASH AND CASH EQUIVALENTS, END OF PERIOD	$	1,032,141		$	491,265

Supplemental disclosures of cash flow information:
Cash payments for interest	$	19,622		$	13,422
Non-cash investing and financing activities:
Capital lease additions	733			741
Tax benefit from the purchase of Convertible Hedge	90,500			—

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

CEPHALON, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Amounts in thousands, except share data

1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Business

Cephalon is an international biopharmaceutical company dedicated to the discovery, development and marketing of products to treat sleep disorders, neurological and psychiatric disorders, cancer and pain. In addition to conducting an active research and development program, we market three products in the United States and a number of products in various countries throughout Europe.

Our corporate and research and development headquarters are in West Chester, Pennsylvania, and we have offices in Salt Lake City, Utah, France, the United Kingdom, Germany and Switzerland. We operate manufacturing facilities in France for the production of modafinil, which is the active drug substance in PROVIGIL® (modafinil) tablets [C-IV], and other products marketed primarily in France. We also operate manufacturing facilities in Salt Lake City, Utah for the production of ACTIQ® (oral transmucosal fentanyl citrate) [C-II] for distribution and sale in the European Union and the United States.

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnote disclosures required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our annual report on Form 10-K, filed with the Securities and Exchange Commission, which includes audited financial statements as of December 31, 2002 and 2001 and for each of the three years in the period ended December 31, 2002. The results of our operations for any interim period are not necessarily indicative of the results of our operations for any other interim period or for a full year.

Foreign Currency

For our foreign operating entities with currencies other than the U.S. Dollar, the local currency is the functional currency and we translate asset and liability balances at exchange rates in effect at the end of the period, and income and expense transactions at the average exchange rates in effect during the period. Resulting translation adjustments are reported as a separate component of accumulated other comprehensive income included in stockholders’ equity. Gains and losses from foreign currency transactions are included in the consolidated statements of operations.

Statement of Financial Accounting Standards (SFAS) No. 95, “Statement of Cash Flows,” requires that the effect of exchange rate changes on cash held in foreign currencies be reported as a separate item in the reconciliation of beginning and ending cash and cash equivalents. All other foreign currency cash flows are reported in the applicable line of the consolidated statement of cash flows using an approximation of the exchange rate in effect at the time of the cash flows.

Revenue Recognition

In the United States, we sell our products to pharmaceutical wholesalers, the largest three of which account for over 90% of our current sales. Decisions made by these wholesalers regarding the levels of inventories they hold can materially affect the level of our sales in any period. We attempt to minimize these fluctuations, both by providing, from time to time, discounts to our customers to stock normal amounts of inventory and by canceling orders if we believe a particular customer is speculatively buying inventory in anticipation of possible price increases. We have no agreements, understandings, or business practices under which we have agreed to extend incentives based on

levels of inventory held by wholesalers, and any incentives we may offer are not intended to have any relation to the wholesaler’s cost of carrying inventory. We believe that wholesaler inventories as of September 30, 2003 for all three of our products were within a normal range. At September 30, 2003, inventory levels maintained by wholesalers and chains were less than one month’s supply for all three of our U.S. products according to IMS Health. Sales recorded for the quarter ended September 30, 2003 were generally representative of underlying demand for the products.

Product sales are recognized upon the transfer of ownership and risk of loss for the product to the customer. In the United States, we sell all commercial products F.O.B. shipping point. Transfer of ownership and risk of loss for the product pass to the customer at the point that the product is picked up by a common carrier for shipment to the customer. In Europe, product sales are recognized predominantly upon customer receipt of the product except in certain contractual arrangements where different terms may be specified. We record product sales net of estimated reserves for contractual allowances, discounts and returns. Contractual allowances result from sales under contracts with managed care organizations and government agencies.

Other revenue, which includes revenues from collaborative agreements, consists primarily of up-front fees, ongoing research and development funding, milestone payments and payments under co-promotional or managed services agreements. Non-refundable up-front fees are deferred and amortized to revenue over the related performance period. We estimate our performance period based on the specific terms of each collaborative agreement. We adjust the performance periods, if appropriate, based upon available facts and circumstances. We recognize periodic payments over the period that we perform the related activities under the terms of the agreements. Revenue resulting from the achievement of milestone events stipulated in the agreements is recognized when the milestone is achieved. Milestones are based upon the occurrence of a substantive element specified in the contract or as a measure of substantive progress towards completion under the contract.

Income Taxes

We account for income taxes using the liability method under SFAS No. 109, “Accounting for Income Taxes.” This method generally provides that deferred tax assets and liabilities be recognized for temporary differences between the financial reporting basis and the tax basis of the assets and liabilities and expected benefits of utilizing net operating loss and tax credit carryforwards. We record a valuation allowance for temporary differences if we believe that we are not likely to realize future tax benefits from them. The impact on deferred taxes of changes in tax rates and laws, if any, are applied to the years during which temporary differences are expected to be settled and reflected in the consolidated financial statements in the period of enactment.

We provided income taxes for the nine months ended September 30, 2003 at an effective rate of 36% of pretax income which is our expected effective tax rate for the year ending December 31, 2003. At September 30, 2003, the deferred tax asset recognized in our consolidated balance sheet is net of a valuation allowance of $45.6 million relating to certain tax credits, international operating loss carryforwards and temporary differences that we believe are not likely to be recovered.

Investments in Non-marketable Securities

We maintain investments in certain non-marketable securities of other unaffiliated entities, which are accounted for under the cost method and included in Other Assets in our consolidated balance sheets. At September 30, 2003 and December 31, 2002, we maintained investments in certain non-marketable securities of approximately $36.5 million and $5.5 million, respectively. We regularly assess whether these investments have been impaired and adjust the carrying values of these assets whenever events or changes in circumstances indicate that some or all of the carrying value of the assets may not be recoverable. In January 2003, we announced that we had entered into a five-year agreement with MDS Proteomics Inc. (MDSP), a subsidiary of MDS Inc., to utilize MDSP’s technologies with the objective of accelerating the clinical development of and broadening the market opportunities for our pipeline of small chemical compounds. MDSP will receive payments from us upon the successful achievement of specified milestones and will receive royalties from us on sales of products resulting from the collaboration. As part of the agreement, we purchased from MDSP a $30.0 million 5% convertible note due 2010. The note is convertible into

MDSP’s common stock at an initial conversion price of $22.00 per share, subject to adjustment if MDSP sells shares of its common stock at a lower price.

Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which requires recognition of the fair value of liabilities associated with the retirement of long-lived assets when a legal obligation to incur such costs arises as a result of the acquisition, construction, development and/or the normal operation of a long-lived asset. SFAS 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset and subsequently allocated to expense over the asset’s useful life. We adopted SFAS 143 on January 1, 2003. The adoption of this new standard did not impact our current financial statements.

In April 2002, the FASB issued SFAS No. 145 “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” This Statement amends or rescinds certain existing authoritative pronouncements including SFAS No. 4, “Reporting Gains and Losses on Extinguishment of Debt,” such that the provisions of Accounting Principles Board (APB) Opinion No. 30 “Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions” must now be followed to determine if the early extinguishment of debt should be classified as an extraordinary item. In addition, any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods that does not meet the criteria in APB 30 must be reclassified. SFAS 145 is effective for fiscal years beginning after May 15, 2002. We adopted this new standard effective December 31, 2002 and reclassified all gains and losses on early extinguishment of debt as other income and expense, rather than extraordinary items, in our current financial statements.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Exit or Disposal Activities.” This Statement addresses the recognition, measurement and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for pursuant to the guidance in Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The Statement requires that costs associated with exit or disposal activities be recorded at their fair values when a liability has been incurred. SFAS 146 is effective for disposal activities initiated after December 31, 2002. The adoption of this new standard did not impact our current financial statements.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” SFAS 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements describing the method of accounting for stock-based employee compensation and the effect of the method used on reported results.

We account for stock-based employee compensation arrangements in accordance with provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Compensation cost, if any, is measured as the excess of the quoted market price of the stock at the date of grant over the amount an employee must pay to acquire the stock. We have opted to disclose only the provisions of SFAS 123, “Accounting for Stock-Based Compensation,” and SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – An Amendment to FASB Statement No. 123,” as they pertain to financial statement recognition of compensation expense attributable to option grants. As such, no compensation cost has been recognized for our stock option plans. If we had elected to recognize compensation cost based on the fair value of granted stock options as prescribed by SFAS 123 and SFAS 148, the pro forma income and income per share amounts would have been as follows:

	For the three months ended September 30,						For the nine months ended September 30,
	2003			2002			2003			2002
Income applicable to common shares, as reported	$	22,272		$	19,976		$	52,633		$	31,534
Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects	(7,808		)	(8,425		)	(23,073		)	(25,781		)
Pro forma income applicable to common shares for basic income per share calculation	$	14,464		$	11,551		$	29,560		$	5,753
Earnings per share:
Basic income per share, as reported	$	0.40		$	0.36		$	0.95		$	0.57
Basic income per share, pro forma	$	0.26		$	0.21		$	0.53		$	0.10

Diluted income per share, as reported	$	0.38		$	0.35		$	0.91		$	0.55
Diluted income per share, pro forma	$	0.25		$	0.20		$	0.52		$	0.10

In November 2002, the FASB issued FASB Interpretation (FIN) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees.” This Interpretation requires that upon the issuance of a guarantee, the guarantor must recognize a liability for the fair value of the obligation it assumes under that guarantee. FIN 45 is effective for guarantees issued or modified after December 31, 2002. The adoption of this new statement did not impact our current financial statements.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. FIN 46 also requires disclosures about variable interest entities that a company is not required to consolidate but in which it has a significant variable interest. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003 and to existing entities in the first fiscal year or interim period ending after December 15, 2003. Certain of the disclosure requirements apply to all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. As a result of the adoption of this standard, Cephalon Clinical Partners, L.P. will be consolidated in our financial statements in the fourth quarter of 2003. This consolidation will not have a material impact on our financial statements. Our investments in non-marketable securities of other entities are not considered variable interest entities and, therefore, we have not consolidated these entities.

In April 2003, the FASB issued SFAS No. 149, “Amendment of FASB Statement 133 on Derivative Instruments and Hedging Activities.” This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” This Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative discussed in SFAS No. 133, clarifies when a derivative contains a financing component, amends the definition of an “underlying” to conform it to language used in FIN No. 45, and amends certain other existing pronouncements. This Statement is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of this new standard did not have any effect on our current financial statements.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). This

Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. This new standard has been considered in accounting for our Convertible Note Hedge and Warrants - see Note 7.

