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 March 31, 2005

	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)

41 Moores Road Frazer, PA		19355
(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 May 3, 2005
Common Stock, par value $.01		58,041,189 Shares

CEPHALON, INC. AND SUBSIDIARIES

INDEX

Cautionary Note Regarding Forward-Looking Statements

PART I – FINANCIAL INFORMATION

	Item 1.	Consolidated Financial Statements

			Consolidated Balance Sheets -
			March 31, 2005 and December 31, 2004

			Consolidated Statements of Income -
			Three months ended March 31, 2005 and 2004

			Consolidated Statements of Stockholders’ Equity -
			March 31, 2005 and December 31, 2004

			Consolidated Statements of Cash Flows -
			Three months ended March 31, 2005 and 2004

			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 2.	Unregistered Sales of Equity Securities and Use of Proceeds

	Item 6.	Exhibits

SIGNATURES

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® (modafinil) tablets [C-IV], ACTIQ® (oral transmucosal fentanyl citrate) [C-II] and GABITRIL® (tiagabine hydrochloride) in the United States and the market prospects and future marketing efforts for these products;

• any potential expansion of the authorized uses of our existing products or success with respect to potential product candidates;

• 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;

• 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;

• 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 new products or for new formulations or indications for our existing 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 or ACTIQ patent litigation;

• the loss of key management or scientific personnel;

• the activities of our competitors in the industry, including the filing of Abbreviated New Drug Applications (ANDAs) with a Paragraph IV certification for GABITRIL or any product containing modafinil or the entry of a generic competitor to ACTIQ;

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

iii

CEPHALON, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)	March 31, 2005			December 31, 2004
	(Unaudited)
ASSETS

CURRENT ASSETS:
Cash and cash equivalents	$	590,262		$	574,244
Investments	219,773			217,432
Receivables, net	205,447			208,225
Inventory, net	95,381			86,629
Deferred tax asset	46,771			47,118
Other current assets	54,857			39,915
Total current assets	1,212,491			1,173,563

PROPERTY AND EQUIPMENT, net	255,644			244,834
GOODWILL	369,534			372,534
INTANGIBLE ASSETS, net	431,200			449,402
DEBT ISSUANCE COSTS, net	23,372			25,401
DEFERRED TAX ASSET, net	152,533			163,620
OTHER ASSETS	22,187			22,549
	$	2,466,961		$	2,451,903

LIABILITIES AND STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES:
Current portion of long-term debt	$	5,655		$	5,114
Accounts payable	53,816			52,488
Accrued expenses	172,981			169,568
Current portion of deferred revenues	1,277			868
Total current liabilities	233,729			228,038

LONG-TERM DEBT	1,282,652			1,284,410
DEFERRED REVENUES	1,169			1,769
DEFERRED TAX LIABILITIES	92,702			94,100
OTHER LIABILITIES	14,168			13,542
Total liabilities	1,624,420			1,621,859

COMMITMENTS AND CONTINGENCIES	—			—

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, 58,039,790 and 57,973,050 shares issued, and 57,707,006 and 57,640,266 shares outstanding	580			580
Additional paid-in capital	1,174,035			1,172,499
Treasury stock, 332,784 and 332,784 shares outstanding, at cost	(14,860		)	(14,860		)
Accumulated deficit	(368,456		)	(395,118		)
Accumulated other comprehensive income	51,242			66,943
Total stockholders’ equity	842,541			830,044
	$	2,466,961		$	2,451,903

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

CEPHALON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

	Three Months Ended March 31,
(in thousands, except per share data)	2005			2004

REVENUES:
Sales	$	266,609		$	210,391
Other revenues	13,372			4,591
	279,981			214,982

COSTS AND EXPENSES:
Cost of sales	41,114			25,977
Research and development	80,766			56,482
Selling, general and administrative	98,229			82,502
Depreciation and amortization	18,650			11,497
	238,759			176,458

INCOME FROM OPERATIONS	41,222			38,524

OTHER INCOME AND EXPENSE
Interest income	4,859			3,246
Interest expense	(5,551		)	(5,890		)
Charge on early extinguishment of debt	—			(961		)
Other income (expense), net	1,335			(466		)
	643			(4,071		)

INCOME BEFORE INCOME TAXES	41,865			34,453

INCOME TAX EXPENSE	(15,203		)	(12,742		)

NET INCOME	$	26,662		$	21,711

BASIC INCOME PER COMMON SHARE	$	0.46		$	0.38

DILUTED INCOME PER COMMON SHARE	$	0.44		$	0.36

WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING	57,994			55,905

WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING-ASSUMING DILUTION	65,065			65,006

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

CEPHALON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

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

BALANCE, JANUARY 1, 2004				$	770,370		55,842,510	$	558	$	1,052,059		308,828	$	(13,692	)	$	(321,305	)	$	52,750

Net Loss	$	(73,813	)	(73,813		)											(73,813		)

Foreign currency translation gain	16,071
Unrealized investment losses	(1,878		)
Other comprehensive gain	14,193			14,193																14,193
Comprehensive loss	$	(59,620	)

Issuance of common stock upon conversion of convertible notes				105,122			1,518,169	15		105,107

Tax effect upon conversion of convertible notes				(10,100		)				(10,100		)

Stock options exercised				12,051			535,446	6		12,045

Tax benefit from the exercise of stock options				8,017						8,017

Restricted stock award plan				5,372			76,925	1		5,371

Treasury stock acquired				(1,168		)							23,956	(1,168		)

BALANCE, DECEMBER 31, 2004				830,044			57,973,050	580		1,172,499			332,784	(14,860		)	(395,118		)	66,943

Net Income	$	26,662		26,662													26,662

Foreign currency translation loss	(14,118		)
Unrealized investment losses	(1,583		)
Other comprehensive loss	(15,701		)	(15,701		)														(15,701		)
Comprehensive gain	$	10,961

Stock options exercised				1,341			66,740	—		1,341

Tax benefit from the exercise of stock options, net of adjustment				(2,348		)				(2,348		)

Restricted stock award plan				2,543						2,543

BALANCE, MARCH 31, 2005 (Unaudited)				842,541			58,039,790	580		1,174,035			332,784	(14,860		)	(368,456		)	51,242

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

CEPHALON, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

	Three Months Ended March 31,
(in thousands)	2005			2004

CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income	$	26,662		$	21,711
Adjustments to reconcile net income to net cash provided by operating activities:
Deferred income taxes	14,677			2,269
Tax benefit from exercise of stock options	652			2,270
Depreciation and amortization	26,586			12,239
Amortization of debt issuance costs	2,138			2,209
Stock-based compensation expense	2,543			1,247
Non-cash charge on early extinguishment of debt	—			961
Pension curtailment	—			(4,214		)
Loss on disposals of property and equipment	—			430
Increase (decrease) in cash due to changes in assets and liabilities, net of effect from acquisition:
Receivables	60			(19,221		)
Inventory	(11,164		)	(4,189		)
Other assets	(21,914		)	(4,907		)
Accounts payable, accrued expenses and deferred revenues	6,486			(1,902		)
Other liabilities	(564		)	479

Net cash provided by operating activities	46,162			9,382

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment	(24,164		)	(9,188		)
Acquistion of intangible assets	(384		)	(240		)
Sales and maturities of investments	14,998			2,057
Purchases of investments	(18,922		)	(16,066		)

Net cash used for investing activities	(28,472		)	(23,437		)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercises of common stock options	1,341			5,377
Principal proceeds (payments on and retirements) of long-term debt	119			(10,986		)

Net cash provided by (used for) financing activities	1,460			(5,609		)

EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS	(3,132		)	(2,798		)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS	16,018			(22,462		)

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD	574,244			1,115,699

CASH AND CASH EQUIVALENTS, END OF PERIOD	$	590,262		$	1,093,237

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. BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America 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 accounting principles generally accepted in the United States of America 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, 2004 and 2003 and for each of the three years in the period ended December 31, 2004. 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.

Reclassifications

Certain reclassifications of prior year amounts have been made to conform with the current year presentation.

Recent Accounting Pronouncements

In addition to the recent accounting pronouncements disclosed in our Annual Report on Form 10-K for the year ended December 31, 2004, the following should be considered.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs,” which requires abnormal amounts of idle capacity and spoilage costs to be excluded from the cost of inventory and expensed when incurred. This Statement is effective for fiscal years beginning after June 15, 2005. We are currently evaluating the impact of SFAS No. 151 and we do not expect the adoption of this statement to have a material impact on the financial statements.

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment,” a revision of SFAS No. 123 “Accounting for Stock-Based Compensation,” that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. This Statement requires that an entity measure the cost of equity based service awards based on the grant-date fair value of the award and recognize the cost of such awards over the period during which the employee is required to provide service in exchange for the award (the vesting period). The Statement requires that an entity measure the cost of liability-based service awards based on current fair value that is remeasured subsequently at each reporting date through the settlement date. On April 14, 2005, the Securities Exchange Commission delayed the effective date of SFAS No. 123R to annual periods that begin after June 15, 2005. We will adopt this new standard effective January 2006, which will require us to recognize share-based compensation expense in our statement of operations. We have not yet quantified the impact this statement will have on our future results but we expect that it will be material.

In December 2004, the FASB issued Staff Position No. FAS 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004” (“FSP No. 109-1”), and Staff Position No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004” (“FSP No. 109-2”). These staff positions provide accounting guidance on how companies should account for the effects of the American Jobs Creation Act of 2004 that was signed into law on October 22, 2004. FSP No. 109-1 states that the tax relief (special tax deduction for domestic manufacturing) from this legislation should be accounted for as a “special deduction” instead of a tax rate reduction. FSP No. 109-2 gives a company additional time to evaluate the effects of the legislation on any plan for reinvestment or repatriation of foreign

earnings for purposes of applying FASB Statement No. 109. FSP No. 109-1 has no significant impact on our current financial statements. We continue to assess FSP 109-2 to determine the impact it could have on our future income tax expense. We expect to complete this evaluation within a reasonable amount of time after additional guidance from the United States Treasury is published.

