10-Q 1 a2014q310-q.htm 10-Q 2014 Q3 10-Q
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
________________________________________________________
FORM 10-Q
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2014
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM              TO             
Commission file number 000-19319
____________________________________________
Vertex Pharmaceuticals Incorporated
(Exact name of registrant as specified in its charter)
Massachusetts
04-3039129
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
50 Northern Avenue, Boston, Massachusetts
02210
(Address of principal executive offices)
(Zip Code)
Registrant’s telephone number, including area code (617) 341-6100
____________________________________________

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o 
Smaller reporting company o
 
                                       (Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
Common Stock, par value $0.01 per share
240,521,809
Class
Outstanding at October 31, 2014

 



VERTEX PHARMACEUTICALS INCORPORATED
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2014

TABLE OF CONTENTS
 
 
Page
 
 
 
Condensed Consolidated Statements of Operations - Three and Nine Months Ended September 30, 2014 and 2013
 
Condensed Consolidated Statements of Comprehensive Loss - Three and Nine Months Ended September 30, 2014 and 2013
 
Condensed Consolidated Balance Sheets - September 30, 2014 and December 31, 2013
 
Condensed Consolidated Statements of Shareholders' Equity and Noncontrolling Interest - Nine Months Ended September 30, 2014 and 2013
 
Condensed Consolidated Statements of Cash Flows - Nine Months Ended September 30, 2014 and 2013
 
 
 
“We,” “us,” “Vertex” and the “Company” as used in this Quarterly Report on Form 10-Q refer to Vertex Pharmaceuticals Incorporated, a Massachusetts corporation, and its subsidiaries.
“Vertex,” “INCIVEK®” and “KALYDECO™” are registered trademarks of Vertex. Other brands, names and trademarks contained in this Quarterly Report on Form 10-Q, including “INCIVO™” and “TELAVIC™,” are the property of their respective owners.




Part I. Financial Information
Item 1.    Financial Statements
VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Statements of Operations
(unaudited)
(in thousands, except per share amounts)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Revenues:
 
 
 
 
 
 
 
Product revenues, net
$
137,099

 
$
186,653

 
$
362,879

 
$
708,823

Royalty revenues
8,386

 
27,012

 
32,134

 
119,705

Collaborative revenues
33,502

 
8,035

 
40,846

 
32,290

Total revenues
178,987

 
221,700

 
435,859

 
860,818

Costs and expenses:
 
 
 
 
 
 
 
Cost of product revenues
10,208

 
20,048

 
28,435

 
75,698

Royalty expenses
3,976

 
7,291

 
18,525

 
32,315

Research and development expenses
190,939

 
219,442

 
654,043

 
643,636

Sales, general and administrative expenses
75,224

 
86,427

 
226,882

 
283,133

Restructuring expenses
40,843

 
12,048

 
46,761

 
12,863

Intangible asset impairment charge

 

 

 
412,900

Total costs and expenses
321,190

 
345,256

 
974,646

 
1,460,545

Loss from operations
(142,203
)
 
(123,556
)
 
(538,787
)
 
(599,727
)
Interest expense, net
(20,384
)
 
(95
)
 
(51,686
)
 
(10,109
)
Other income (expense), net
(3,990
)
 
4,751

 
34,192

 
3,360

Loss from continuing operations before provision for (benefit from) income taxes
(166,577
)
 
(118,900
)
 
(556,281
)
 
(606,476
)
Provision for (benefit from) income taxes
3,419

 
2,555

 
4,915

 
(123,774
)
Loss from continuing operations
(169,996
)
 
(121,455
)
 
(561,196
)
 
(482,702
)
Loss from discontinued operations, net of tax benefit of $0, $3,306, $0 and $9,089, respectively
(64
)
 
(7,207
)
 
(703
)
 
(20,299
)
Loss from discontinued operations attributable to noncontrolling interest (Alios)

 
4,530

 

 
13,688

Net loss from discontinued operations attributable to Vertex
(64
)
 
(2,677
)
 
(703
)
 
(6,611
)
Net loss attributable to Vertex
$
(170,060
)
 
$
(124,132
)
 
$
(561,899
)
 
$
(489,313
)
Net loss per share from continuing operations:
 
 
 
 
 
 
 
Basic
$
(0.72
)
 
$
(0.53
)
 
$
(2.40
)
 
$
(2.17
)
Diluted
$
(0.72
)
 
$
(0.53
)
 
$
(2.40
)
 
$
(2.17
)
Net loss from discontinued operations per share attributable to Vertex common shareholders:
 
 
 
 
 
 
 
Basic
$

 
$
(0.01
)
 
$

 
$
(0.03
)
Diluted
$

 
$
(0.01
)
 
$

 
$
(0.03
)
Net loss per share attributable to Vertex common shareholders:
 
 
 
 
 
 
 
Basic
$
(0.72
)
 
$
(0.54
)
 
$
(2.40
)
 
$
(2.20
)
Diluted
$
(0.72
)
 
$
(0.54
)
 
$
(2.40
)
 
$
(2.20
)
Shares used in per share calculations:
 
 
 
 
 
 
 
Basic
236,137

 
230,505

 
234,207

 
222,764

Diluted
236,137

 
230,505

 
234,207

 
222,764

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


2


VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Statements of Comprehensive Loss
(unaudited)
(in thousands)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
Loss from continuing operations
$
(169,996
)
 