In May 2003, the FASB’s Emerging Issues Task Force reached consensus on Issue 00-21. This Issue addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. Specifically, this Issue addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. In applying this Issue, separate contracts with the same entity or related parties that are entered into at or near the same time are presumed to have been negotiated as a package and should, therefore, be evaluated as a single arrangement in considering whether there are one or more units of accounting. That presumption may be overcome if there is sufficient evidence to the contrary. This Issue also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. The guidance in this Issue is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The application of this Issue did not have any effect on our current financial statements.

2. JOINT VENTURE

In December 2001, we formed a joint venture with unaffiliated third party investors to fund additional commercial activities in support of PROVIGIL and GABITRIL in the United States. In exchange for our transfer to the joint venture of certain intellectual property and other rights related to these two products, we received a Class B interest, representing a 50% interest in the joint venture. In exchange for a contribution of $50.0 million in cash to the joint venture, the investors received Class A interests, also representing a 50% interest in the joint venture. As of December 31, 2001, the $50.0 million investors’ Class A interest was recorded on our balance sheet as long-term debt, and the joint venture’s cash balance of $50.0 million was included in our balance of cash and cash equivalents.

On March 29, 2002, we acquired the investors’ Class A interests and ended the joint venture by issuing to the investors, through a private placement, $55.0 million aggregate principal amount of 3.875% convertible subordinated notes due March 2007.

The purchase of the investor’s Class A interests in the joint venture resulted in the recognition of a charge of $7.1 million on the early extinguishment of debt during the first quarter of 2002. The following table summarizes the calculation of this charge:

Carrying value of the debt as of December 31, 2001	$	50,000
Interest accreted during the first quarter 2002 at 20%	2,500
Carrying value of the debt as of March 29, 2002	52,500
Less: unamortized joint venture formation costs as of March 29, 2002	(4,642		)
	47,858
Fair value of subordinated notes issued on March 29, 2002	(55,000		)
Charge on early extinguishment of debt	$	(7,142	)

In addition, our statement of operations for the nine months ended September 30, 2002 included certain charges related to the operations of the joint venture, as follows:

Selling, general and administrative expenses	$	3,508
Interest expense	3,163
Interest income	(190		)
Total	$	6,481

3. CASH, CASH EQUIVALENTS AND INVESTMENTS

Cash, cash equivalents and investments consisted of the following:

	September 30, 2003		December 31, 2002
Cash and cash equivalents:
Demand deposits and money market funds	$	191,667	$	486,097
Asset-backed securities	125,000		—
Repurchase agreements	334,530		—
Commercial paper	380,944		—
	1,032,141		486,097

Short-term investments (at market value):
U.S. government agency obligations	—		4,994
Asset-backed securities	23,320		65,796
Bonds	23,430		25,801
	46,750		96,591

Total cash, cash equivalents and investments	$	1,078,891	$	582,688

The contractual maturities of our investments in cash, cash equivalents, and investments at September 30, 2003 are as follows:

Less than one year	$	1,032,162
Greater than one year but less than two years	6,369
Greater than two years	40,360
	$	1,078,891

4. RECEIVABLES

Receivables consisted of the following:

	September 30, 2003			December 31, 2002
Trade receivables	$	90,542		$	63,659
Receivables from collaborations	13,034			12,321
Other receivables	5,581			12,251
	109,157			88,231
Reserve for sales discounts, returns and allowances	(9,276		)	(5,101		)
	$	99,881		$	83,130

5. INVENTORY

Inventory consisted of the following:

	September 30, 2003		December 31, 2002
Raw materials	$	23,342	$	28,628
Work-in-process	7,266		2,448
Finished goods	28,852		23,223
	$	59,460	$	54,299

Effective January 1, 2002, we changed our method of valuing domestic inventories from the first-in, first-out, or FIFO method, to the last-in, first-out, or LIFO method. We recognized a charge of $3.5 million in the first quarter of 2002 as the cumulative effect of adopting the LIFO inventory costing method. The acquisition of additional manufacturing operations at the end of 2001 and the expansion of our internal manufacturing capacity for ACTIQ has reduced our reliance on third party manufacturers. The expansion of our internal manufacturing capabilities should allow us to benefit from efficiencies of scale and lead to lower per unit inventory costs. The LIFO method will reflect these expected changes to manufacturing costs on the statement of operations on a more timely basis, resulting in a better matching of current costs of products sold with product revenues.

6. OTHER INTANGIBLE ASSETS, NET

Other intangible assets consisted of the following:

	September 30, 2003						December 31, 2002
	Gross Carrying Amount		Accumulated Amortization		Net Carrying Amount		Gross Carrying Amount		Accumulated Amortization		Net Carrying Amount
Developed technology acquired from Lafon	$	132,000	$	17,267	$	114,733	$	132,000	$	9,867	$	122,133
Trademarks/tradenames acquired from Lafon	16,000		1,867		14,133		16,000		1,067		14,933
GABITRIL product rights	114,163		18,692		95,471		110,749		12,431		98,318
Novartis CNS product rights	41,641		11,451		30,190		41,641		8,328		33,313
ACTIQ marketing rights	75,465		14,143		61,322		75,465		8,396		67,069
Modafinil marketing rights	8,739		848		7,891		7,906		209		7,697
Other product rights	13,651		5,940		7,711		12,377		4,121		8,256
	$	401,659	$	70,208	$	331,451	$	396,138	$	44,419	$	351,719

Other intangible assets are amortized over their estimated useful economic life using the straight-line method. Amortization expense was $8.3 million and $7.4 million for the three months ended September 30, 2003 and 2002, respectively, and $24.8 million and $20.2 million for the nine months ended September 30, 2003 and 2002, respectively. Estimated amortization expense of intangible assets for each of the next five fiscal years is approximately $32.8 million.

7. LONG-TERM DEBT

Long-term debt consisted of the following:

	September 30, 2003			December 31, 2002
2.5% convertible subordinated notes due December 2006	$	602,677		$	600,000
Zero Coupon convertible subordinated notes first putable June 2008	375,000			—
Zero Coupon convertible subordinated notes first putable June 2010	375,000			—
5.25% convertible subordinated notes due May 2006	—			183,000
3.875% convertible subordinated notes due March 2007	43,000			55,000
Due to Abbott Laboratories	16,406			17,162
Mortgage and building improvement loans	10,505			10,940
Capital lease obligations	2,429			2,594
Other	5,762			7,603
Total debt	1,430,779			876,299
Less current portion	(14,133		)	(15,402		)
Total long-term debt	$	1,416,646		$	860,897

Interest Rate Swaps

In January 2003, we entered into an interest rate swap agreement with a financial institution, relating to our $600.0 million 2.5% convertible subordinated notes, in the aggregate notional amount of $200.0 million. Under the swap, we agreed to pay a variable interest rate on this $200.0 million notional amount equal to LIBOR-BBA + .29% in exchange for the financial institution’s agreement to pay a fixed rate of 2.5%. The variable interest rate is re-calculated at the beginning of each quarter. The interest rate in effect during the third quarter of 2003 was 1.39%. We also agreed to provide the financial institution with cash collateral to support our obligations under the agreement. The initial collateral amount was $3.0 million and was recorded in Other Assets in our consolidated balance sheet. We increased the carrying value of the subordinated notes by $2.2 million at the time the agreement was made. This amount is being amortized over the four-year term of the agreement. At the end of each quarter, we record an adjustment to the carrying value of the subordinated notes and the amount due for settling the interest rate swap based on their fair values as of that date. The carrying value of the interest rate swap was $0.8 million as of September 30, 2003 and is recorded in Other Assets in our consolidated balance sheet.

Zero Coupon Convertible Subordinated Notes

On June 11, 2003, we issued and sold in a private placement $750.0 million of Zero Coupon Convertible Subordinated Notes (the “Notes”). The interest rate on the Notes is zero and the notes will not accrete interest. The Notes were issued in two tranches and have the following salient terms:

• $375.0 million of Zero Coupon Convertible Subordinated Notes due June 15, 2033, first putable for cash on June 15, 2008 (the “2008 Notes”) at a price of 100.25% of the face amount of the notes. The holders of the 2008 Notes may also require us to repurchase all or a portion of the 2008 Notes for cash on June 15, 2013, June 15, 2018, June 15, 2023 and June 15, 2028, in each case at a price equal to the face amount of the notes. The 2008 Notes are convertible prior to maturity, subject to certain conditions described below, into shares of our common stock at a conversion price of $59.50 per share (a conversion rate of approximately 16.8067 shares per $1,000 principal amount of notes). We may redeem any outstanding 2008 Notes for cash on June 15, 2008 at a price equal to 100.25% of the principal amount of such notes redeemed and after June 15, 2008 at a price equal to 100% of the principal amount of such notes redeemed; and

• $375.0 million of Zero Coupon Convertible Subordinated Notes due June 15, 2033, first putable for cash on June 15, 2010 (the “2010 Notes”) at a price of 100.25% of the face amount of the notes. The holders of the 2010 Notes may also require us to repurchase all or a portion of the 2010 Notes for cash on June 15, 2015, June 15, 2020, June 15, 2025 and June 15, 2030, in each case at a price equal to the face amount of the notes. The 2010 Notes are convertible prior to maturity, subject to certain conditions described below, into shares of our common stock at a conversion price of $56.50 per share (a conversion rate of approximately 17.6991 shares per $1,000 principal amount of notes). We may redeem any outstanding 2010 Notes for cash on June 15, 2010 at a price equal to 100.25% of the principal amount of such notes redeemed and after June 15, 2010 at a price equal to 100% of the principal amount of such notes redeemed.

The aggregate commissions and other debt issuance costs incurred with respect to the Notes were $22.9 million, which have been capitalized in Debt Issuance Costs on our consolidated balance sheet and are being amortized over five and seven years. The Notes are subordinate to our existing and future senior indebtedness. The outstanding principal balance of the 2008 and 2010 Notes will be first classified as Current Portion of Long-Term Debt during the twelve months prior to the respective dates on which the Notes are first putable.

The Notes also contain restricted convertibility terms that do not affect the conversion price of the notes but, instead, place restrictions on a holder’s ability to convert their notes into shares of our common stock (“conversion shares”). A holder may convert the notes if one or more of the following conditions are satisfied:

• if, on the trading day prior to the date of surrender, the closing sale price of our common stock is more than 120% of the applicable conversion price per share (the “conversion price premium”);

• if we have called the notes for redemption;

• if the average of the trading prices of the notes for a specified period is less than 100% of the average of the conversion values of the notes during that period; provided, however, that no notes may be converted based on the satisfaction of this condition during the six-month period immediately preceding each specified date on which the holders may require us to repurchase their notes (for example, with respect to the June 15, 2008 put date for the 2008 notes, the 2008 Notes may not be converted from December 15, 2007 to June 15, 2008); or

• if we make certain significant distributions to our holders of common stock or we enter into specified corporate transactions.