2. ACQUISITION OF CIMA LABS INC.

On August 12, 2004, we completed our acquisition of CIMA LABS INC. Under the Agreement and Plan of Merger dated November 3, 2003, we acquired each outstanding share of CIMA LABS common stock for $34.00 per share in cash. The total cash paid to CIMA LABS stockholders in the transaction was approximately $482.5 million, net of CIMA LABS’ existing cash on hand, or $409.4 million, net of its cash, cash equivalents and investments. As a result of the acquisition, we obtained the rights to CIMA LABS’ ORAVESCENT® fentanyl product candidate, which is currently in Phase 3 clinical trials for the treatment of breakthrough cancer pain in opioid-tolerant patients. ORAVESCENT fentanyl utilizes an enhanced absorption transmucosal drug delivery technology that we believe may facilitate the rapid onset of pain relief in such patients. We are targeting approval of this product by the FDA in late 2006.

The total purchase price of $514.1 million consists of $500.1 million for all outstanding shares of CIMA LABS at $34.00 per share and $14.0 million in direct transaction costs. The acquisition was funded from Cephalon’s existing cash and short-term investments. In connection with the acquisition, CIMA LABS used $18.8 million of their own funds to purchase all outstanding employee stock options, whether or not vested or exercisable, for an amount equal to $34.00 less the exercise price for such option.

The following table summarizes the estimated fair values of assets acquired and liabilities assumed at the date of acquisition.

	At August 12, 2004
Cash and cash equivalents	$	31,604
Available-for-sale investments	73,169
Receivables	8,821
Inventory	6,224
Deferred tax asset, net	20,985
Other current assets	555
Property, plant and equipment	82,474
Intangible assets	113,100
Acquired in-process research and development	185,700
Goodwill	68,843
Total assets acquired	591,475
Current liabilities	(32,783		)
Deferred tax liability	(44,567		)
Total liabilities assumed	(77,350		)
Net assets acquired	$	514,125

Of the $113.1 million of acquired intangible assets, $70.0 million was assigned to the DuraSolv® technology with an estimated useful life of 14 years, $32.7 million was assigned to the OraSolv® technology with a weighted average estimated useful life of approximately 6 years, and $10.4 million was assigned to the developed ORAVESCENT technology with an estimated useful life of 15 years. The $68.8 million of goodwill was assigned to our single biopharmaceutical segment. In accordance with SFAS 142, goodwill is not amortized, but will be subject to a periodic assessment for impairment by applying a fair-value-based test. None of this goodwill is expected to be deductible for income tax purposes.

Our purchase price allocation was finalized during the first quarter of 2005. We allocated $185.7 million of the purchase price to in-process research and development projects. In-process research and development (IPR&D) represents the valuation of acquired, to-be-completed research projects. At the acquisition date, CIMA LABS’

ongoing research and development initiatives were primarily involved with the development and commencement of Phase 3 clinical trials of ORAVESCENT fentanyl for the treatment of breakthrough cancer pain in opioid-tolerant patients, and several other minor ongoing research and development projects. At the acquisition date of August 12, 2004, CIMA LABS had spent approximately $5.6 million on the ORAVESCENT in-process research and development project. As of the end the first quarter of 2005, we spent an additional $6.8 million on the project, and we expect to spend an additional $9.4 million through the remainder of 2005. We expect to complete our ORAVESCENT fentanyl Phase 3 clinical trials and submit an NDA for approval of this product in late 2005. The estimated revenues for the in-process projects are expected to be recognized from 2006 through 2019.

The value assigned to purchased in-process technology was determined by estimating the costs to develop the acquired technology into commercially viable products, estimating the resulting net cash flows from the projects, and discounting the net cash flows to their present value. The revenue projections used to value the in-process research and development were, in some cases, reduced based on the probability of developing a new drug, and considered the relevant market sizes and growth factors, expected trends in technology, and the nature and expected timing of new product introductions by us and our competitors. The resulting net cash flows from such projects are based on management’s estimates of cost of sales, operating expenses, and income taxes from such projects. The rates utilized to discount the net cash flows to their present value were based on estimated cost of capital calculations. Due to the nature of the forecast and the risks associated with the projected growth and profitability of the developmental projects, discount rates of 28 percent were considered appropriate for the in-process research and development. These discount rates were commensurate with the projects’ stage of development and the uncertainties in the economic estimates described above.

If these projects are not successfully developed, the sales and profitability of the combined company may be adversely affected in future periods. Additionally, the value of other acquired intangible assets may become impaired. We believed that the foregoing assumptions used in the in-process research and development analysis were reasonable at the time of the acquisition. No assurance can be given, however, that the underlying assumptions used to estimate expected project sales, development costs or profitability, or the events associated with such projects, will transpire as estimated. At the date of acquisition, the development of these projects had not yet reached technological feasibility, and the research and development in progress had no alternative future uses. Accordingly, these costs in the amount of $185.7 million were charged to expense in the third quarter of 2004.

The results of operations for CIMA LABS have been included in our consolidated statements since the acquisition date of August 12, 2004.

The following unaudited pro forma information shows the results of our operations for the three months ended March 31, 2004 as though the acquisition had occurred as of the beginning of the period presented:

	For the three months ended March 31,
	2004
Total revenues	$	230,676
Net income	$	20,121
Basic and diluted net income per common share:
Basic income per common share	$	0.36
Diluted income per common share	$	0.34

The pro forma results have been prepared for comparative purposes only and are not necessarily indicative of the actual results of operations had the acquisition taken place as of the beginning of the periods presented, or the results that may occur in the future. Furthermore, the pro forma results do not give effect to all cost savings or incremental costs that may occur as a result of the integration and consolidation of the acquisition.

3. STOCK-BASED COMPENSATION

We account for stock option plans and restricted stock award plans using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Compensation cost for stock options, 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. Restricted stock awards are recorded as compensation cost over the requisite vesting periods based on the market value on the date of grant. We have opted to disclose only the provisions of Statement of Financial Accounting Standards (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:

Our previously reported earnings per share for the three months ended March 31, 2004 has been restated as required by EITF Issue No. 03-6 and No. 04-8. See Note 9.

	For the three months Ended March 31,
	2005			2004
Net income, as reported	$	26,662		$	21,711
Add: Stock-based compensation expense included in net income, net of related tax effects	1,620			786
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects	(6,880		)	(7,504		)

Pro forma net income	$	21,402		$	14,993

Earnings per share:
Basic income per share, as reported	$	0.46		$	0.38
Basic income per share, pro forma	$	0.37		$	0.27

Diluted income per share, as reported	$	0.44		$	0.36
Diluted income per share, pro forma	$	0.36		$	0.26

4. INVENTORY, NET

Inventory consisted of the following:

	March 31, 2005		December 31, 2004
Raw materials	$	42,167	$	31,511
Work-in-process	14,171		4,286
Finished goods	39,043		50,832
	$	95,381	$	86,629

We capitalize inventory costs associated with marketed products and certain products prior to regulatory approval and product launch, based on management’s judgment of probable future commercial use and net realizable value. We could be required to expense previously capitalized costs related to pre-approval or pre-launch inventory upon a change in such judgment, due to a denial or delay of approval by regulatory bodies, a delay in commercialization, or other potential factors. At March 31, 2005, we had $27.1 million of capitalized inventory costs.

5. INTANGIBLE ASSETS, NET

Intangible assets consisted of the following:

		March 31, 2005						December 31,2004
	Estimated Useful Lives	Gross Carrying Amount		Accumulated Amortization		Net Carrying Amount		Gross Carrying Amount		Accumulated Amortization		Net Carrying Amount
Developed technology acquired from Group Lafon	10-15 years	$	132,000	$	32,067	$	99,933	$	132,000	$	29,600	$	102,400
Trademarks/tradenames acquired from Group Lafon	15 years	16,000		3,467		12,533		16,000		3,200		12,800
GABITRIL product rights	9-15 years	114,860		31,519		83,341		119,352		29,859		89,493
Novartis CNS product rights	10 years	41,641		17,697		23,944		41,641		16,656		24,985
ACTIQ marketing rights	10 years	75,465		25,620		49,845		75,465		23,707		51,758
Modafinil marketing rights	10 years	9,739		2,432		7,307		10,288		2,314		7,974
DuraSolv® technology	14 years	70,000		3,043		66,957		70,000		1,826		68,174
OraSolv® technology	6 years	32,700		3,277		29,423		32,700		1,966		30,734
ORAVESCENT® technology	15 years	10,400		423		9,977		10,400		254		10,146
NAXY AND MONO-NAXY product rights	5 years	41,948		2,098		39,850		44,343		176		44,167
Other product rights	5-14 years	21,514		13,424		8,090		22,283		15,512		6,771
		$	566,267	$	135,067	$	431,200	$	574,472	$	125,070	$	449,402

Other intangible assets are amortized over their estimated useful economic life using the straight-line method. Amortization expense was $13.3 million and $8.4 million for the three months ended March 31, 2005 and 2004, respectively. Estimated amortization expense of intangible assets for each of the next five fiscal years is approximately $52 million.