Because of the inclusion of the restricted convertibility terms of the Notes, our diluted income per common share calculation does not give effect to the dilution from the conversion of the Notes until our share price exceeds the 20% conversion price premium or one of the other conditions above is satisfied.

Convertible Note Hedge Strategy

Concurrent with the private placement of the Notes, we purchased a Convertible Note Hedge from Credit Suisse First Boston International (CSFBI) at a cost of $258.6 million. We also sold to CSFBI warrants to purchase an aggregate of 12,939,689 shares of our common stock and received net proceeds from the sale of $178.3 million. Taken together, the Convertible Note Hedge and warrants have the effect of increasing the effective conversion price of the notes from our perspective to $72.08, a 50% premium to the last reported Nasdaq composite bid for our common stock on the day preceding the date of these agreements. At our option, the Convertible Note Hedge and warrants may be settled in either net cash or net shares. If we elect to settle both instruments in cash, we would receive an amount equal to zero if the market price per share of our stock is at or below $56.50 to a maximum of $182.6 million if the market price per share is at or above $72.08. If we elect to settle the Convertible Note Hedge and warrants in shares, we would receive shares of our stock from CSFBI, not to exceed 2.5 million shares, with a value equal to the amount otherwise receivable on cash settlement. In accordance with Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled In, a Company’s Own Stock” and SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” we have recorded the Convertible Note Hedge and warrants in additional paid in capital as of June 30, 2003, and will not recognize subsequent changes in fair value. We also recognized a deferred tax asset

of $90.5 million in the second quarter of 2003 for the effect of the future tax benefits related to the Convertible Note Hedge.

The warrants have a strike price of $72.08. Of the total warrants sold, 6,302,521 warrants expire on June 15, 2008, with the remaining 6,637,168 warrants expiring on June 15, 2010. The warrants are exercisable only on the respective expiration dates (European style) or upon the conversion of the notes, if earlier.

Convertible Subordinated Notes Purchases/Redemption

In March 2003, we purchased $2.0 million of the 5.25% notes in the open market at a 2.5% discount. In April 2003, we purchased $7.0 million of the 5.25% notes in the open market at par value. In July 2003, we redeemed for cash all of the $174.0 million outstanding 5.25% notes at a redemption price of 103.15% per $1,000 aggregate principal amount of notes. In July 2003, we purchased $12.0 million of the 3.875% notes from one of the holders in a private transaction at a price of 106% of the face amount of the notes.

During the third quarter of 2003, $9.8 million was recognized in our financial statements as a charge on early extinguishment of debt as follows:

	Principal Amount		Premium		Write-off of unamortized debt issuance costs		Total Charge On Early Extinguishment of Debt
5.25% Notes redeemed in July 2003	174,000		5,481		3,598		9,079
3.875% Notes purchased in July 2003	12,000		720		17		737
	$	186,000	$	6,201	$	3,615	$	9,816

8. COMMITMENTS AND CONTINGENCIES

Takeover Bid for SIRTeX Medical Limited

On March 7, 2003, our wholly-owned subsidiary, Cephalon Australia Pty. Limited, formally commenced a takeover bid for SIRTeX Medical Limited, an Australian public company. The bid was subject to a number of conditions, including the requirement that we obtain an interest in at least 90% of the issued share capital of SIRTeX. On May 27, 2003, we announced that our bid had expired prior to our satisfying this 90% condition. The net aggregate impact to our statement of income for the six months ended June 30, 2003 from this expired bid was a gain of $2.5 million, consisting of a gain from our forward exchange contract to protect against fluctuations in the Australian Dollar against the U.S. Dollar, offset by costs incurred in connection with the bid.

Cephalon Clinical Partners, L.P.

In August 1992, we exclusively licensed our rights to MYOTROPHIN for human therapeutic use within the United States, Canada and Europe to Cephalon Clinical Partners, L.P. (CCP). A subsidiary of Cephalon is the sole general partner of CCP. We developed MYOTROPHIN on behalf of CCP under a research and development agreement. Under this agreement, CCP granted us an exclusive license to manufacture and market MYOTROPHIN for human therapeutic use within the United States, Canada and Europe, and we agreed to make royalty payments equal to a percentage of product sales and a milestone payment of approximately $16.0 million upon regulatory approval. We have a contractual option, but not an obligation, to purchase all of the limited partnership interests of CCP, which is exercisable upon the occurrence of certain events following the first commercial sale of MYOTROPHIN. If, and only if, we decide to exercise this purchase option, we would make an advance payment of approximately $40.3 million in cash or, at our election, approximately $42.4 million in shares of common stock or a combination thereof. If we discontinue development of MYOTROPHIN, or if we do not exercise this purchase option, our license will terminate and all rights to manufacture or market MYOTROPHIN in the United States, Canada and Europe will revert to CCP, which may then commercialize MYOTROPHIN itself or license or assign its

rights to a third party. In that event, we would not receive any benefits from such commercialization, license or assignment of rights.

Legal Proceedings

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

9. COMPREHENSIVE INCOME

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

	Three months ended September 30,					Nine months ended September 30,
	2003			2002		2003			2002
Net income	$	22,272		$	19,976	$	52,633		$	31,534

Foreign currency translation adjustment	2,597			595		14,907			10,032
Unrealized investment gains (losses)	(572		)	1,687		(1,003		)	3,452
Other comprehensive income	2,025			2,282		13,904			13,484

Comprehensive income	$	24,297		$	22,258	$	66,537		$	45,018

10. EARNINGS PER SHARE

We compute income per common share in accordance with SFAS No. 128, “Earnings Per Share.” Basic income per common share is computed based on the weighted average number of common shares outstanding during the period. Diluted income per common share is computed based on the weighted average shares outstanding and the dilutive impact of common stock equivalents outstanding during the period. The dilutive effect of employee stock options and restricted stock awards is measured using the treasury stock method. The dilutive effect of convertible notes is measured using the “if-converted” method. Common stock equivalents are not included in periods where there is a loss, as they are anti-dilutive. Because of the inclusion of the restricted convertibility terms of the Zero Coupon Convertible Subordinated Notes, our diluted income per common share calculation does not give effect to the dilution from the conversion of the notes until our share price exceeds the 120% conversion price premium. See Note 7. The following is a reconciliation of net income and weighted average common shares outstanding for purposes of calculating basic and diluted income per common share:

	Three months ended September 30,				Nine months ended September 30,
	2003		2002		2003		2002
Basic income per share computation:
Numerator:
Income before cumulative effect of a change in accounting principle	$	22,272	$	19,976	$	52,633	$	35,068
Cumulative effect of a change in accounting principle	—		—		—		(3,534		)
Net income used for basic income per common share	$	22,272	$	19,976	$	52,633	$	31,534

	Three months ended September 30,				Nine months ended September 30,
	2003		2002		2003		2002
Denominator:
Weighted average shares used for basic income per common share	55,573,000		55,128,000		55,510,000		55,044,000

Basic income per common share:
Income per common share before cumulative effect of a change in accounting principle	$	0.40	$	0.36	$	0.95	$	0.63
Cumulative effect of a change in accounting principle	—		—		—		(0.06		)
	$	0.40	$	0.36	$	0.95	$	0.57
Diluted income per share computation:
Numerator:
Income before cumulative effect of a change in accounting principle	$	22,272	$	19,976	$	52,633	$	35,068
Cumulative effect of a change in accounting principle	—		—		—		(3,534		)
Net income used for basic income per common share	22,272		19,976		52,633		31,534
Interest on convertible subordinated notes (net of tax)	2,049		—		6,359		—
Net income used for diluted income per common share	$	24,321	$	19,976	$	58,992	$	31,534

Denominator:
Weighted average shares used for basic income per common share	55,573,000		55,128,000		55,510,000		55,044,000
Effect of dilutive securities:
Employee stock options and restricted stock awards	1,571,000		1,602,000		1,579,000		1,927,000
Convertible subordinated notes	7,408,000		—		7,408,000		—
Weighted average shares used for diluted income per common share	64,552,000		56,730,000		64,497,000		56,971,000

Diluted income per common share:
Income per common share before cumulative effect of a change in accounting principle	$	0.38	$	0.35	$	0.91	$	0.61
Cumulative effect of a change in accounting principle	—		—		—		(0.06		)
	$	0.38	$	0.35	$	0.91	$	0.55

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

	Three months ended September 30,		Nine months ended September 30,
	2003	2002	2003	2002
Weighted average shares excluded:
Employee stock options	5,674,000	3,633,000	5,698,000	2,317,000
Convertible subordinated notes	13,730,000	10,662,000	7,702,000	10,662,000
	19,404,000	14,295,000	13,400,000	12,979,000

In addition, we have excluded shares related to zero coupon convertible note warrants of 12.9 million and 5.3 million for the three and nine months ended September 30, 2003 respectively, and all of the shares related to the Convertible Note Hedge, as such shares would be anti-dilutive. The convertible note hedge and warrant transactions are expected to reduce the potential dilution from the conversion of the zero coupon convertible subordinated notes from 12.9 million shares to as few as 10.4 million shares.

11. SEGMENT AND SUBSIDIARY INFORMATION

We have significant sales, manufacturing, and research operations conducted by several subsidiaries located in Europe. Prior to 2002, our European operations were immaterial.

Although we have significant European operations, we have determined that all of our operations have similar economic characteristics and may be aggregated with our United States operations into a single operational segment for reporting purposes. Summarized revenue and long-lived asset information by geographic region is provided below:

Revenues:

	Three months ended September 30,				Nine months ended September 30,
	2003		2002		2003		2002
United States	$	155,507	$	100,349	$	402,574	$	275,908
Europe	34,536		30,014		100,993		86,683
Total	$	190,043	$	130,363	$	503,567	$	362,591

Long-lived assets:

	September 30, 2003		December 31, 2002
United States	$	499,463	$	383,768
Europe	530,889		519,342
Total	$	1,030,352	$	903,110

12. SUBSEQUENT EVENTS

On November 3, 2003, we entered into an Agreement and Plan of Merger with CIMA LABS INC. Pursuant to this agreement, we will acquire CIMA through the merger of a wholly-owned subsidiary of Cephalon with and into CIMA, with CIMA surviving as a wholly-owned subsidiary of Cephalon. In connection with the merger, each outstanding share of CIMA common stock will be converted into the right to receive $34.00 per share in cash. Each outstanding option to purchase CIMA common stock, whether or not vested or exercisable, will be converted into the right to receive in cash an amount equal to $34.00 less the exercise price for such option. The total value of the transaction is approximately $515 million, or $397 million net of CIMA’s cash and cash equivalents. The completion

of the transaction is subject to several conditions, including the approval of the merger by the stockholders of CIMA and the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976. We expect the merger to be completed in the first quarter of 2004.

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

The following discussion should be read in conjunction with our audited financial statements, including the related notes, presented in our Annual Report on Form 10-K for the year ended December 31, 2002.