6. LONG-TERM DEBT

Long-term debt consisted of the following:

	March 31, 2005			December 31, 2004
2.5% convertible subordinated notes due December 2006	$	521,750		$	521,750
Change in fair value of hedged portion of 2.5% convertible subordinated notes	(2,870		)	(1,772		)
Zero Coupon convertible subordinated notes first putable June 2008 (Old)	303			303
Zero Coupon convertible subordinated notes first putable June 2010 (Old)	99			102
Zero Coupon convertible subordinated notes first putable June 2008 (New)	374,764			374,697
Zero Coupon convertible subordinated notes first putable June 2010 (New)	374,940			374,898
Due to Abbott Laboratories	559			531
Mortgage and building improvement loans	9,553			9,721
Capital lease obligations	3,099			3,270
Other	6,110			6,024
Total debt	1,288,307			1,289,524
Less current portion	(5,655		)	(5,114		)
Total long-term debt	$	1,282,652		$	1,284,410

Subordinated Convertible Notes

In March 2004, we purchased $10.0 million of the 3.875% convertible subordinated notes from one of the holders in a private transaction at a price of 109.5% of the face amount of the notes. As a result, during the first quarter of 2004, $1.0 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

3.875% convertible subordinated notes	$	10,000	$	950	$	11	$	961

7. LEGAL PROCEEDINGS

We have filed patent infringement lawsuits in U.S. District Court in New Jersey against Teva Pharmaceuticals USA, Inc., Mylan Pharmaceuticals, Inc., Ranbaxy Laboratories Limited, Barr Laboratories, Inc. and Sandoz, Inc. based upon the ANDAs filed by each of these companies with the FDA seeking approval to market a generic form of modafinil. The lawsuits claim infringement of our U.S. Patent No. RE37,516 which covers the pharmaceutical compositions and methods of treatment with the form of modafinil contained in PROVIGIL. Each of the defendants has asserted defenses and/or counterclaims for non-infringement and/or patent invalidity. Defendants Teva, Ranbaxy and Mylan have recently amended their answers to state inequitable conduct as a defense to our infringement claims. Defendants Mylan and Ranbaxy also have recently asserted new counterclaims for patent unenforceability based on alleged inequitable conduct. We have moved to dismiss those new counterclaims, Mylan and Ranbaxy have opposed our motions, and a decision is pending. These lawsuits are currently in the discovery phase; we expect a trial to begin no earlier than late 2005. Sandoz, Inc. recently notified us that it intends to convert its modafinil ANDA from a Paragraph IV filing to a Paragraph III filing. The effect of this conversion is that Sandoz will certify to the FDA that it does not intend to market a generic form of modafinil until after the expiration of the patent in 2014. Upon such amendment of Sandoz’s ANDA, it will no longer be necessary for us to pursue further our patent infringement litigation against Sandoz. We also recently filed suit against Carlsbad Technology, Inc. based upon the ANDA filed by Carlsbad with the FDA seeking to market a generic form of modafinil. Carlsbad has not yet answered the complaint, and discovery in this action has not yet commenced. 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.

In January 2005, we filed a patent infringement lawsuit in U.S. District Court in Delaware against Barr Laboratories, Inc., based on an ANDA filed by Barr seeking approval to market a generic form of ACTIQ. Barr has asserted counterclaims for non-infringement and patent invalidity. We have moved to dismiss those counterclaims, Barr has opposed our motion, and a decision is pending. This lawsuit is currently in the discovery phase. Neither the ANDA filing nor this lawsuit affects the terms of the existing license grant to Barr of certain intellectual property related to ACTIQ, and we do not expect any change in the anticipated date of Barr’s entry to the market. At the same time we continue to comply in good faith with the FTC Decision and Order requiring us to provide ACTIQ manufacturing process and other information to Barr to assist its efforts to manufacture a licensed generic version of ACTIQ when Barr’s license becomes effective. While we intend to vigorously defend the validity of the ACTIQ patents and prevent infringement by Barr until the license effective date, these efforts will be both expensive and time consuming and, ultimately, may not be successful, which would allow Barr to enter the market prior to the license effective date.

In April 2005, we received notice from SUN Pharmaceutical Industries Limited that it had filed an ANDA with the FDA seeking approval to market a generic form of GABITRIL. GABITRIL is protected by four Orange Book-listed patents, including a composition of matter patent claiming tiagabine, the active drug substance contained

in GABITRIL. The ANDA as filed does not include a Paragraph IV certification with respect to this composition of matter patent and, as such, SUN is not seeking to market a generic form of GABITRIL until the expiration of this patent in 2011. Instead, SUN’s notice states that its ANDA alleges (1) non-infringement of a patent claiming crystalline tiagabine hydrochloride monohydrate and its use as an anti-epileptic agent and a patent claiming the pharmaceutical formulation of the product and (2) non-infringement and invalidity of our patent claiming anhydrous crystalline tiagabine hydrochloride and its processes for preparation.

In September 2004, we announced that we had received subpoenas from the U.S. Attorney’s Office in Philadelphia with respect to PROVIGIL, ACTIQ and GABITRIL. This investigation is ongoing and appears to be focused on our sales and promotional practices. We are cooperating with the investigation and are providing documents to the Government. In addition, we have engaged in ongoing discussions with the Attorney General in Pennsylvania regarding recent media reports of instances of abuse and diversion of ACTIQ. We have had similar discussions with the Office of the Connecticut Attorney General; in September 2004, we received a voluntary request for information from the Office of the Connecticut Attorney General asking us to provide information generally relating to our sales and promotional practices for our U.S. products. We have agreed to comply with this voluntary request. These matters may involve the bringing of criminal charges and fines, and/or civil penalties. We cannot predict or determine the outcome of these matters or reasonably estimate the amount or range of amounts of any fines or penalties that might result from an adverse outcome. However, an adverse outcome could have a material adverse effect on our financial position, liquidity and results of operations.

We are a party to certain other litigation in the ordinary course of our business, including, among others, 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.

8. COMPREHENSIVE INCOME

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

	Three months ended March 31,
	2005			2004
Net income	$	26,662		$	21,711

Foreign currency translation adjustment	(14,118		)	(6,247		)
Unrealized investment losses	(1,583		)	(181		)
Other comprehensive loss	(15,701		)	(6,428		)

Comprehensive income	$	10,961		$	15,283

9. 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, restricted stock awards and the New Zero Coupon Convertible Notes is measured using the treasury stock method. The dilutive effect of all other 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.

We adopted the guidance from the EITF’s Issue 03-6 in the second quarter of 2004. Under the guidance, we must apply the two-class method of computing EPS and allocate undistributed earnings to participating securities. We determined that our 3.875% convertible subordinated notes were participating securities as these notes contained a provision that stated that if we distributed cash to all or substantially all of our common stock holders, whether by dividend or otherwise, the holders were entitled to such distribution as if they had converted their notes into shares. As of March 31, 2005, none of the 3.875% convertible notes are outstanding. Our previously reported earnings per share have been restated as required by EITF Issue 03-6. For the three months ended March 31, 2004, both basic and diluted income per common share have been restated with a decrease of $0.01 per share.

In September 2004, the EITF reached consensus on Issue 04-8, “Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effects on Diluted Earnings per Share.” This Issue requires the inclusion of convertible shares for contingently convertible debt in the calculation of diluted EPS regardless of whether the contingency has been met, if the effect is dilutive. The Issue is effective for periods ending after December 15, 2004 and requires the restatement of previously reported EPS. In December 2004, we exchanged $749.6 million of the Old Notes for the New Notes with substantially the same terms and conditions. For the quarters ended March 31, 2005 and 2004, the inclusion of the remaining $0.4 million of Old Notes using the if-converted method had no effect on diluted EPS.

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 March 31,
	2005		2004
			Restated
Basic income per share computation:
Numerator:
Net income used for basic income per common share	$	26,662	$	21,486
Net income used for basic income per participating security	—		225
Total net income	$	26,662	$	21,711
Denominator:
Weighted average shares used for basic income per common share	57,994		55,905

Basic income per common share:	$	0.46	$	0.38

Diluted income per share computation:
Numerator:
Net income used for basic income per common share	$	26,662	$	21,486
Interest on convertible subordinated notes, net of tax	2,189		2,023
Net income used for diluted income per common share	$	28,851	$	23,509

Denominator:
Weighted average shares used for basic income per common share	57,994		55,905
Effect of dilutive securities:
Employee stock options and restricted stock awards	622		1,687
Convertible subordinated notes	6,449		7,414
Weighted average shares used for diluted income per common share	65,065		65,006

Diluted income per common share:	$	0.44	$	0.36

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 March 31,
	2005	2004
Weighted average shares excluded:
Employee stock options	5,328	2,231
Convertible subordinated notes	12,935	13,524
	18,263	15,755

The New Zero Coupon Convertible Notes are considered to be Instrument C’s as defined by EITF 90-19; therefore, the New Notes are included in the dilutive earnings per share calculation using the treasury stock method. Under the treasury stock method, we must calculate the number of shares issuable under the terms of the New Notes based on the average market price of the stock during the period, and include that number of shares in the total diluted shares figure for the period. For example, using the treasury stock method, if the average price of our stock during the three months ended March 31, 2005 had been $65.00, $80.00 or $90.00, the shares from the New Notes to be included in diluted EPS would have been 1.4 million, 3.6 million and 4.6 million shares, respectively. The total number of shares that could potentially be included under the New Notes is 12.9 million. Since the average share price of our stock during the three months ended March 31, 2005 did not exceed the conversion prices of $56.50 and $59.50, there was no impact of these New Notes on diluted shares or diluted EPS during that period.

In July 2003, we purchased Convertible Note Hedges and sold Warrants which, in combination, have the effect of reducing the dilutive impact of the Zero Coupon Convertible Notes by increasing the effective conversion price for these Notes, from our perspective, to $72.08. SFAS 128, however, requires us to analyze the impact of the Convertible Note Hedges and Warrants on diluted EPS separately. As a result, the purchase of the Convertible Note Hedge is excluded because its impact will always be anti-dilutive. SFAS 128 further requires that the impact of the sale of the Warrants be computed using the treasury stock method. For example, using the treasury stock method, if the average price of our stock during the three months ended March 31, 2005 had been $72.08, $80.00 or $90.00, the shares from the Warrants to be included in diluted EPS would have been zero, 1.0 million and 2.1 million shares, respectively. The total number of shares that could potentially be included under the Warrants is 12.9 million. Since the average share price of our stock during the year ended March 31, 2005 did not exceed the Conversion Price of $72.08, there was no impact of these Warrants on diluted shares or diluted EPS during that period.

10. SEGMENT AND SUBSIDIARY INFORMATION

Although we have significant sales, manufacturing, and research operations conducted by several subsidiaries located throughout the United States and Europe, including our latest acquisition of CIMA LABS, Cephalon management makes operating decisions and assesses performance based on a single biopharmaceutical segment. CIMA LABS’ operations consist of contract manufacturing and research and development of pharmaceutical products which we have included in our single operational segment for reporting purposes.