RECENT DEVELOPMENTS

Since June 30, 2003, we have announced the following significant events:

On September 25, 2003, we announced that the Peripheral and Central Nervous System Drugs Advisory Committee of the FDA had recommended that the label for PROVIGIL be expanded. As part of that announcement, we indicated our intent to increase the number of persons in our existing sales force in anticipation of this expanded label. On October 21, 2003, we announced that we had received an approvable letter from the FDA stating that PROVIGIL was approvable for improving wakefulness in patients with excessive sleepiness associated with shift work sleep disorder and in patients with obstructive sleep apnea/hypopnea syndrome. We expect to launch these new indications for PROVIGIL in the first quarter of 2004, subject to final FDA approval and the determination of the precise wording of the label for PROVIGIL with respect to these new indications.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions are developed, and challenged periodically, by management based on historical experience and on various other factors that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

Our significant accounting policies are described in Note 1 to the consolidated financial statements included in Item 1 of this Form 10-Q and Note 1 to the consolidated financial statements included in Item 8 of our Form 10-K for the year ended December 31, 2002. The SEC defines critical accounting policies as those that are, in management’s view, most important to the portrayal of the company’s financial condition and results of operations and most demanding of their judgment. Management considers the following policies to be critical to an understanding of our consolidated financial statements and the uncertainties associated with the complex judgments made by us that could impact our results of operations, financial position and cash flows.

Revenue recognition, current—In the United States, we sell our products to pharmaceutical wholesalers, the largest three of which account for over 90% of our current sales. Decisions made by these wholesalers regarding the levels of inventories they hold can materially affect the level of our sales in any period. We attempt to minimize these fluctuations, both by providing, from time to time, discounts to our customers to stock normal amounts of inventory and by canceling orders if we believe a particular customer is speculatively buying inventory in anticipation of

possible price increases. We have no agreements, understandings, or business practices under which we have agreed to extend incentives based on levels of inventory held by wholesalers, and any incentives we may offer are not intended to have any relation to the wholesaler’s cost of carrying inventory. We believe that wholesaler inventories as of September 30, 2003 for all three of our products were within a normal range. At September 30, 2003, inventory levels maintained by wholesalers and chains were less than one month’s supply for all three of our U.S. products, according to IMS Health. Sales recorded for the quarter ended September 30, 2003 were generally representative of underlying demand for the products.

Payments under co-promotional or managed services agreements are recognized over the period when the products are sold or the promotional activities are performed. The portion of the payments that represent reimbursement of our expenses are recognized as an offset to those expenses in our statement of income.

Inventories— Our inventories are valued at the lower of cost or market, and include the cost of raw materials, labor, overhead and shipping and handling costs. Cost is computed on domestic inventories using the last-in, first-out (LIFO) method. For the majority of our foreign inventories, the first-in, first-out (FIFO) method is utilized. The majority of our inventories are subject to expiration dating. We regularly evaluate the carrying value of our inventories and when, in our opinion, factors indicate that impairment has occurred, we establish a reserve against the inventories’ carrying value. Our determination that a valuation reserve might be required, in addition to the quantification of such reserve, requires us to utilize significant judgment. We base our analysis, in part, on the level of inventories on hand in relation to our estimated forecast of product demand, production requirements over the next 12 months and the expiration dates of raw materials and finished goods. Although we make every effort to ensure the accuracy of forecasts of future product demand, any significant unanticipated decreases in demand could have a material impact on the carrying value of our inventories and our reported operating results. To date, inventory adjustments have not been material.

Valuation of Property and Equipment, Goodwill, Intangible Assets and Investments— Our property and equipment has been recorded at cost and is being amortized on a straight-line basis over the estimated useful life of those assets. Our intangible assets (which consist primarily of developed technology, trademarks, and product and marketing rights), are amortized over estimated useful lives which are intended to approximate the estimated pattern of economic benefits generated by the asset. Determining the “estimated pattern of economic benefit” for an intangible asset is a highly subjective and difficult assessment. To the extent that the pattern cannot be reliably determined, a straight line amortization method is used.

In conjunction with acquisitions of businesses or product rights, we allocate the purchase price based upon the relative fair values of the assets acquired and liabilities assumed. In certain circumstances, fair value may be assigned to purchased in-process technology and expensed immediately.

We regularly assess whether intangibles, long-lived assets and goodwill have been impaired and adjust the carrying values of these assets whenever events or changes in circumstances indicate that some or all of the carrying value of the assets may not be recoverable. Our judgments regarding the existence of impairment indicators are based on legal factors, market conditions and operating performances of our businesses and products. Future events could cause us to conclude that impairment indicators exist and that the carrying values of our property and equipment, intangible assets or goodwill are impaired. Any resulting impairment loss could have a material adverse impact on our financial position and results of operations. No impairment losses have been recorded to date.

We evaluate our investments in non-marketable securities of outside entities on a quarterly basis by reviewing key indicators of the entities’ financial performance, condition and outlook. We review the entities’ most recent financial statements and discuss the entities’ current and future financial and operational strategies with their senior management personnel. We also discuss with our senior research and development personnel the current status of and future expectations for any collaborative agreements we have with those entities. Based on this information, we make a determination as to whether any impairment in the carrying value of our investments exists. This determination is a highly subjective process that is based on the evaluation of qualitative information and numerous assumptions as to future events. Nonetheless, we believe our evaluation process provides a reasonable basis for our determination. Any impairment loss on one or more of our investments could have a material adverse impact on our financial position and results of operations.

We evaluate the recoverability and measure the possible impairment of our goodwill under Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets.” The impairment test is a two-step process that begins with the estimation of the fair value of the reporting unit. The first step screens for potential impairment, and the second step measures the amount of the impairment, if any. Our estimate of fair value considers publicly available information regarding the market capitalization of our company, as well as (i) publicly available information regarding comparable publicly-traded companies in the pharmaceutical industry, (ii) the financial projections and future prospects of our business, including our growth opportunities and likely operational improvements, and (iii) comparable sales prices, if available. As part of the first step to assess potential impairment, we compare our estimate of fair value for the company to the book value of our consolidated net assets. If the book value of our consolidated net assets were greater than our estimate of fair value, we would then proceed to the second step to measure the impairment, if any. The second step compares the implied fair value of goodwill with its carrying value. The implied fair value is determined by allocating the fair value of the reporting unit to all of the assets and liabilities of that unit as if the reporting unit had been acquired in a business combination, and the fair value of the reporting unit was the purchase price paid to acquire the reporting unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. If the carrying amount of the reporting unit goodwill is greater than its implied fair value, an impairment loss will be recognized in the amount of the excess.

We performed our annual test of impairment of goodwill as of July 1, 2003. We have only one reporting unit, a pharmaceutical unit, that constitutes our entire business. We compared the fair value of this reporting unit with its carrying value. Our quoted market value at July 1, 2003 was used as the fair value of the reporting unit. Since the fair value of the reporting unit exceeded its carrying value at July 1, 2003, no adjustment to our goodwill for impairment is necessary.

On a quarterly basis, we perform a review of our business to determine if events or changes in circumstances have occurred that could have a material adverse effect on the fair value of our company and its goodwill. If we determine that such events or changes in circumstances have occurred, we would consult with one or more valuation specialists in estimating the impact of these on our estimate of fair value. We believe the estimation methods are reasonable and reflective of common valuation practices.

Income taxes—We provide for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” which requires the recognition of deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax and financial reporting bases of assets and liabilities.

Prior to 2002, we had a history of losses from our operations, which generated significant international, federal and state net operating loss carryforwards. We record a valuation allowance against deferred tax assets if we

believe that we are not likely to realize future tax benefits from them. Based on our profitability for the year ended December 31, 2002 and projected future results, in the fourth quarter of 2002, we concluded that it was likely that we would be able to realize a significant portion of the deferred tax assets, and therefore, we reversed a significant portion of the valuation allowance. As a result, beginning in 2003, we are providing for income taxes at a rate equal to our estimated annual combined federal, state and foreign statutory effective rates. Subsequent adjustments to our estimates of our ability to recover the deferred tax assets or other changes in circumstances or estimates could cause our provision for income taxes to vary from period to period.

RESULTS OF OPERATIONS

Three months ended September 30, 2003 compared to three months ended September 30, 2002

	Three months ended September 30,
In thousands:	2003		2002

Sales:*
PROVIGIL	$	79,746	$	52,898
ACTIQ	65,451		35,025
GABITRIL	17,243		13,429
Other	22,437		21,012
Total sales	184,877		122,364

Total other revenues	5,166		7,999

Total revenues	$	190,043	$	130,363

* Certain sales amounts for the three months ended September 30, 2002 have been reclassified to conform to current period presentation.

Revenues—Total sales in the third quarter of 2003 increased 51% over the third quarter of 2002. The increase is attributable to a number of factors including:

• Sales of PROVIGIL increased 51% as compared to the same period last year. The increase was the result of strong U.S. demand for PROVIGIL as indicated by a 31% increase in prescriptions, according to IMS Health, driven by an expansion of both our sales force and marketing efforts, and by aggregate domestic price increases in 2003 of approximately 5.1%. International sales of PROVIGIL increased by $3.7 million during the period.

• Sales of ACTIQ increased 87% as compared to the same period last year. This increase was due, in part, to an expanded sales force and continued, focused marketing efforts to pain specialists as indicated by a 82% increase in U.S. prescriptions, according to IMS Health.

• Sales of GABITRIL increased 28% compared to the same period last year. Domestic sales increased 27% driven by an expansion of both our sales force and marketing efforts as indicated by a 43% increase in U.S. prescriptions, according to IMS Health. Average aggregate increases in domestic prices of approximately 6.5% in 2003 also contributed to higher sales recorded in the third quarter of 2003.

• Other sales consist primarily of sales of other products and certain third party products in various international markets, principally in France. A strengthening of the Euro versus the U.S. dollar favorably impacted sales in the third quarter of 2003.

reduction in the amount of revenue recorded under our agreements with Sanofi-Synthélabo and Novartis Pharma AG. The level of other revenue recognized from period to period may continue to fluctuate based on the status of each related project and terms of each collaboration agreement. Therefore, past levels of other revenues may not be indicative of future levels.

Cost of Sales— The cost of sales was approximately 12% of net sales for the third quarter of 2003 and 16% of net sales for the third quarter of 2002. The decrease is primarily due to cost savings we realized when we began utilizing our Salt Lake City facility as our sole manufacturer of ACTIQ beginning in June 2003.

Research and Development Expenses—Research and development expenses increased $13.8 million, or 45%, to $44.5 million for the third quarter of 2003 from $30.7 million for the third quarter of 2002. Approximately $9.3 million of this increase is due to costs associated with additional clinical studies conducted in 2003 to explore the utility of GABITRIL beyond its current indication, increased expenditures associated with the Phase 2/3 study of CEP-1347 in Parkinson’s Disease and costs incurred on Phase 1 studies of the R-isomer of modafinil. In the third quarter of 2003, we also recorded a $2.0 million charge relating to the write-off as an R&D expense of the value of an investment in an unaffiliated entity. These increases were offset by a decrease in expenditures of $2.2 million related predominantly to producing clinical supplies in 2002 for our Phase 1 studies associated with our angiogenesis inhibitors program in collaboration with Sanofi-Synthélabo.

Selling, General and Administrative Expenses—Selling, general and administrative expenses increased $18.3 million, or 41%, to $63.5 million for the third quarter of 2003 from $45.2 million for the third quarter of 2002. Sales and marketing costs increased $18.2 million in the U.S. as a result of the expansion of our field sales forces, additional product promotional expenses and an increased number of medical education programs. This increase was partially offset by a $2.0 million expense recorded in the third quarter of 2002 related to moving our manufacturing activities from a contractor to our Salt Lake City facility.

Depreciation and Amortization Expenses—Depreciation and amortization expenses increased $2.3 million, or 26%, to $11.0 million for the third quarter of 2003 from $8.7 million for the third quarter of 2002. Of this increase, $1.2 million is attributable to additional amortization in 2003 associated with the October 2002 acquisition of ACTIQ marketing rights in certain countries, principally in Europe. Depreciation expense increased by $0.8 million as a result of increased purchases for manufacturing equipment at our Salt Lake City location for the production of ACTIQ for the U.S. market and increased capital spending on building improvements at both our West Chester and Salt Lake City locations.

Other Income and Expense—Total other expenses, net, increased $8.9 million, or 187%, to $13.6 million for the third quarter of 2003 from $4.7 million for the third quarter of 2002 due primarily to:

In Millions
$	9.8		the recognition of a pre-tax charge associated with the redemption of the outstanding balance of 5.25% convertible notes, and the repurchase of a portion of our 3.875% convertible notes,
(2.6		)	a decrease in interest and amortization expense associated with the redemption of our 5.25% convertible notes,
(0.7		)	a decrease in interest expense on our 2.5% convertible subordinated notes as a result of the interest rate swap agreement in effect for $200.0 million of the outstanding $600.0 million balance,
1.0			an increase in amortization expense associated with the June 2003 placement of zero coupon convertible subordinated notes,
1.0			a decrease in interest income from the third quarter of 2002 due to lower investment returns slightly offset by higher average investment balances,
0.4			other.
$	8.9

Income Taxes— We recognized $12.5 million of income tax expense in the third quarter of 2003 based on an overall estimated annual effective tax rate of 36%. Income tax expense of $1.5 million recorded in the third quarter of 2002 represents foreign income taxes associated with activities in France.

Nine months ended September 30, 2003 compared to nine months ended September 30, 2002

	Nine months ended September 30,
In thousands:	2003		2002
Sales:*
PROVIGIL	$	205,058	$	149,366
ACTIQ	164,316		82,802
GABITRIL	44,473		33,705
Other	68,898		61,061
Total sales	482,745		326,934

Total other revenues	20,822		35,657

Total revenues	$	503,567	$	362,591

* Certain sales amounts for the nine months ended September 30, 2002 have been reclassified to conform to current period presentation.

Revenues— Total sales in the first nine months of 2003 increased 48% over the first nine months of 2002. The increase is attributable to a number of factors including:

• Sales of PROVIGIL increased 37% as compared to the same period last year. The increase was the net result of strong U.S. demand for PROVIGIL as indicated by a 32% increase in prescriptions, according to IMS Health, driven by an expansion of both our sales force and marketing efforts, and by weighted average domestic price increases of approximately 6.5%. Throughout 2002 and early 2003, higher than normal inventory levels, which existed at certain wholesalers due to significant speculative buying at the end of 2001, were depleted.

• Sales of ACTIQ increased 98% as compared to the same period last year. This increase was due, in part, to an expanded sales force and continued, focused marketing efforts to pain specialists as indicated by an 82% increase in U.S. prescriptions, according to IMS Health. Domestic weighted average price increases of approximately 4.9% also contributed to higher sales recorded in 2003.

• Sales of GABITRIL increased 32% compared to the same period last year. Domestic sales increased 35% driven by an expansion of both our sales force and marketing efforts as indicated by a 60% increase in U.S. prescriptions, according to IMS Health. Weighted average increases in domestic prices of approximately 5.5% also contributed to higher sales recorded in 2003.

Amounts recorded as other revenues primarily consist of amortization of up-front fees, ongoing research and development funding, milestone payments and payments under co-promotional or managed services agreements. Total other revenues decreased approximately 42% from period to period. The decrease is primarily due to the reduction in the amount of revenue recorded under our agreements with Sanofi-Synthélabo and Novartis Pharma AG. The level of other revenue recognized from period to period may continue to fluctuate based on the status of each related project and terms of each collaboration agreement. Therefore, past levels of other revenues may not be indicative of future levels.

Cost of Sales— The cost of sales was approximately 14% of net sales for the nine months ended September 30, 2003 and 15% of net sales for the nine months ended September 30, 2002. The decrease is primarily due to cost savings we realized when we began utilizing our Salt Lake City facility as our sole manufacturer of ACTIQ beginning in June 2003.

Research and Development Expenses—Research and development expenses increased $25.4 million, or 28%, to $117.3 million for the first nine months of 2003 from $91.9 million for the first nine months of 2002. Approximately $20.0 million of this increase is due to costs associated with additional clinical studies conducted in 2003 to explore the utility of GABITRIL beyond its current indication, increased expenditures associated with the Phase 2/3 study of CEP-1347 in Parkinson’s Disease and costs incurred with Phase 1 studies of the R-isomer of modafinil. In the third quarter of 2003, we also recorded a $2.0 million charge relating to the write-off as R&D expense of the value of an investment in an unaffiliated entity. These increases were partially offset by a decrease in expenditures associated with the conclusion or near-conclusion of clinical studies of PROVIGIL in shift work sleep disorder and adult attention deficit/hyperactivity disorder of $3.9 million and by a decrease in expenditures of $5.8 million related predominantly to producing clinical supplies in 2002 for our Phase 1 studies associated with our angiogenesis inhibitors program in collaboration with Sanofi-Synthélabo.

Selling, General and Administrative Expenses—Selling, general and administrative expenses increased $53.3 million, or 41%, to $183.7 million for the first nine months of 2003 from $130.4 million for the first nine months of 2002. Sales and marketing costs increased $47.7 million in the U.S. as a result of the expansion of our field sales forces, additional product promotional expenses and an increased number of medical education programs. Selling, general and administrative expenses at our Cephalon France subsidiary increased by $5.1 million over the same period in 2002 due primarily to the strengthening of the Euro as compared to the U.S. dollar. These increases were partially offset by a $2.0 million expense recorded in the third quarter of 2002 related to moving our manufacturing activities from a contractor to our Salt Lake City facility.

Depreciation and Amortization Expenses—Depreciation and amortization expenses increased by $7.5 million, or 30%, to $32.6 million for the first nine months of 2003 from $25.1 million for the first nine months of 2002, of which $3.5 million is attributable to additional amortization in 2003 associated with the October 2002 acquisition of ACTIQ marketing rights in certain countries. Depreciation expenses increased by $2.3 million as a result of increased purchases for manufacturing equipment at our Salt Lake City location for the production of ACTIQ for the U.S. market and increased capital spending on building improvements at both our West Chester and Salt Lake City locations.

Other Income and Expense— Total other expenses, net, decreased $5.3 million, or 19%, to $22.5 million for the first nine months of 2003 from $27.8 million for the first nine months of 2002 due to:

(in millions)
$	(3.2	)	Decrease in interest expense because 2002 included non-repeating interest expense associated with the joint venture,
(2.7		)	a decrease in interest and amortization expense associated with the redemption of our 5.25% convertible notes during 2003,
(1.8		)	a decrease in interest expense on our 2.5% convertible subordinated notes as a result of the interest rate swap agreement in effect for $200.0 million of the outstanding $600.0 million balance,
1.0			an increase in amortization expense associated with our June 2003 placement of zero coupon convertible subordinated notes;
2.7			the recognition of charges on the early extinguishment of debt in both 2002 and 2003 resulting in an increase of $2.7 million from year to year. The charge in 2002 of $7.1 million resulting from our purchase of the investor’s interests in the joint venture. This charge consisted of a write-off of $4.6 million of the remaining capitalized costs associated with the formation of the joint venture and a $2.5 million loss on the early extinguishment of debt. The charge in 2003 of $9.8 million is associated with the redemption of the outstanding balance of 5.25% convertible notes, and the repurchase of a portion of our 3.875% convertible notes;
(3.6		)	an increase in other income from the first nine months of 2002 primarily due to the effect of foreign currency gains from the Australian dollar hedge related to the SIRTeX bid, offset by foreign currency losses recorded by our European subsidiaries relating to the weakening of the U.S. Dollar relative to other currencies,
2.4			a decrease in interest income from the first nine months of 2002 due to lower investment returns slightly offset by higher average investment balances,
(0.1		)	other.
$	(5.3	)

Income Taxes—We recognized $29.6 million of income tax expense in the first nine months of 2003 based on an overall estimated annual effective tax rate of 36%. Income tax expense of $3.5 million recorded in the first nine months of 2002 represents foreign income taxes associated with activities in France.

Cumulative Effect of Changing Inventory Costing Method from FIFO to LIFO—Effective January 1, 2002, we changed our method of valuing domestic inventories from the first-in, first-out, or FIFO method, to the last-in, first-out, or LIFO method. We recognized a charge of $3.5 million in the first quarter of 2002 as the cumulative effect of adopting the LIFO inventory costing method.

LIQUIDITY AND CAPITAL RESOURCES

Cash, cash equivalents and investments at September 30, 2003 were $1.1 billion, representing 46% of total assets. Working capital, which is calculated as current assets less current liabilities, was $1.2 billion at September 30, 2003.

Net Cash Provided by Operating Activities

Net cash provided by operating activities was $105.8 million for nine months ended September 30, 2003 as compared to $84.6 million for the same period in 2002. The increase in cash provided by operating activities in the first nine months of 2003 over the comparable period in 2002 was due primarily to higher income from operations in 2003.