As required by SFAS 131, “Disclosure about Segments of an Enterprise and Related Information,” revenue and long-lived asset information summarized by geographic region is provided below:

Revenues for the three months ended March 31:

	2005						2004
	United States		Europe		Total		United States		Europe		Total
PROVIGIL sales	92,149		7,981		100,130		87,931		6,622		94,553
ACTIQ sales	98,868		3,057		101,925		68,659		1,497		70,156
GABITRIL sales	24,701		1,689		26,390		21,034		1,677		22,711
Other sales	9,194		28,970		38,164		—		22,971		22,971
Other revenue	11,565		1,807		13,372		2,944		1,647		4,591
Total	$	236,477	$	43,504	$	279,981	$	180,568	$	34,414	$	214,982

Long-lived assets:

	March 31, 2005		December 31, 2004
United States	$	679,408	$	695,279
Europe	575,062		583,061
Total	$	1,254,470	$	1,278,340

11. PENSIONS AND OTHER POSTRETIREMENT BENEFITS

We have a defined benefit pension plan and other postretirement benefit plans covering employees at our French subsidiaries. These plans are noncontributory and are not funded; benefit payments are funded from operations.

A summary of the components of net periodic benefit costs is as follows:

	Pension Benefits For the three months ended March 31,						Other Benefits For the three months ended March 31,
	2005			2004			2005			2004
Service cost	$	133		$	115		$	9		$	8
Interest cost	84			83			15			21
Recognized actuarial gain	(68		)	(63		)	(9		)	(9		)
Recognized gain due to plan curtailment	—			—			—			(4,214		)
Change in benefit obligation	$	149		$	135		$	15		$	(4,194	)

In the first quarter of 2004, we cancelled postretirement health care benefits for employees not yet retired. This resulted in a gain of $4.2 million, which has been recognized as an offset to net periodic benefits costs for the three months ended March 31, 2004.

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

Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide information to assist you in better understanding and evaluating our financial condition and results of operations. We recommend that you read this MD&A in conjunction with our consolidated financial statements included in Item 1 of this Quarterly Report on Form 10-Q, as well as our Annual Report on Form 10-K for the year ended December 31, 2004.

EXECUTIVE SUMMARY

Cephalon is an international biopharmaceutical company dedicated to the discovery, development and marketing of innovative products to treat sleep disorders, neurological disorders, cancer and pain. In addition to conducting an active research and development program, we market three products in the United States and numerous products in various countries throughout Europe. Through our wholly-owned subsidiary, CIMA LABS INC., we develop and manufacture orally disintegrating tablets using proprietary technologies. Our three largest products in terms of product sales, PROVIGIL, ACTIQ and GABITRIL, comprised approximately 86% of our worldwide net sales for the three months ended March 31, 2005. We market PROVIGIL, ACTIQ and GABITRIL in the United States through our approximately 500-person sales force.

Our corporate headquarters are in Frazer, Pennsylvania, and our research and development headquarters are in West Chester, Pennsylvania. In addition, we have offices in Utah, Minnesota, 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, in Utah for the production of ACTIQ for worldwide distribution and sale, and in Minnesota for the production of orally disintegrating versions of drugs for our partners.

Our future success is highly dependent on obtaining and maintaining patent protection for our products and technology. With respect to PROVIGIL, we have filed patent infringement lawsuits against five generic companies based upon the ANDAs filed by these companies seeking FDA approval to market a generic version of modafinil. We anticipate that the first trial will begin no earlier than late 2005. See “– Certain Risks Related to Our Business.” For ACTIQ, the patents covering the previous and current formulations of the product are set to expire as early as May 2005 and September 2006, respectively. As a result of the License and Supply Agreement we entered into with Barr Laboratories, Inc. in July 2004, we could face generic competition from Barr prior to September 2006 if we receive FDA approval of ORAVESCENT fentanyl before this date. See “Acquisition of CIMA LABS INC.” below. In December 2004, we announced that the FDA had acknowledged receipt of an ANDA filed by Barr seeking approval to market a generic form of ACTIQ. In January 2005, we filed a patent infringement lawsuit against Barr to defend our patents until the license effective date. Neither the ANDA filing nor this lawsuit modify the existing license grant to Barr, and we do not expect any change in the anticipated date of Barr’s entry to market.

In April 2005, we received notice from SUN Pharmaceutical Industries Limited that it had filed an ANDA with the FDA seeking approval for a generic form of GABITRIL. GABITRIL is protected by four Orange Book-listed patents, including a composition of matter patent claiming tiagabine, the active drug substance contained in GABITRIL. The ANDA as filed does not include a Paragraph IV certification with respect to this patent and, as such, SUN is not seeking to market a generic form of GABITRIL until the expiration of this patent in 2011. Instead, the ANDA alleges (1) non-infringement of our patent claiming crystalline tiagabine hydrochloride monohydrate and its use as an anti-epileptic agent and our patent claiming the pharmaceutical formulation of the product and (2) non-infringement and invalidity of our patent claiming anhydrous crystalline tiagabine hydrochloride and its processes for preparation. The loss of patent protection on any of our existing U.S. products, whether by third-party challenge, invalidation, circumvention, license or patent expiration, would materially impact our results of operations.

As part of our business strategy, in the future we expect to continue to consider and, as appropriate, consummate acquisitions of other technologies, products and businesses. Over the past few years, we also have pursued a strategy of both broadening the range of clinical uses that are approved by regulatory authorities and seeking new and improved formulations of our currently marketed products. During the first quarter of 2005, we continued to make progress towards these goals. Some notable achievements include:

• Our sNDA for our proprietary pediatric formulation of modafinil for ADHD was accepted by the FDA for review;

• We submitted an NDA to the FDA seeking approval to market NUVIGIL™ to improve wakefulness in patients suffering from excessive sleepiness associated with narcolepsy, shift work sleep disorder and obstructive sleep apnea/hypopnea syndrome;

• We received an approvable letter from the FDA with respect to our sugar-free formulation of ACTIQ and expect final approval of this new formulation in the third quarter of 2005; and

• We continued to make progress in our clinical programs studying ORAVESCENT fentanyl for the treatment of breakthrough cancer pain and GABITRIL for generalized anxiety disorder, both of which should be completed this year.

On May 5, 2005, we announced positive results from our 123-patient, double-blind, placebo-controlled, variable dose Phase 3 trial with ORAVESCENT fentanyl. Data from the major efficacy trial showed statistically significant and clinically relevant benefit to patients with breakthrough cancer pain who were already receiving around-the-clock pain-controlling medication for their underlying chronic pain. The primary endpoint was the Sum of Pain Intensity Difference scale. ORAVESCENT fentanyl was generally well tolerated in this trial.

We also have significant research programs focused on developing therapeutics to treat neurological and oncological disorders. In the neurology area, we have a program with H. Lundbeck A/S to evaluate a molecule, CEP-1347, that has entered into an 800-patient Phase 2/3 clinical trial for the treatment of patients with early stage Parkinson’s disease. In the second quarter of 2005, we expect to conduct an interim analysis of the clinical data from this trial. In the cancer area, we have a program with a molecule, CEP-701, and are currently conducting Phase 2 clinical trials in patients suffering from acute myeloid leukemia (AML). We also are conducting a Phase 1/2 program with another molecule, CEP-7055, to evaluate safety and tolerability and to gather preliminary evidence of efficacy in patients with treatment refractory tumors. In the pharmaceutical industry, the regulatory approval for the sale of new pharmaceutical products remains highly uncertain because the majority of therapeutic candidates fail to show the human safety and efficacy necessary for regulatory approval and successful commercialization. In addition, these efforts require substantial time, effort and financial resources. Our success in developing and commercializing these product candidates, or new or improved formulations of existing products, will be a significant factor in our future success.

We have significant levels of indebtedness outstanding, the majority of which consists of convertible notes with stated conversion prices or restricted conversion prices higher than our stock price as of the date of this filing. Of our outstanding convertible notes, $521.8 million in aggregate principal amount outstanding matures in December 2006.

The rate of our future growth and our ability to generate sufficient cash flows from operations to service and repay our indebtedness ultimately will depend, in large part, on our ability to maintain patent protection on our existing products and successfully acquire or develop new products and new indications for our existing products.

Acquisition of CIMA LABS INC.

On August 12, 2004, we completed our acquisition of CIMA LABS INC. Under the Agreement and Plan of Merger dated November 3, 2003, we acquired each outstanding share of CIMA LABS common stock for $34.00 per share in cash. The total cash paid to CIMA LABS stockholders in the transaction was approximately $482.5 million, net of CIMA LABS’ existing cash on hand, or $409.4 million, net of its cash, cash equivalents and investments. As a result of the acquisition, we obtained the rights to CIMA LABS’ ORAVESCENT fentanyl product candidate, which is currently in Phase 3 clinical trials for the treatment of breakthrough cancer pain in opioid-tolerant patients. ORAVESCENT fentanyl utilizes an enhanced absorption transmucosal drug delivery technology that we believe may facilitate the rapid onset of pain relief in such patients. We are targeting approval of this product by the FDA in late 2006.

To secure FTC clearance of the CIMA LABS acquisition, we entered into a license and supply agreement with Barr whereby we agreed to license to Barr our U.S. rights to any intellectual property related to ACTIQ. The license to ACTIQ will become effective upon the earliest to occur of (i) final FDA approval of ORAVESCENT

fentanyl, (ii) September 5, 2006, if we have not received either (A) final FDA approval of the sugar free formulation of ACTIQ by September 14, 2005 or (B) a pediatric extension for ACTIQ or (iii) February 3, 2007, if we have received a pediatric extension for ACTIQ. As we currently expect to receive both a pediatric extension for ACTIQ prior to September 2006 and FDA approval for the sugar-free formulation of ACTIQ by September 14, 2005, we anticipate that the Barr license will be effective upon ORAVESCENT fentanyl approval. Under the agreement, Barr also may receive a license to the sugar-free formulation of ACTIQ under development; this license would become effective upon ORAVESCENT fentanyl approval by the FDA or if the sugar-free approval timeline described above is not achieved.

Under the license and supply agreement, we also agreed to transfer to Barr our technological know-how and intellectual property related to ACTIQ and to sell to Barr, for period of up to three years, a generic form of ACTIQ for resale in the United States if Barr is unable to manufacture an FDA-approved generic version of ACTIQ by the date the license takes effect. In addition, we have agreed to forbear from asserting any remaining patent rights in ACTIQ against other parties beginning on the earlier of August 3, 2007 or six months following the effective date of Barr’s license.