Net Cash Used for Investing Activities

Net cash used for investing activities was $13.1 million for the nine months ended September 30, 2003 as compared to $130.7 million for the same period in 2002. Significantly higher purchases of available for sale investments and acquisitions of intangible assets in 2002 were partially offset by purchases of investments of non-marketable securities in 2003, including MDS Proteomics Inc. (MDSP)

Net Cash Provided by (Used for) Financing Activities

Net cash provided by financing activities was $449.3 million for the nine months ended September 30, 2003, as compared to net cash used for financing activities of $14.4 million for the same period in 2002. The period-to-period change is primarily the result of net proceeds of $727.1 million received from the sale of zero coupon convertible subordinated notes partially offset by the retirement of $195.0 million in convertible subordinated notes. Concurrent with the private placement of the zero coupon convertible subordinated notes, we purchased a Convertible Note Hedge for $258.6 million and sold warrants for $178.3 million.

Commitments and Contingencies

—Legal Proceedings

against us and do not believe these matters, even if adversely adjudicated or settled, would have a material adverse effect on our financial condition, results of operations or cash flows.

—Cephalon Clinical Partners, L.P.

In August 1992, we exclusively licensed our rights to MYOTROPHIN for human therapeutic use within the United States, Canada and Europe to Cephalon Clinical Partners, L.P. (CCP). A subsidiary of Cephalon is the sole general partner of CCP. We developed MYOTROPHIN on behalf of CCP under a research and development agreement. Under this agreement, CCP granted an exclusive license to manufacture and market MYOTROPHIN for human therapeutic use within the United States, Canada and Europe, and we agreed to make royalty payments equal to a percentage of product sales and a milestone payment of approximately $16.0 million upon regulatory approval. We have a contractual option, but not an obligation, to purchase all of the limited partnership interests of CCP, which is exercisable upon the occurrence of certain events following the first commercial sale of MYOTROPHIN. If, and only if, we decide to exercise this purchase option, we would make an advance payment of approximately $40.3 million in cash or, at our election, approximately $42.4 million in shares of common stock or a combination thereof. If we discontinue development of MYOTROPHIN, or if we do not exercise this purchase option, our license will terminate and all rights to manufacture or market MYOTROPHIN in the United States, Canada and Europe will revert to CCP, which may then commercialize MYOTROPHIN itself or license or assign its rights to a third party. In that event, we would not receive any benefits from such commercialization, license or assignment of rights.

Outlook

Cash, cash equivalents and investments at September 30, 2003 were $1.1 billion. We expect to use our remaining cash, cash equivalents and investments for working capital and general corporate purposes, including the acquisition of businesses, products, product rights, or technologies, the payment of contractual obligations, including scheduled interest payments on our convertible notes, and/or the purchase, redemption or retirement of our convertible notes. On November 3, 2003, we announced that we had signed a definitive agreement to acquire by merger all of the outstanding shares of CIMA LABS INC. for $34 cash per share. The total value of the transaction is approximately $397 million net of CIMA’s cash and cash equivalents, which we would expect to fund from our existing cash, cash equivalents and investments. Prior to 2001, we had negative cash flows from operations and used the proceeds of public and private placements of our equity and debt securities to fund operations. We expect that sales of our three most significant marketed products, PROVIGIL, ACTIQ and GABITRIL, in combination with other revenues, should allow us to continue to generate profits and significant positive cash flows from operations for the next several years. At this time, however, we cannot accurately predict the effect of certain developments on product sales in 2005 and beyond, such as the degree of market acceptance and exclusivity of our products, competition, the effectiveness of our sales and marketing efforts and the outcome of our current efforts to demonstrate the utility of our products in indications beyond those already included in the FDA approved labels.

Analysis of prescription data for PROVIGIL in the United States indicates physicians have elected to prescribe the product to treat a number of indications outside of its currently labeled indication of excessive daytime sleepiness associated with narcolepsy. Our strategy for PROVIGIL is to broaden the range of clinical uses that are approved by the FDA and European regulatory agencies to include many of its currently prescribed uses. On October 21, 2003, we announced that we had received an approvable letter from the FDA to expand the label for PROVIGIL. The letter states that PROVIGIL is approvable for improving wakefulness in patients with excessive sleepiness associated with shift work sleep disorder and in patients with obstructive sleep apnea/hypopnea syndrome. Subject to final FDA approval, we expect to launch PROVIGIL for these new indications in the first quarter of 2004 with an expanded sales force of nearly 500 persons. We expect the addition of these new indications, coupled with a larger sales force, to have a meaningful and positive impact on PROVIGIL product sales in 2004 and beyond.

Continued sales growth of PROVIGIL beyond the December 2005 expiration of orphan drug exclusivity depends, in part, on our maintaining protection on the modafinil particle-size patent through its expiration beginning in 2014. If we perform an additional clinical study of PROVIGIL in pediatric patients that is agreeable to the FDA, the FDA could grant us a six-month extension of our current exclusivity and of the particle-size patent. We intend to perform such a study when we reach an agreement with the FDA.

On March 28, 2003, we filed a patent infringement lawsuit in U.S. District Court in New Jersey against Teva Pharmaceuticals USA, Inc., Mylan Pharmaceuticals Inc., Ranbaxy Pharmaceuticals Inc., and Barr Laboratories, Inc. based upon the ANDAs filed by each of these companies seeking FDA approval for a generic equivalent of modafinil. The lawsuit claims infringement of our U.S. Patent No. RE37516, which covers the pharmaceutical compositions and methods of treatment with the form of modafinil contained in PROVIGIL. We intend to vigorously defend the validity, and prevent infringement, of this patent. This litigation is currently in the discovery phase and we expect that the trial will begin sometime in 2005. See “—Certain Risks Related to Our Business.” Our sales of ACTIQ also depend on our existing patent protection for the approved compressed powder formulation, which expires in the U.S. in September 2006, and for the formulation of ACTIQ we sold prior to June 2003, which expires in May 2005. If we perform an additional clinical study in pediatric patients that is agreeable to the FDA, the FDA could grant us six-month extensions of these patents. We intend to perform such a study when we reach an agreement with the FDA.

We expect to continue to incur significant expenditures associated with manufacturing, selling and marketing our products and conducting additional clinical studies to explore the utility of these products in treating disorders beyond those currently approved in their respective labels. With respect to PROVIGIL, we are currently enrolling patients into a Phase 3 clinical trial in attention deficit/hyperactivity disorder in children and expect to initiate a Phase 3 program in the fourth quarter of 2003 with respect to the R-isomer of modafinil. With respect to GABITRIL, we have completed dose ranging studies in the therapeutic areas of anxiety, neuropathic pain and insomnia. In the second quarter of 2003, we initiated larger Phase 2 studies for GABITRIL in Generalized Anxiety Disorder and Post Traumatic Stress Disorder, which should be completed in the first half of 2004. Depending on the results of these studies, we would expect to begin a Phase 3 program in one of these indications in the second half of 2004. We also expect to initiate in 2004 an additional Phase 2 study of GABITRIL in insomnia. In the future, we will continue to incur significant expenditures to fund research and development activities, including clinical trials, for our other product candidates and for improved formulations for our existing products. In the future, we may seek to mitigate the risk in our research and development programs by seeking sources of funding for a portion of these expenses through collaborative arrangements with third parties. However, we intend to retain a portion of the commercial rights to these programs and, as a result, we still expect to spend significant funds on our share of the cost of these programs, including the costs of research, preclinical development, clinical research and manufacturing.

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

• product sales and cost of product sales;

• inventory stocking or destocking practices of our large customers;

• achievement and timing of research and development milestones;

• collaboration revenues;

• cost and timing of clinical trials;

• marketing and other expenses; and

• manufacturing or supply disruptions.

We have significant indebtedness outstanding, consisting principally of indebtedness on convertible subordinated notes. The following table summarizes the principal terms of our convertible subordinated notes outstanding as of September 30, 2003:

Security	Outstanding (in millions)		Conversion Price		Other
2.5% Convertible Subordinated Notes due December 2006	$	600.0	$	81.00	• Redeemable on or after December 20, 2004 at our option at a redemption price of 100% of the principal amount redeemed.
3.875% Convertible Subordinated Notes due March 2007	$	43.0	$	70.36	• Redeemable on March 28, 2005 at option of holder at a redemption price of 100% of principal amount redeemed
Zero Coupon Convertible Notes due June 2033, first putable June 15, 2008	$	375.0	$	59.50	• Conversion by holders at stated conversion price into shares of our common stock is subject to certain additional restrictions
					• Redeemable on June 15, 2008 at either option of holder or us at a redemption price of 100.25% of the principal amount redeemed.
Zero Coupon Convertible Notes due June 2033, first putable June 15, 2010	$	375.0	$	56.50	• Conversion by holders at stated conversion price into shares of our common stock is subject to certain additional restrictions
					• Redeemable on June 15, 2010 at either option of holder or us at a redemption price of 100.25% of the principal amount redeemed.

The annual interest payments on the $1,393.0 million of convertible notes outstanding as of September 30, 2003 are $16.7 million, payable at various dates throughout the year. In the future, we may agree to exchanges of the notes for shares of our common stock or may determine to use a portion of our existing cash on hand to purchase, redeem or retire all or a portion of the outstanding convertible notes. In January 2003, we entered into an interest rate swap agreement with a financial institution relating to our $600.0 million 2.5% convertible notes in the aggregate notional amount of $200.0 million. Under the swap, we agreed to pay a variable interest rate on this $200.0 million notional amount equal to LIBOR-BBA + .29% in exchange for the financial institution’s agreement to pay a fixed rate of 2.5%. The variable interest rate is re-calculated at the beginning of each quarter. Effective October 1, 2003, the interest rate is 1.43%. We also agreed to provide the financial institution with cash collateral to support our obligations under the agreement. The current collateral amount is $3.0 million and is recorded in Other Assets in our consolidated balance sheet.

As part of our business strategy, we plan to consider and, as appropriate, make acquisitions of other businesses, products, product rights or technologies. For example, on November 3, 2003, we signed a definitive agreement to acquire by merger all of the outstanding shares of CIMA LABS INC. Although we presently have sufficient cash and cash equivalents on hand to complete this transaction, in the future our cash reserves and other liquid assets may be inadequate to consummate these acquisitions and it may be necessary for us to raise substantial additional funds in the future to complete these transactions. In addition, as a result of our acquisition efforts, we are likely to experience significant charges to earnings for merger and related expenses (whether or not our efforts are successful) that may include transaction costs, closure costs or acquired in-process research and development charges.

Based on our current level of operations and projected sales of our products combined with other revenues and interest income, we believe that we will be able to service our existing debt and meet our capital expenditure and working capital requirements for the next several years. However, we cannot be sure that our anticipated revenue growth will be realized or that we will continue to generate significant positive cash flow from operations. We may need to obtain additional funding for our operational needs, to repay our outstanding indebtedness or for future significant strategic transactions, and we cannot be certain that funding will be available on terms acceptable to us, or at all.

CERTAIN RISKS RELATED TO OUR BUSINESS

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

A significant portion of our revenues is derived from U.S. sales of our three largest products, and our future success will depend on the continued acceptance and growth of these products.

For the nine months ended September 30, 2003, approximately 86% of our total worldwide net product sales were derived from sales of PROVIGIL, ACTIQ and GABITRIL. We cannot be certain that these products will continue to be accepted in their markets. Specifically, the following factors, among others, could affect the level of market acceptance of PROVIGIL, ACTIQ and GABITRIL:

• the perception of the healthcare community of their safety and efficacy, both in an absolute sense and relative to that of competing products;

• the effectiveness of our sales and marketing efforts, particularly with respect to our efforts in 2004 directed to General Practitioners for the expected new indications for PROVIGIL;

• any unfavorable publicity regarding these products or similar products;

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

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

• regulatory developments affecting the manufacture, marketing or use of these products.

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

We may be unsuccessful in our efforts to expand the number and scope of authorized uses of PROVIGIL or GABITRIL, which would significantly hamper sales and earnings growth.

Even with the anticipated broader label for PROVIGIL described above, the market for the approved indications of two of our three largest products is relatively small. Analysis of prescription data indicates that a significant portion of our product sales is derived from the use of these products outside of their labeled indications. We believe that the growth of PROVIGIL and GABITRIL will be greater if we are able to further expand the approved indications for these products.

We are developing a proprietary formulation of modafinil for the treatment of ADHD in children and are currently enrolling patients into a Phase 3 program. We also have initiated Phase 2 studies of GABITRIL in Generalized Anxiety Disorder and Post Traumatic Stress Disorder and expect to begin Phase 2 studies in insomnia in 2004. If the results of these Phase 2 GABITRIL studies are positive, we will need to conduct additional studies before we can apply to regulatory authorities to expand the authorized uses of GABITRIL for these indications.

We do not know whether these current or future studies will demonstrate safety and efficacy, or if they do, whether we will succeed in receiving regulatory approval to market these products for these or other disorders. If the results of some of these additional studies are negative, this could undermine physician and patient comfort with the product, limit its commercial success, and diminish its acceptance. Even if the results of these studies are positive, the impact on sales of these products may be minimal unless we are able to obtain FDA and foreign medical authority approval to expand the authorized uses of this product. FDA regulations limit our ability to communicate the results of additional clinical studies to patients and physicians without first obtaining regulatory approval for any expanded uses.

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

We place considerable importance on obtaining patent protection for new technologies, products and processes. To that end, we file applications for patents covering the compositions or uses of our drug candidates or our proprietary processes. The patent positions of pharmaceutical and biotechnology companies can be highly uncertain and involve complex legal, scientific and factual questions. To date, there has emerged no consistent policy regarding breadth of claims in such companies’ patents. Accordingly, the patents and patent applications relating to our products, product candidates and technologies may be challenged, invalidated or circumvented by third parties and might not protect us against competitors with similar products or technology. Patent disputes in our industry are frequent and can preclude commercialization of products. If we ultimately engage in and lose any such disputes, we could be subject to competition or significant liabilities, we could be required to enter into third party licenses or we could be required to cease using the technology or product in dispute. In addition, even if such licenses are available, the terms of any license requested by a third party could be unacceptable to us.

The U.S. composition of matter patent for modafinil expired in 2001. We own U.S. and foreign patent rights that expire between 2014 and 2015 covering pharmaceutical compositions of modafinil and, more specifically, covering certain particle sizes contained in this pharmaceutical composition. Ultimately, these patents might be found invalid if challenged by a third party, or a potential competitor could develop a competing product or product formulation that avoids infringement of these patents. To date, the FDA has accepted four abbreviated new drug applications, or ANDAs, for pharmaceutical products containing modafinil. Each of these ANDAs contained a Paragraph IV certification in which the ANDA applicant certified that the U.S. particle-size modafinil patent covering PROVIGIL either is invalid or will not be infringed by the ANDA product. On March 28, 2003, we filed a patent infringement lawsuit in U.S. District Court in New Jersey against Teva Pharmaceuticals USA, Inc., Mylan Pharmaceuticals Inc., Ranbaxy Pharmaceuticals Inc., and Barr Laboratories, Inc. based upon the ANDAs filed by each of these companies with the FDA. The lawsuit claims infringement of our U.S. Patent No. RE37516. While we intend to vigorously defend the validity of this patent and prevent infringement, these efforts will be both expensive and time consuming and, ultimately, may not be successful. This litigation is currently in the discovery phase, and we expect that the trial will begin sometime in 2005. If an ANDA is approved, a competitor could begin selling a modafinil-based product upon the expiration of our FDA orphan drug exclusivity, currently in December 2005, which would significantly and negatively impact revenues from PROVIGIL. If we perform an additional clinical study of PROVIGIL in pediatric patients that is agreeable to the FDA, the FDA could grant us a six-month extension of our orphan drug exclusivity (to June 2006) and of the particle size patent term. However, we cannot be sure that we will be able to reach an agreement with the FDA with respect to an appropriate pediatric study.

With respect to ACTIQ, we hold an exclusive license to a U.S. patent covering the currently approved compressed powder pharmaceutical composition and methods for administering fentanyl via this composition that is set to expire in September 2006, though the FDA could grant us a six-month extension of these patents if we perform an agreed upon clinical study in pediatric patients. We cannot be sure that we will be able to reach an agreement with the FDA with respect to an appropriate pediatric study. Corresponding patents in foreign countries are set to expire between 2009 and 2010. Our patent protection with respect to the ACTIQ formulation we sold prior to June 2003 will expire in May 2005. The loss of patent protection on ACTIQ, beginning in May 2005 in the United States in the absence of a six-month pediatric extension, could significantly and negatively impact our revenues from the sale of ACTIQ.

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

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

The manufacture, supply and distribution of pharmaceutical products, both inside and outside the United States, is highly regulated and complex. We, and the third parties we rely upon for the manufacturing and distribution of our products, must comply with all applicable regulatory requirements of the FDA and foreign authorities, including current Good Manufacturing Practice regulations. In addition, we must comply with all applicable regulatory requirements of the Drug Enforcement Administration and analogous foreign authorities for certain of our products that contain controlled substances. The facilities used to manufacture, store and distribute our products also are subject to inspection by regulatory authorities at any time to determine compliance with regulations. These regulations are complex, and any failure to comply with them could lead to remedial action, civil and criminal penalties and delays in production or distribution of material.

We predominately depend on single sources for the manufacture of both the active drug substances contained in our products and for finished commercial supplies. For example:

• PROVIGIL: Our manufacturing facility in France is the sole source of the active drug substance modafinil. With respect to finished commercial supplies of PROVIGIL, we currently have one qualified manufacturer, DSM Pharmaceuticals, in Greenville, North Carolina, though we are in the process of qualifying a second manufacturer that we expect to be on-line in late 2003.

• ACTIQ: Our U.S. facility in Salt Lake City, Utah, is the sole source for the manufacture of ACTIQ.

• GABITRIL: Abbott Laboratories manufactures finished commercial supplies of GABITRIL for the U.S. market and Sanofi-Synthelabo manufactures GABITRIL for non-U.S. markets.

• Other Products: Certain of our products are manufactured at our facilities in France, with the remaining products manufactured by single source third parties.

The process of changing or adding a manufacturer or changing a formulation requires prior FDA and/or European medical authority approval and is very time-consuming. If we are unable to manage this process effectively or if an unforeseen event occurs at any facility, we could face supply disruptions that would result in significant costs and delays, undermine goodwill established with physicians and patients, damage commercial prospects for our products and adversely affect operating results. We also rely on third parties to distribute our products, perform customer service activities and accept and process product returns.

In April 2003, we initiated a voluntary recall of certain batches of ACTIQ that were distributed in Europe based upon our determination that some units in these batches might contain levels of fentanyl that were higher than those established in the product specifications. Following investigation, we identified the underlying cause and we believe we have taken appropriate corrective action. We have discussed the nature of the recall and our corrective action with appropriate regulatory authorities, including the FDA, have filed the necessary documentation to evidence these changes, and are manufacturing, distributing and selling ACTIQ in the United States and Europe. The recall resulted in a reduction of sales revenue and an increase in cost of sales in the first half of 2003, with an aggregate financial impact in the amount of $2.2 million. We are not aware of any adverse events with respect to any ACTIQ product contained in any of the recalled batches.

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

During research and development, the use of pharmaceutical products, such as ours, is limited principally to clinical trial patients under controlled conditions and under the care of expert physicians. The widespread commercial use of our products could produce undesirable or unintended side effects that have not been evident in our clinical trials or the relatively limited commercial use to date. In addition, in patients who take multiple medications, drug interactions could occur that can be difficult to predict. Additionally, incidents of product misuse may occur. These events, among others, could result in additional regulatory controls that could limit the circumstances under which the product is prescribed or even lead to the withdrawal of the product from the market. More specifically, ACTIQ has been approved under regulations concerning drugs with certain safety profiles, under which the FDA has established

special restrictions to ensure safe use. Any violation of these special restrictions could lead to the imposition of further restrictions or withdrawal of the product from the market.

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

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

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

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

• fines, recalls or seizures of products;

• total or partial suspension of manufacturing activities and/or product sales;

• non-approval of product license applications;

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

• criminal prosecution.

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

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

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

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

As of September 30, 2003, we had $1,430.8 million of indebtedness outstanding, of which $600.0 million matures in 2006. There are no restrictions on our use of our existing cash, cash equivalents and investments, and we cannot be sure that these funds will be available or sufficient in the future to enable us to repay our indebtedness. In the future, the level of our indebtedness, among other things, could make it difficult for us to repay or refinance our indebtedness or to obtain additional financing in the future, or limit our future flexibility and make us more vulnerable in the event of a downturn in our business. Unless we are able to generate cash flow from operations that, together with our available cash on hand, is sufficient to repay our indebtedness, we will be required to raise additional funds. Because the financing markets may be unwilling to provide funding to us or may only be willing to provide funding on terms that we would consider unacceptable, we may not have cash available or be able to obtain funding to permit us to meet our repayment obligations, thus adversely affecting the market price for our securities.

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

A number of analysts and investors who follow our stock have developed models to attempt to forecast future product sales and expenses and have established earnings expectations based upon those models. These models, in turn, are based in part on estimates of projected revenue and earnings that we disclose publicly. Forecasting future revenues is difficult, especially when there is only a few years of commercial history and when the level of market acceptance of our products is uncertain. Forecasting is further complicated by the difficulties in estimating stocking levels at pharmaceutical wholesalers and at retail pharmacies, the timing of purchases by wholesalers and retailers to replenish stock and the frequency and amount of potential product returns. As a result, it is likely that there will be significant fluctuations in revenues, which may not meet with market expectations and which also may adversely affect our stock price. There are a number of other factors that could cause our financial results to fluctuate unexpectedly, including:

• the cost of product sales;

• achievement and timing of research and development milestones;

• collaboration revenues;

• cost and timing of clinical trials and regulatory approvals;

• marketing and other expenses; and

• manufacturing or supply disruptions.