RESULTS OF OPERATIONS

Three months ended March 31, 2005 compared to three months ended March 31, 2004:

	For the three months ended March 31,
	2005		2004		Change		% Change
Sales:
PROVIGIL	$	100,130	$	94,553	$	5,577	6	%
ACTIQ	101,925		70,156		31,769		45	%
GABITRIL	26,390		22,711		3,679		16	%
Other	38,164		22,971		15,193		66	%
Total sales	266,609		210,391		56,218		27	%

Total other revenues	13,372		4,591		8,781		191	%

Total revenues	$	279,981	$	214,982	$	64,999	30	%

Sales— In the United States, we sell our products to pharmaceutical wholesalers, the largest three of which accounted for 87% of our worldwide net sales for the three months ended March 31, 2005. Decisions made by these wholesalers regarding the levels of inventory they hold (and thus the amount of product they purchase from us) can materially affect the level of our sales in any particular period and thus may not necessarily correlate to the number of prescriptions written for our products as reported by IMS Health. We believe that this speculative buying of product, particularly in anticipation of possible price increases, has been the historic practice of many pharmaceutical wholesalers. For our part, we have attempted to minimize these fluctuations, both by providing, from time to time, discounts to our customers to stock normal amounts of inventory (which we define as approximately one month’s supply at our current sales level) and by canceling orders if we believe a particular customer is speculatively buying inventory in anticipation of possible price increases. During the first quarter of 2005, we extended additional discounts totaling $2.2 million to certain of our wholesalers in order to maintain inventory at estimated historic levels. The impact of these discounts was recognized as a reduction to gross sales in the first quarter of 2005.

In recent months, our wholesaler customers, as well as others in the industry, have begun to modify their business models from arrangements where they derive profits from the management of various discounts and rebates, to arrangements where they charge a fee for their services. In connection with this new wholesaler business model, we have been negotiating Wholesaler Service Agreements with our major wholesaler customers. When ultimately executed, these agreements will obligate the wholesalers to provide us with periodic retail demand information and current inventory levels for our products held at their warehouse locations; additionally they will agree to manage the variability of their purchases within specified limits. In return, we will provide the wholesalers with additional discounts in exchange for their services. When executed, we believe wholesalers will reduce, over time, the levels of

inventory of our products they hold from approximately one month to approximately 2 to 3 weeks by the end of 2005. During the first quarter of 2005, we did not have Wholesaler Service Agreements in place with any wholesalers.

As of March 31, 2005, we received information from our three largest U.S. wholesaler customers about the levels of inventory they held for our three products. Based on this information, which we have not independently verified, we believe that inventory held at these wholesalers is within the normal range for our business of approximately one month’s supply of our current sales level.

The factors that contributed to the increase in sales are summarized as follows:

• Sales of PROVIGIL increased 6% in the first quarter of 2005 as compared to 2004. U.S. prescriptions for PROVIGIL increased by 28%, according to IMS Health. During the first quarter of 2005, sales of PROVIGIL were impacted by a decrease in the number of units of inventory held by wholesalers during the quarter as well as an increase in the adjustments recorded to gross sales, slightly offset by domestic price increases of approximately 18% from period to period.

• Sales of ACTIQ increased 45% as compared to the same period last year. U.S. prescriptions for ACTIQ increased by 14%, according to IMS Health. During the first quarter of 2005, sales of ACTIQ were impacted by an increase in the number of units of inventory held by wholesalers during the quarter as well as an increase in domestic prices of approximately 15% from period to period, slightly offset by an increase in adjustments recorded to gross sales.

• Sales of GABITRIL increased 16% as compared to the same period last year. U.S. prescriptions for GABITRIL increased by 18%, according to IMS Health. During the first quarter of 2005, sales of GABITRIL were impacted by an increase number of units held by wholesalers during the quarter as well as an increase in domestic prices of approximately 21% from period to period, offset by an increase in adjustments recorded to gross sales.

• Other sales consist primarily of sales of other products and certain third party products. The most significant sales in this category are SPASFON® (phloroglucinol) and NAXY® (clarithromycin), which was acquired in December 2004, and sales of products manufactured and sold to pharmaceutical partners by CIMA LABS, which was acquired in the third quarter of 2004,.

Analysis of gross sales to net sales—The following table presents the adjustments deducted from gross sales to arrive at a net sales figure:

	For the quarter ended March 31,
	2005			2004			Change		% Change
Gross sales:	$	307,730		$	231,742		$	75,988	33	%

Adjustments to gross sales:
Prompt payment discounts	5,166			4,063			1,103		27	%
Wholesaler discount reserve	7,298			—			7,298		—	%
Returns	3,995			2,912			1,083		37	%
Coupons	4,723			3,274			1,449		44	%
Medicaid discounts	15,445			8,847			6,598		75	%
Managed care and governmental agreements	4,494			2,255			2,239		99	%
	41,121			21,351			19,770

Net sales	$	266,609		$	210,391		$	56,218	27	%

Adjustments to gross sales as a percentage of gross sales	13.4		%	9.2		%

Increases in the dollar amount of adjustments to gross sales from quarter ending March 31, 2004 to quarter ending March 31, 2005 primarily reflects the establishment of a wholesaler discount reserve to provide for fees consistent with the terms of the Wholesaler Service Agreements currently being finalized with our customers, and increased Medicaid discounts resulting from both increased usage and increased discount percentages due to price increases.

Other Revenues—The increase of 191% from period to period is primarily due to the inclusion of product development and licensing fees and royalties of $7.7 million attributable to CIMA LABS, which was acquired in the third quarter of 2004.

	For the three months ended March 31,
	2005		2004		Change		% Change
Costs and expenses:
Cost of sales	$	41,114	$	25,977	$	15,137	58	%
Research and development	80,766		56,482		24,284		43	%
Selling, general and administrative	98,229		82,502		15,727		19	%
Depreciation and amortization	18,650		11,497		7,153		62	%
	$	238,759	$	176,458	$	62,301	35	%

Cost of Sales— The cost of sales was approximately 15% of net sales for the first quarter of 2005 and 12% of net sales for the first quarter of 2004. The increase is primarily due to the addition of CIMA LABS’ product sales for which the margin is lower than our other products and which was acquired in the third quarter of 2004.

Research and Development Expenses—Research and development expenses increased $24.3 million, or 43%, in the first quarter of 2005 as compared to the first quarter of 2004. Approximately $11.9 million of this increase is due to costs in our clinical research group associated with (1) clinical studies to explore the utility of GABITRIL in generalized anxiety disorder, (2) continuing costs of our NUVIGIL program, and (3) Phase 3 studies of ORAVESCENT fentanyl. The remainder of the increase from period to period is largely due to an increase in headcount and the inclusion of CIMA LABS, which was acquired in the third quarter of 2004.

Selling, General and Administrative Expenses—Selling, general and administrative expenses increased $15.7 million, or 19%, in the first quarter of 2005 as compared to the first quarter of 2004. Selling, general and administrative expenses increased period to period primarily due to (1) increased sales and marketing costs in France to support NAXY® and MONO-NAXY® acquired from Sanofi-Synthelabo France in the fourth quarter of 2004, (2) expenditures associated with an increase in headcount, (3) the inclusion of CIMA LABS, which was acquired in the third quarter of 2004, and (4) the recognition of a gain of $4.2 million in the first quarter in 2004 as a result of retiree medical benefit changes for employees at Cephalon France for which there is no comparable amount in the first quarter of 2005.

Depreciation and Amortization Expenses—Depreciation and amortization expenses increased by $7.2 million, or 62%, in the first quarter of 2005 as compared to the first quarter of 2004. Depreciation expense increased period over period primarily as a result of increased capital investments in software, building, leasehold and laboratory improvements at our West Chester and Frazer locations, increased spending on manufacturing equipment at our Salt Lake City location and the acquisition of property, plant and equipment associated with the CIMA LABS acquisition. Amortization expense increased due to the amortization of technology, trademark and marketing rights acquired from CIMA LABS in the third quarter of 2004 and the amortization of French marketing rights to NAXY® and MONO-NAXY® acquired from Sanofi-Synthelabo France in the fourth quarter of 2004.

	For the three months ended March 31,
	2005			2004			Change		% Change
Other income and (expense):
Interest income	$	4,859		$	3,246		$	1,613	50	%
Interest expense	(5,551		)	(5,890		)	339		6	%
Charge on early extinguishment of debt	—			(961		)	961		100	%
Other income (expense), net	1,335			(466		)	1,801		386	%
	$	643		$	(4,071	)	$	4,714	116	%

Other Income and Expense— Total other income and expense, net, increased $4.7 million, or 116%, in the first quarter of 2005 from the first quarter of 2004 due to:

• Interest income increased by $1.6 million in the first quarter of 2005 due to higher investment returns partially offset by lower average investment balances.

• In the first quarter of 2004, we recognized a charge on early extinguishment of debt of $1.0 million associated with the repurchase of $10.0 million of our 3.875% convertible subordinated notes.

• Other income increased by $1.8 million in the first quarter of 2005 from the first quarter of 2004 primarily due to gains recorded on foreign currency transactions.

	For the three months ended March 31,
	2005			2004			Change			% Change
Income tax expense	$	(15,203	)	$	(12,742	)	$	(2,461	)	19	%

Income Taxes— We recognized $15.2 million of income tax expense in the first quarter of 2005 and $12.7 million of income tax expense in the first quarter of 2004 based on an overall estimated annual effective tax rate of approximately 36% in 2005 and 37% in 2004.

LIQUIDITY AND CAPITAL RESOURCES

Cash, cash equivalents and investments at March 31, 2005 were $810 million, representing 33% of total assets. Working capital, which is calculated as current assets less current liabilities, was $978.8 million at March 31, 2005.

Net Cash Provided by Operating Activities

Net cash provided by operating activities was $46.2 million for the three months ended March 31, 2005 as compared to $9.4 million for 2004. The increase in cash provided by operating activities in 2005 is primarily a result of increases in sales of our products offset by uses of cash to fund purchases of inventory and other current assets.