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

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

In the United States, there have been, and we expect there will continue to be, various proposals to implement similar controls. The commercial success of our products could be limited if federal or state governments adopt any such proposals. In addition, in the United States and elsewhere, sales of pharmaceutical products depend in part on the availability of reimbursement to the consumer from third party payers, such as government and private insurance plans. These third party payers increasingly challenge the prices charged for pharmaceutical products and seek to limit reimbursement levels offered to consumers for such products. These third party payers could focus their cost control efforts on our products, especially with respect to prices of and reimbursement levels for products prescribed outside their labeled indications. In these cases, their efforts could negatively impact our product sales and profitability.

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

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

The conditions that our products treat, and some of the other disorders for which we are conducting additional studies, are currently treated with several drugs, many of which have been available for a number of years or are available in inexpensive generic forms. With respect to PROVIGIL, there are several other products used for the treatment of narcolepsy in the United States, including methylphenidate products such as RITALIN® by Novartis, and in our other territories, many of which have been available for a number of years and are available in inexpensive generic forms. With respect to ACTIQ, we face competition from inexpensive oral opioid tablets and more expensive but quick-acting invasive (i.e., intravenous, intramuscular and subcutaneous) opioid delivery systems. Other technologies for rapidly delivering opioids to treat breakthrough pain are being developed, at least one of which is in clinical trials. With respect to GABITRIL, there are several products, including NEURONTIN® (gabapentin) by Pfizer, used as adjunctive therapy for the partial seizure market. Some are well-established therapies that have been on the market for several years while others have recently entered the partial seizure marketplace. In addition, several treatments for partial seizures are available in inexpensive generic forms. Thus, we need to demonstrate to physicians, patients and third party payers that the cost of our products is reasonable and appropriate in the light of their safety and efficacy, the price of competing products and the related health care benefits to the patient.

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

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

On November 3, 2003, we signed a definitive agreement to acquire by merger all of the outstanding shares of CIMA LABS INC. for $34 cash per share. The merger is subject to certain closing conditions, including the approval of the merger agreement by CIMA stockholders and the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (HSR), as amended. If the HSR condition is not satisfied, we will be required to pay CIMA a break fee in the amount of $16.25 million. If the transaction does not close for any reason, we will not realize the anticipated benefits of the CIMA transaction.

As part of our review of CIMA, we conducted business, legal and financial due diligence with the goal of identifying and evaluating material risks involved in the transaction. Despite our efforts, we ultimately may be unsuccessful in ascertaining or evaluating all such risks and, as a result, we might not realize the intended advantages of the acquisition. We also must consolidate and integrate CIMA’s operations with our business. Integration efforts often take a significant amount of time, place a significant strain on our managerial, operational and financial resources and could prove to be more difficult and expensive than we predicted. If we fail to realize the expected benefits from this acquisition, or from acquisitions we may consummate in the future, whether as a result of unidentified risks, integration difficulties, regulatory setbacks or otherwise, our business, results of operations and financial condition could be adversely affected.

In addition, as a result of our efforts to acquire businesses or enter into other significant transactions such as CIMA, we have experienced, and will likely continue to experience, significant charges to earnings for merger and related expenses (whether or not our efforts are successful) that may include transaction costs, closure costs, acquired in-process research and development charges or break fees. These costs also may include substantial fees for investment bankers, attorneys, accountants and other advisers, as well as severance and other closure costs associated with the elimination of duplicate operations and facilities. Our incurrence of these charges could adversely affect our results of operations for particular quarterly or annual periods.

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

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

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

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

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

Because we have limited resources, we have entered into a number of collaboration agreements with other pharmaceutical companies, including H. Lundbeck A/S with respect to our research efforts in Parkinson’s Disease, and with a number of marketing partners for our products in certain countries outside the United States. In some cases, our collaboration agreements call for our partners to control:

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

• the design and execution of clinical studies;

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

• marketing and selling of any approved product.

In each of these areas, our partners may not support fully our research and commercial interests because our program may compete for time, attention and resources with the internal programs of our corporate collaborators. As

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

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

The market price of our common stock is highly volatile, and we expect it to continue to be volatile for the foreseeable future. For example, from January 1, 2002 through November 7, 2003, our common stock traded at a high price of $78.88 and a low price of $35.82. Negative announcements, including, among others:

• adverse regulatory decisions;

• disappointing clinical trial results;

• disputes and other developments concerning patent or other proprietary rights with respect to our products; or

• operating results that fall below the market’s expectations

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

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

Historically, a portion of our revenues and expenses has been earned and incurred, respectively, in currencies other than the U.S. dollar. For the year ended December 31, 2002, approximately 22% of our revenues were denominated in currencies other than the U.S. dollar. We translate revenues earned and expenses incurred into U.S. dollars at the average exchange rate applicable during the relevant period. A weakening of the U.S. dollar would, therefore, increase both our revenues and expenses. Fluctuations in the rate of exchange between the U.S. dollar and the euro and other currencies may affect period-to-period comparisons of our operating results. Historically, we have not hedged our exposure to these fluctuations in exchange rates.

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

As a biopharmaceutical company, we are or may become a party to litigation in the ordinary course of our business, including, among others, matters alleging employment discrimination, product liability, patent or other intellectual property rights infringement, patent invalidity or breach of commercial contract. In general, litigation claims can be expensive and time consuming to bring or defend against and could result in settlements or damages that could significantly impact results of operations and financial condition. We currently are vigorously defending ourselves against certain litigation matters. While we currently do not believe that the settlement or adverse adjudication of these lawsuits would materially impact our results of operations or financial condition, the final resolution of these matters and the impact, if any, on our results of operations, financial condition or cash flows could be material.

Our customer base is highly concentrated.

Our principal customers are wholesale drug distributors. These customers comprise a significant part of the distribution network for pharmaceutical products in the United States. Three large wholesale distributors control a significant share of the market. For the year ended December 31, 2002, these wholesaler customers, Cardinal Health, Inc., McKesson Corporation and AmerisourceBergen Corporation, in the aggregate, accounted for 72% of our total

gross product sales. The loss or bankruptcy of any of these customers could materially and adversely affect our results of operations and financial condition.

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

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

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

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

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

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

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

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

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

In addition to historical facts or statements of current condition, this report and the documents into which this report is and will be incorporated contain forward-looking statements within the meaning of Section 27A of the

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

• our dependence on sales of PROVIGIL, ACTIQ and GABITRIL in the United States and the market prospects and future marketing efforts for these products, including with respect to expected new indications for PROVIGIL;

• any potential expansion of the authorized uses of our existing products;

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

• the timing and unpredictability of regulatory approvals in the pharmaceutical industry;

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

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

• our ability to close the CIMA LABS transaction and the timing thereof; and

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

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

• the acceptance of our products by physicians and patients in our current markets and new markets;

• our ability to obtain regulatory approvals of expanded indications for certain of our products;

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

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

• the inability to adequately protect our key intellectual property rights, including as a result of an adverse adjudication with respect to the PROVIGIL litigation;

• the loss of key management or scientific personnel;

• the activities of our competitors in the industry, including the filing of ANDAs with a Paragraph IV certification for any product containing modafinil;

• market conditions in the biotechnology industry that make raising capital or consummating acquisitions difficult, expensive or both;

• our ability to obtain the necessary regulatory and shareholder approvals to complete the CIMA transaction; and

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

We do not intend to update publicly any forward-looking statement, whether as a result of new information, future events or otherwise, except as required by law. We discuss in more detail the risks that we anticipate in the section above included in this Item 2 and entitled “Certain Risks Related to our Business.” This discussion is permitted by the Private Securities Litigation Reform Act of 1995.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

We are exposed to foreign currency exchange risk related to operations conducted by our European subsidiaries that have transactions, assets, and liabilities denominated in foreign currencies that are translated into U.S. dollars for consolidated financial reporting purposes. Historically, we have not hedged any of these foreign currency exchange risks. For the nine months ended September 30, 2003, an average 10% weakening of the U.S. dollar relative to the currencies in which our European subsidiaries operate would have resulted in an increase of $10.1 million in reported total revenues and a corresponding increase in reported expenses. This sensitivity analysis of the effect of changes in foreign currency exchange rates does not assume any changes in the level of operations of our European subsidiaries.

In January 2003, we entered into an interest rate swap agreement with a financial institution, relating to or $600.0 million 2.5% convertible subordinated notes, in the aggregate notional amount of $200.0 million. We pay interest under the swap based on the 3-month LIBOR-BBA rate plus 29 basis points, adjusted quarterly. At inception, we recognized a premium on the value of the bonds of $2.2 million that we will amortize and recognize as interest expense over the remaining term of the notes. We also recognize adjustments to interest expense based on changes in the fair values of the bonds and the swap agreement each quarter. If LIBOR increases or decreases by 100 basis points, our annual interest expense would change by $2.0 million. Changes in interest rates and the price and volatility of our common stock would also affect the fair values of the notes and the swap agreement, resulting in adjustments to interest expense.

In January 2003, we entered into a foreign exchange contract to protect against fluctuations in the Australian Dollar against the U.S. Dollar related to our unsuccessful bid for SIRTeX Medical Limited. We terminated this contract in the second quarter of 2003.

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

ITEM 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this report have been designed and are functioning effectively to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. We believe that a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

(b) Change in Internal Control over Financial Reporting

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

PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits:

Exhibit No.		Description
31.1		Certification of Frank Baldino, Jr., Chairman and Chief Executive Officer of the Company, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of J. Kevin Buchi, Senior Vice President and Chief Financial Officer of the Company, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1*		Certification of Frank Baldino, Jr., Chairman and Chief Executive Officer of the Company, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2*		Certification of J. Kevin Buchi, Senior Vice President and Chief Financial Officer of the Company, as required pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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

(b) Reports on Form 8-K:

During the third quarter of 2003, we filed the following Current Report on Form 8-K:

• On July 22, 2003, we filed a Current Report on Form 8-K (Item 11) that publicly announced a temporary suspension of trading in our stock by our directors and executive officers as a result of a change in the plan provider for our 401(k) Profit Sharing Plan. The temporary suspension began at 4:00 p.m. on August 22, 2003 and ended on September 8, 2003.

In addition, on August 4, 2003, we furnished a Current Report on Form 8-K (Item 12) that included a Press Release dated August 4, 2003 publicly announcing our Second Quarter 2003 financial results.

SIGNATURES

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

	CEPHALON, INC. (Registrant)

November 14, 2003	By	FRANK BALDINO, JR.
		Frank Baldino, Jr., Ph.D.
		Chairman and Chief Executive Officer (Principal executive officer)

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