Net Cash Used for Investing Activities

Net cash used for investing activities was $28.5 million for the three months ended March 31, 2005 as compared to $23.4 million for 2004. Capital expenditures increased due to facilities improvements at our new corporate headquarters in Frazer, Pennsylvania and our West Chester, Salt Lake City and France locations to accommodate our growth and also for manufacturing equipment at our Salt Lake City location for the production of ACTIQ for the U.S. and European markets.

Net Cash Provided by (Used for) Financing Activities

Net cash provided by financing activities was $1.5 million for the three months ended March 31, 2005. Net cash used for financing activities was $5.6 million in 2004. The change is primarily the result of the retirement in March 2004 of $10.0 million in convertible subordinated notes, partially offset by a decreased volume of exercises of common stock options in the first quarter of 2005 as compared to the same period in 2004. The extent and timing of option exercises are primarily dependent upon the market price of our common stock and general financial market conditions, as well as the exercise prices and expiration dates of the options.

Outlook

Cash, cash equivalents and investments at March 31, 2005 were $810 million. 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. At this time, we cannot accurately predict the effect of certain developments on the rate of sales growth in 2006 and beyond, such as the degree of market acceptance and exclusivity of our products, the impact of competition, the effectiveness of our sales and marketing efforts and the outcome of our current efforts to develop new products and formulations of our existing products and to demonstrate the utility of our products in indications beyond those already included in the FDA approved labels. However, we expect that sales of our three most significant marketed products, PROVIGIL, ACTIQ and GABITRIL, in combination with other revenues, should allow us to generate profits and positive cash flows from operations in the near term.

Based on our current level of operations and projected sales of our products combined with other revenues and interest income, we also believe that we will be able to service our existing debt and meet our capital expenditure and working capital requirements in the near term. 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 future significant strategic transactions, to repay our outstanding indebtedness or for our future operational needs, and we cannot be certain that funding will be available on terms acceptable to us, or at all.

Products

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. See “—Commitments and Contingencies— Legal Proceedings” above. If we complete clinical studies of PROVIGIL in pediatric patients that are agreeable to the FDA, the FDA could grant us a six-month extension of our current exclusivity and of the particle-size patent. Future growth of modafinil-based product sales in 2006 and beyond also will depend on our ability to achieve FDA approval of NUVIGIL and our proprietary pediatric formulation of modafinil for ADHD.

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 previous formulation of ACTIQ, which expires in May 2005. See “Commitments and Contingencies—Legal Proceedings” above. If we complete clinical studies in pediatric patients that are agreeable to the FDA, the FDA could grant us six months of exclusivity beyond the September 2006 compressed powder patent expiration. However, even with this additional exclusivity, Barr’s license to the ACTIQ patents could become effective as early as the launch of ORAVESCENT fentanyl (expected in late 2006), and in no event later than February 3, 2007. The entry of Barr with a generic form of ACTIQ beginning in late 2006 or early 2007 likely will significantly and negatively impact future ACTIQ sales and could potentially have a negative impact on sales of ORAVESCENT fentanyl, if approved.

Clinical Studies

In 2004, we incurred significant expenditures related to conducting clinical studies to develop new pharmaceutical products and exploring the utility of our existing products in treating disorders beyond those currently approved in their respective labels. In 2005 and beyond, we expect to increase the level of our research and

development activities, including clinical trials, for our other product candidates, and for improved formulations for our existing products. With respect to GABITRIL, we are continuing a Phase 3 clinical program evaluating GABITRIL for the treatment of GAD. With respect to new product candidates, we are continuing Phase 3 clinical trials of ORAVESCENT fentanyl for the treatment of breakthrough cancer pain and our Phase 2/3 studies of CEP-1347 for the treatment of Parkinson’s disease. We also are continuing clinical development of CEP-701 and CEP-7055 for treatment of certain malignancies. 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.

Manufacturing, Selling and Marketing Efforts

We also expect to continue to incur significant expenditures associated with manufacturing, selling and marketing our products. In 2005, we expect to continue a nearly $70 million capital expansion at our Salt Lake City facility that will increase our ACTIQ capacity and provide us with flexibility to manufacture other products.

Indebtedness

We have significant indebtedness outstanding, consisting principally of indebtedness on convertible subordinated notes. The following table summarizes the principal terms of our most significant convertible subordinated notes outstanding as of March 31, 2005:

Security	Outstanding			Conversion Price				Other
	(in millions)
2.5% Convertible Subordinated Notes due December 2006	$	521.8		$		81.00		• Redeemable on or after December 20, 2004 at our option at a redemption price of 100% of the principal amount redeemed.
Zero Coupon Convertible Notes due June 2033, first putable June 15, 2008	$	374.8		$	59.50		*	• 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	$		374.9	$	56.50		*	• Redeemable on June 15, 2010 at either option of holder or us at a redemption price of 100.25% of the principal amount redeemed.

* Stated conversion prices as per the terms of the notes. However, each convertible note contains certain terms restricting a holder’s ability to convert the notes, including that a holder may only convert if the closing price of our stock on the day prior to conversion is higher than $71.40 or $67.80 with respect to the 2008 notes or the 2010 notes, respectively. If the restrictions on conversion are satisfied, we would classify the then-aggregate outstanding principal balance of the 2008 notes and/or the 2010 notes as a current liability on our balance sheet. For a more complete description of these notes, including the convertible note hedge strategy, see Notes 1 and 11 to our consolidated financial statements included in Item 8 of our Form 10-K for the fiscal year ended December 31, 2004.

The annual interest payments on our convertible notes outstanding as of March 31, 2005 are $13.0 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 debt, 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 2.5% convertible notes in the aggregate notional amount of $200.0 million. Although we exchanged $78.3 million of these notes in July 2004 for 1,518,169 shares of our common stock, the interest rate swap remains at $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 April 1, 2005, the interest rate is 3.49%. 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.

Acquisition Strategy

As part of our business strategy, we plan to consider and, as appropriate, make acquisitions of other businesses, products, product rights or technologies. We expect the merger will be completed in the second quarter of 2005. Our cash reserves and other liquid assets may be inadequate to consummate such acquisitions and it may be necessary for us to raise substantial additional funds in the future to complete future 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.

In February 2004, we filed with the SEC a $1.0 billion universal shelf registration statement covering the issuance and sale from time to time, of common and preferred stock, debt securities and warrants. While we have no current plans to access the capital markets, the shelf registration statement would allow us to expediently access capital markets periodically in the future.

Other

We may experience 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 wholesalers and large retail chain 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.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Preparation of these statements requires management to make judgments and estimates. Some accounting policies have a significant impact on amounts reported in these financial statements. A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2004 in the “Critical Accounting Policies and Estimates” section and the “Recent Accounting Pronouncements” section.

Gross to Net Sales Adjustments— We record product sales net of the following significant categories of gross to net sales adjustments: prompt payment discounts, returns, coupons, Medicaid discounts and managed care and governmental contracts. In addition to these adjustments, in the first quarter of 2005 we also began recording an adjustment to product sales for wholesaler discount reserves. Calculating each of these items involves significant estimates and judgments and requires us to use information from external sources.

Wholesaler discount reserves — We are currently finalizing standard Wholesaler Service Agreements that will provide our wholesalers with the opportunity to earn up to 2% in additional discounts in exchange for the performance of certain services. These agreements will be effective from January 1, 2005. We have therefore recorded a provision equal to 2% of sales for the quarter. In addition, at our discretion, we may provide additional discounts to wholesalers such as the discounts of $2.2 million that were provided and recorded during the first quarter of 2005. Actual discounts provided could therefore exceed historical experience and our estimates of expected discounts. If these discounts were to increase by 1.0% of sales for the first quarter of 2005, then an additional provision of $3.1 million would result.

The following table summarizes activity in each of the above categories for the year ended December 31, 2004 and the three months ended, March 31, 2005 (in thousands):

																Managed
	Prompt			Wholesaler												Care and
	Payment			Discount									Medicaid			Governmental
	Discounts			Reserves			*Returns			Coupons			Discounts			Agreements			Total

Balance at January 1, 2004	$	(1,108	)	$	—		$	(7,121	)	$	(2,175	)	$	(10,038	)	$	(1,692	)	$	(22,134	)

Provision:
Current period	(18,443		)	—			(12,822		)	(16,521		)	(41,027		)	(12,263		)	(101,076		)
Prior periods	—			—			1,575			—			(247		)	(285		)	1,043
Total	(18,443		)	—			(11,247		)	(16,521		)	(41,274		)	(12,548		)	(100,033		)

Actual:
Current period	15,497			—			—			13,538			25,321			8,118			62,474
Prior periods	1,155			—			6,641			993			7,916			1,713			18,418
Total	16,652			—			6,641			14,531			33,237			9,831			80,892

Balance at December 31, 2004	(2,899		)	—			(11,727		)	(4,165		)	(18,075		)	(4,409		)	(41,275		)

Provision:
Current period	(5,166		)	(7,298		)	(3,995		)	(4,723		)	(14,864		)	(4,550		)	(40,596		)
Prior periods	—			—			—			—			(581		)	56			(525		)
Total	(5,166		)	(7,298		)	(3,995		)	(4,723		)	(15,445		)	(4,494		)	(41,121		)

Actual:
Current period	2,030			—			—			637			—			1,843			4,510
Prior periods	2,899			—			1,947			4,150			10,193			3,013			22,202
Total	4,929			—			1,947			4,787			10,193			4,856			26,712

Balance at March 31, 2005	$	(3,136	)	$	(7,298	)	$	(13,775	)	$	(4,101	)	$	(23,327	)	$	(4,047	)	$	(55,684	)

* Given our returned goods policy, we assume that all returns in a current year relate to prior period sales.

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 other factors not perceived by us to present significant risks to our business at this time 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 three months ended March 31, 2005, approximately 86% of our worldwide net 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:

• a change in 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;

• any unfavorable publicity regarding these products or similar products;

• the price of the product relative to other competing drugs or treatments, including potential generic forms of our products;

• 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 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 obtain regulatory approval for new products or for new formulations or indications for our existing products, which would significantly hamper future sales and earnings growth.

Our prospects, particularly with respect to the growth of our future sales and earnings, depend substantially on our ability to obtain FDA approval for our four near-term product candidates: NUVIGIL, a proprietary modafinil formulation for use in treating pediatric ADHD, ORAVESCENT fentanyl and GABITRIL for GAD. Recently, we filed an sNDA with the FDA seeking approval for the use of modafinil for ADHD in children and an NDA seeking approval for NUVIGIL. We do not know whether we will succeed in obtaining regulatory approval to market these products or what level of market acceptance these products may achieve, particularly if we ultimately face competition in the form of a generic version of PROVIGIL. We also have not yet completed Phase 3 studies of GABITRIL for use in treating GAD. If the results of some of these additional studies are negative or adverse, this could undermine physician and patient comfort with the current product, limit its commercial success, and diminish its acceptance. Even if the results of these studies are positive, the impact on sales of GABITRIL may be minimal unless we are able to obtain regulatory 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. Finally, we are continuing our Phase 3 clinical program with ORAVESCENT fentanyl for treatment of breakthrough cancer pain. As with our GABITRIL studies, we do not know whether these studies will demonstrate long-term safety, or if they do, whether we will succeed in receiving regulatory approval to market this product. Even if we obtain regulatory approval for ORAVESCENT fentanyl, the availability of a generic version of ACTIQ at that time could significantly and negatively impact sales of ORAVESCENT fentanyl.

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, no consistent policy has emerged 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 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.

PROVIGIL

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 and cover pharmaceutical compositions and uses of modafinil, specifically, certain particle sizes of modafinil contained in the pharmaceutical composition. Ultimately, these patents might be found invalid as the result of a challenge by a third party, or a potential competitor could develop a competing product or product formulation that avoids infringement of these patents. As of the date of this report, the FDA has accepted five ANDAs for pharmaceutical products containing modafinil and containing 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. We have filed patent infringement lawsuits 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. RE37,516. Each of the defendants has asserted defenses and/or counterclaims for non-infringement and/or patent invalidity, and defendants Teva, Ranbaxy and Mylan have moved to amend their answers and counterclaims to state inequitable conduct as a defense to our claims (we have opposed the motions and a decision is pending). These lawsuits are currently in the discovery phase; we expect a trial to begin no earlier than late 2005. We also recently filed suit against Carlsbad with respect to the ANDA they have filed with the FDA and discovery in this action has not yet commenced. 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.

We recently learned that Sandoz, Inc. has amended their ANDA filing from a Paragraph IV to a Paragraph III filing thereby agreeing that it will not sell a generic form of modafinil until after the expiration of the patent in 2014. As such, we have dropped Sandoz as a party to this litigation.

Barr, Mylan and Ranbaxy have each announced the receipt of tentative FDA approval for their respective generic versions of PROVIGIL. Under the provisions of the Hatch-Waxman Act, we are entitled to a 30-month stay of final FDA approval of these generic versions of PROVIGIL. This stay precludes these companies from selling a modafinil-based product until the earlier to occur of the conclusion of the lawsuit or June 2006. However, if the court finds our particle-size patent is invalid or not infringed, these companies could begin selling their modafinil-based products upon the expiration of our FDA orphan drug exclusivity, currently in December 2005, which would significantly and negatively impact revenues from PROVIGIL. We do not know whether the ANDAs filed by Teva and Carlsbad have been, or will be, tentatively approved by the FDA.

If we complete clinical studies of PROVIGIL in pediatric patients that are acceptable to the FDA, the FDA could grant us a six-month extension of our orphan drug exclusivity (to June 2006) and six months of exclusivity beyond the 2014 expiration of the particle-size patent term.

ACTIQ

With respect to ACTIQ, we hold an exclusive license to U.S. patents covering the currently approved compressed powder pharmaceutical composition and methods for administering fentanyl via this composition that are set to expire in September 2006. 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. If we complete an additional clinical study in pediatric patients that is agreeable to the FDA, the FDA could grant us six months of exclusivity beyond the September 2006 compressed powder patent expiration. However, even with this additional exclusivity, Barr’s license to the ACTIQ patents under the license and supply agreement could become effective as early as the launch of ORAVESCENT fentanyl (expected in late 2006), and in no event later than February 3, 2007. In December 2004, we announced that FDA had acknowledged receipt of an ANDA filed by Barr seeking approval for a generic form of ACTIQ and in January 2005, we filed a patent infringement lawsuit against Barr to defend our patents until the license effective date. Neither the ANDA filing nor this lawsuit modify the existing license grant to Barr, and we do not expect any change in the anticipated date of Barr’s entry to market. The entry of Barr with a generic form of ACTIQ likely will significantly and negatively impact future ACTIQ sales.

GABITRIL

With respect to GABITRIL, there are four U.S. composition-of-matter patents covering the currently approved product: a patent claiming tiagabine, the active drug substance contained in GABITRIL; a patent claiming crystalline tiagabine hydrochloride monohydrate and its use as an anti-epileptic agent; a patent claiming the pharmaceutical formulation; and a patent claiming anhydrous crystalline tiagabine hydrochloride and processes for its preparation. These patents currently are set to expire in 2011, 2012, 2016 and 2017, respectively. Supplemental Protection Certificates based upon corresponding foreign patents covering this product are set to expire in 2011. Ultimately, these patents might be found invalid as the result of a challenge by a third party, or a potential competitor could develop a competing product or product formulation that avoids infringement of these patents.

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.

In April 2005, we received notice from SUN Pharmaceutical Industries Limited that it had filed an ANDA with the FDA seeking approval to market a generic form of GABITRIL. The ANDA as filed does not include a Paragraph IV certification with respect to the patent claiming tiagabine and, as such, SUN is not seeking to market a generic form of GABITRIL until the expiration of this patent in 2011. Instead, the ANDA alleges (1) non-infringement of a patent claiming crystalline tiagabine hydrochloride monohydrate and its use as an anti-epileptic agent and a patent claiming the pharmaceutical formulation of the product and (2) non-infringement and invalidity of our patent claiming anhydrous crystalline tiagabine hydrochloride and its processes for preparation.

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 other things:

• fines, recalls or seizures of products;

• total or partial suspension of manufacturing or commercial activities;

• non-approval of product license applications;

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

• criminal prosecution.

In September 2004, we announced that we had received subpoenas from the U.S. Attorney’s Office in Philadelphia with respect to PROVIGIL, ACTIQ and GABITRIL. This investigation is ongoing and appears to be focused on our sales and promotional practices. We are cooperating with the investigation and are providing documents to the government. In addition, we have engaged in ongoing discussions with the Attorney General in Pennsylvania regarding recent media reports of instances of abuse and diversion of ACTIQ. We have had similar discussions with the Office of the Connecticut Attorney General; in September 2004, we received a voluntary request for information from the Office of the Connecticut Attorney General asking us to provide information generally relating to our sales and promotional practices for our U.S. products. We have agreed to comply with this voluntary request. These matters may involve the bringing of criminal charges and fines, and/or civil penalties. We cannot predict or determine the outcome of these matters or reasonably estimate the amount or range of amounts of any fines or penalties that might result from an adverse outcome. However, an adverse outcome could have a material adverse effect on our financial position, liquidity and results of operations.

It is both costly and time-consuming for us to comply with these inquiries and 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 a 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, each of which requires us to comply with extensive government regulations. 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 and the heightened level of media attention given to this issue, it is possible that these regulatory agencies could impose additional restrictions on marketing or even withdraw regulatory approval for such products. In addition, adverse publicity may bring about a rejection of the product by the medical community. If the DEA, FDA or a foreign medical authority withdrew the approval of, or placed additional significant restrictions on the marketing of any of our products, our product sales and ability to promote our products could be substantially affected.

We rely on third parties for the timely supply of specified raw materials, equipment, contract manufacturing, formulation or packaging services, product distribution services, customer service activities and product returns processing. Although we actively manage these third party relationships to ensure continuity and quality, some events beyond our control could result in the complete or partial failure of these goods and services. Any such failure could have a material adverse effect on our financial condition and result of operations.

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 upon 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 primary source of the active drug substance modafinil. With respect to finished commercial supplies of PROVIGIL, we currently have two qualified manufacturers, DSM Pharmaceuticals, in Greenville, North Carolina, and Patheon, Inc., in Ontario, Canada.

• ACTIQ: Our U.S. facility in Salt Lake City, Utah, is the sole source for the worldwide manufacture and supply of finished commercial supplies of ACTIQ.

• GABITRIL: Abbott Laboratories manufactures finished commercial supplies of GABITRIL for the U.S. market (through at least December 2008) and Sanofi-Synthelabo manufactures GABITRIL for non-U.S. markets (through January 2005, although Sanofi has agreed to continue to produce GABITRIL through the end of the third quarter of 2005). We have identified a third party manufacturer for the future worldwide production of the active drug substance tiagabine and finished commercial supplies of GABITRIL. We are in the process of qualifying this manufacturer with appropriate U.S. and European regulatory authorities.

• Other Products: Certain of our products are manufactured at our facilities in France, with the remaining products manufactured by single source third parties. CIMA LABS also manufactures products at its Minnesota facilities for certain of its pharmaceutical company partners.

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.

As our products are used commercially, unintended side effects, adverse reactions or incidents of misuse may occur that could result in additional regulatory controls, adverse publicity 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 identify undesirable or unintended side effects that have not been evident in our clinical trials or the relatively limited commercial use to date. For example, in February 2005, working with the FDA, we updated our prescribing information for GABITRIL to include a bolded warning describing the risk of new onset seizures in non-induced patients without epilepsy. In addition, in patients who take multiple medications, drug interactions could occur that can be difficult to predict. Additionally, incidents of product misuse, product diversion or theft may occur, particularly with respect to products such as ACTIQ and PROVIGIL, which contain controlled substances. These events, among others, could result in adverse publicity that harms the commercial prospects of our products or lead to 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. In particular, 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.

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 we only have a few years of commercial history and when the level of market acceptance of our products is changing rapidly. Forecasting is further complicated by the difficulties in estimating both existing inventory levels for our products at pharmaceutical wholesalers and retail pharmacies and the timing of their purchases to replenish these stocks. As a result, it is likely that our product sales will fluctuate significantly,

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:

• 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;

• manufacturing or supply disruptions; and

• costs associated with the operations of recently-acquired businesses and technologies.

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 cost of product liability insurance has increased in recent years, and the availability of coverage has decreased. Nevertheless, we maintain product liability insurance in amounts we believe to be commercially reasonable. However, 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.

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

As of March 31, 2005, we had $1,288.3 million of indebtedness outstanding, including $1,271.9 million outstanding under convertible notes with stated conversion prices or restricted conversion prices higher than our stock price as of the date of this filing. Of our convertible notes outstanding as of the filing date of this report, $521.8 million mature 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, these factors, among other things, could make it difficult for us to service, repay or refinance our indebtedness or to obtain additional financing, or limit our 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 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, Cardinal Health, Inc., McKesson Corporation and AmerisourceBergen Corporation, control a significant share of this network. These three wholesaler customers, in the aggregate, accounted for 87% of our worldwide net sales for the quarter ended March 31, 2005. Fluctuations in the buying patterns of these customers, which may result from seasonality, wholesaler buying decision or other factors outside of our control, could significantly affect the level of our net sales on a period to period basis. Because of this, the amounts purchased by these customers during any quarterly or annual period may not correlate to the level of underlying demand evidenced by the number of prescriptions written for such products, as reported by IMS Health Incorporated. Furthermore, the loss or bankruptcy of any of these customers could materially and adversely affect our results of operations and financial condition.

Our internal controls over financial reporting may not be considered effective, which could result in possible regulatory sanctions and a decline in our stock price.

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to furnish annually a report on our internal controls over financial reporting. The internal control report must contain an assessment by our management of the effectiveness of our internal control over financial reporting (including the disclosure of any material weakness) and a statement that our independent auditors have attested to and reported on management’s evaluation of such internal controls. The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and internal controls over financial reporting. In order for management to evaluate our internal controls, we must regularly review and document our internal control processes and procedures and test such controls. Ultimately, we or our independent auditors could conclude that our internal control over financial reporting may not be effective if, among others things:

• any material weakness in our internal controls over financial reporting exist; or

• we fail to remediate assessed deficiencies.

Due to the number of controls to be examined, the complexity of the project, and the subjectivity involved in determining the effectiveness of controls, we cannot be certain that, in the future, all of our controls will continue to be considered effective by management or, if considered effective by our management, that our auditors will agree with such assessment.

If, in the future, we are unable to assert that our internal control over financial reporting is effective, or if our auditors are unable to attest that our management’s report is fairly stated or they are unable to express an opinion on our management’s evaluation, we could be subject to regulatory sanctions or lose investor confidence in the accuracy and completeness of our financial reports, either of which could have an adverse effect on the market price for our securities.

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 governmental efforts in France to limit or eliminate reimbursement for some of our products, particularly FONZYLANE, 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 are increasingly utilizing their significant purchasing power to challenge the prices charged for pharmaceutical products and seek to limit reimbursement levels offered to consumers for such products. Moreover, many governments and private insurance plans have instituted reimbursement schemes that favor the substitution of generic pharmaceuticals for more expensive brand-name pharmaceuticals. In the U.S. in particular, generic substitution statutes have been enacted in virtually all states and permit or require the dispensing pharmacist to substitute a less expensive generic drug instead of an original branded drug. 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. In addition, our two largest products, PROVIGIL and ACTIQ, could face competition from

companies seeking to market generic forms of these products if our patent infringement lawsuits against these companies are unsuccessful.

The conditions that our products treat, and some of the other disorders for which we are conducting additional studies, are currently treated with many drugs, several of which have been available for a number of years or are available in inexpensive generic forms. With respect to PROVIGIL, and, if approved, NUVIGIL, there are several other products used for the treatment of excessive sleepiness or 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. If we are successful in obtaining FDA approval of modafinil for the treatment of ADHD in children and adolescents, we will face competition from stimulants such as RITALIN® by Novartis, STRATERRA® by Eli Lilly, and CONCERTA® by McNeil Consumer, as well as from amphetamines such as DEXEDRINE® by GlaxoSmithKline and ADDERALL® by Shire. With respect to ACTIQ, we face competition from numerous short- and long-acting opioid products, including three products—Johnson & Johnson’s DURAGESIC®, Purdue Pharmaceutical’s OXYCONTIN® and MS-CONTIN®—that dominate the market as well as Purdue’s PALLADONE® which was approved in September 2004. In addition, we are aware of numerous other companies developing other technologies for rapidly delivering opioids to treat breakthrough pain, including transmucosal, transdermal, nasal spray and inhaled delivery systems, among others, that will compete against ACTIQ and, if approved, ORAVESCENT fentanyl. 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. If we are successful in our efforts to expand the label of GABITRIL to include anxiety disorders, we will face significant competition from well-established Selective Serotonin Reuptake Inhibitor (SSRI) products such as Paxil®, Effexor XR® and Lexapro®. For all of our products, 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.

As part of our efforts to acquire businesses or to enter into other significant transactions, we conduct 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 the operations of an acquired business 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 acquisitions we may consummate in the future, whether as a result of unidentified risks, integration difficulties, regulatory setbacks or other events, our business, results of operations and financial condition could be adversely affected.

In our acquisition of CIMA LABS, we secured rights to the product development candidate, ORAVESCENT fentanyl, as well as CIMA LABS’ existing drug delivery business. We estimated a value for ORAVESCENT fentanyl by making certain assumptions about, among other things, the likelihood and timing of ORAVESCENT fentanyl

approval and the potential market for the product. This estimated value of ORAVESCENT fentanyl comprised a significant portion of the total consideration we paid to CIMA LABS stockholders. Ultimately, our assumptions may prove to be incorrect, which could cause us to fail to realize the anticipated benefits of the CIMA LABS transaction.

In addition, we have experienced, and will likely continue to experience, significant charges to earnings related to our efforts to consummate acquisitions. For transactions that ultimately are not consummated, these charges may include fees and expenses for investment bankers, attorneys, accountants and other advisers in connection with our efforts. Even if our efforts are successful, we may incur as part of a transaction substantial charges for closure costs associated with the elimination of duplicate operations and facilities and acquired in-process research and development charges. In either case, the incurrence of these charges could adversely affect our results of operations for particular quarterly or annual periods.

The failure to successfully integrate CIMA LABS could negatively impact our results of operations.

The integration of CIMA LABS following our August 2004 acquisition involves a number of risks and presents financial, managerial and operational challenges, including:

• diversion of management attention from our existing operations;

• difficulty with integration of personnel, and accounting, financial reporting, internal control and other systems; and

• increased operations that may be difficult to manage, especially since we have limited experience in drug delivery technologies.

In light of these challenges, we may not be able to successfully manage the operations and personnel of CIMA LABS. Customer dissatisfaction, manufacturing, supply or distribution problems associated with the products that utilize CIMA LABS’ technology and intense competition in the filed of drug delivery technology could cause its pharmaceutical business to underperform relative to our expectations, which could have a material adverse effect on our business. We also could experience financial or other setbacks if CIMA LABS’ business has problems or liabilities of which we were not aware or that are substantially greater than we anticipated based on our evaluation of the business prior to the acquisition. Currently, a significant majority of CIMA LABS’ revenues are derived from only three customers. The loss of any one of these customers, or a decline in the market acceptance of the products we develop and manufacture for them, could significantly impact revenues from the CIMA LABS business.

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.

In the pharmaceutical business, the research and development process can take up to 12 years, or even longer, from discovery to commercial product launch. During each stage of this process, there is a substantial risk of failure. 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 with 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, 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 an 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, 2004 through March 31, 2005 our common stock traded at a high price of $60.98 and a low price of $41.58. 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

• sales 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 or our customers, 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 is subject to exchange rate fluctuations in the normal course of business, which 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 quarter ended March 31, 2005, approximately 16% 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 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 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 could adversely affect 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.

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 three months ended March 31, 2005, 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 $4.4 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 our $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.

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

The information required by this Item is incorporated by reference to footnote 7 of the Consolidated Financial Statements included in Part I, Item 1 of this Report.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Purchases of Equity Securities by the Company and Affiliated Purchasers. During the first quarter of 2005, we repurchased $3,000 principal amount of our zero coupon convertible subordinated notes first putable June 2010. The Notes are convertible, at the holder’s option, into shares of our common stock at a price of $56.50 per share, subject to certain limitations. The following table sets forth information regarding our repurchases of the Notes.

ISSUER PURCHASES OF EQUITY SECURITIES

Period	Total Principal Amount of Notes Purchased			Average Price Paid Per $1,000 Principal Amount of the Notes			Total Principal Amount of Notes Purchased as Part of Publicly Announced Plans or Programs	Approximate Dollar Value of Notes that May Yet Be Purchased Under the Plans or Programs
January 1 – January 31, 2005	—			—			—	—
February 1 – February 28, 2005	$	3,000	(1)	$	700	(2)	—	—
March 1 – March 31, 2005	—			—			—	—
Total	$	3,000		$	700		—	—

(1) The total principal amount of these Notes was convertible into 53 shares of the Company’s common stock as of the date of repurchase.

(2) On an “as converted” basis, the average purchase price paid per share of common stock issuable upon conversion of the Notes was $39.62.

ITEM 5. OTHER INFORMATION

Ratios of Earnings to Fixed Charges

Our deficiency of earnings available to cover fixed charges for the years ended December 31, 2000, 2001 and 2004 was $102.8 million, $61.1 million and $28.2 million, respectively. Since earnings were insufficient to cover fixed charges for the years ended December 31, 2000, 2001 and 2004 we are unable to provide ratios of earnings to fixed charges for each respective period.

Our ratio of earnings to fixed charges for the years ended December 31, 2002 and 2003 and the three months ended March 31, 2005 was 2.57x, 5.18x, and 7.14x, respectively.

ITEM 6. EXHIBITS

Exhibits:

Exhibit No.		Description
10.1		Cephalon, Inc. 2005 Management Incentive Compensation Plan, previously filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K dated February 3, 2005.

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.

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)


May 9, 2005	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)