$
(121,455
)
 
$
(561,196
)
 
$
(482,702
)
Loss from discontinued operations
(64
)
 
(7,207
)
 
(703
)
 
(20,299
)
Net loss
(170,060
)
 
(128,662
)
 
(561,899
)
 
(503,001
)
Changes in other comprehensive loss:
 
 
 
 
 
 
 
Unrealized holding gains (losses) on marketable securities
(30
)
 
166

 
25

 
7

Unrealized gains on foreign currency forward contracts
1,838

 

 
1,713

 

Foreign currency translation adjustment
(624
)
 
514

 
(271
)
 
(7
)
Total changes in other comprehensive loss
1,184

 
680

 
1,467

 

Comprehensive loss
(168,876
)
 
(127,982
)
 
(560,432
)
 
(503,001
)
Comprehensive loss attributable to noncontrolling interest (Alios)

 
4,530

 

 
13,688

Comprehensive loss attributable to Vertex
$
(168,876
)
 
$
(123,452
)
 
$
(560,432
)
 
$
(489,313
)
The accompanying notes are an integral part of these condensed consolidated financial statements.


3


VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Balance Sheets
(unaudited)
(in thousands, except share and per share amounts)
 
September 30,
 
December 31,
 
2014
 
2013
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
718,563

 
$
569,299

Marketable securities, available for sale
759,174

 
895,777

Accounts receivable, net
114,308

 
85,517

Inventories
16,753

 
14,147

Prepaid expenses and other current assets
41,298

 
23,836

Total current assets
1,650,096

 
1,588,576

Restricted cash
121

 
130

Property and equipment, net
720,878

 
696,911

Goodwill
30,992

 
30,992

Other assets
3,999

 
2,432

Total assets
$
2,406,086

 
$
2,319,041

Liabilities and Shareholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
38,472

 
$
49,327

Accrued expenses
244,279

 
271,077

Deferred revenues, current portion
21,210

 
21,510

Accrued restructuring expenses, current portion
38,384

 
14,286

Capital lease obligations, current portion
18,124

 
16,893

Other liabilities, current portion
11,709

 
24,736

Total current liabilities
372,178

 
397,829

Deferred revenues, excluding current portion
34,723

 
49,459

Accrued restructuring expenses, excluding current portion
17,218

 
14,067

Capital lease obligations, excluding current portion
42,200

 
48,754

Construction financing lease obligation, excluding current portion
473,172

 
440,937

Senior secured term loan
294,740

 

Other liabilities, excluding current portion
15,950

 
11,590

Total liabilities
1,250,181

 
962,636

Commitments and contingencies


 


Shareholders’ equity:
 
 
 
Preferred stock, $0.01 par value; 1,000,000 shares authorized; none issued and outstanding at September 30, 2014 and December 31, 2013

 

Common stock, $0.01 par value; 300,000,000 shares authorized at September 30, 2014 and December 31, 2013; 240,238,090 and 233,788,852 shares issued and outstanding at September 30, 2014 and December 31, 2013, respectively
2,375

 
2,320

Additional paid-in capital
5,681,163

 
5,321,286

Accumulated other comprehensive gain (loss)
1,161

 
(306
)
Accumulated deficit
(4,528,794
)
 
(3,966,895
)
Total shareholders’ equity
1,155,905

 
1,356,405

Total liabilities and shareholders’ equity
$
2,406,086

 
$
2,319,041


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


4


VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Statements of Shareholders’ Equity and Noncontrolling Interest
(unaudited)
(in thousands)
 
Common Stock
 
Additional
Paid-in Capital
 
Accumulated
Other
Comprehensive Loss
 
Accumulated Deficit
 
Total Vertex
Shareholders’ Equity
 
Noncontrolling
Interest in Discontinued Operations (Alios)
 
Total
Shareholders’ Equity
 
Redeemable
Noncontrolling Interest (Alios)
 
Shares
 
Amount
 
 
 
 
 
 
 
Balance, December 31, 2012
217,287

 
$
2,149

 
$
4,519,448

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

 
$
196,672

 
$
1,195,852

 
$
38,530

Unrealized holding gains on marketable securities
 
 
 
 
 
 
7

 
 
 
7

 
 
 
7

 
 
Foreign currency translation adjustment
 
 
 
 
 
 
(7
)
 
 
 
(7
)
 
 
 
(7
)
 
 
Net loss
 
 
 
 
 
 
 
 
(489,313
)
 
(489,313
)
 
(13,688
)
 
(503,001
)
 
 
Issuance of common stock under benefit plans
8,029

 
79

 
248,207

 
 
 
 
 
248,286

 
(70
)
 
248,216

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

 
83

 
402,182

 
 
 
 
 
402,265

 
 
 
402,265

 
 
Stock-based compensation expense
 
 
 
 
104,470

 
 
 
 
 
104,470

 
348

 
104,818

 
 
Change in liquidation value of noncontrolling interest
 
 
 
 
 
 
 
 
 
 
 
 
(1,094
)
 
(1,094
)
 
1,094

Balance, September 30, 2013
233,592

 
$
2,311

 
$
5,274,307

 
$
(550
)
 
$
(4,011,180
)
 
$
1,264,888

 
$
182,168

 
$
1,447,056

 
$
39,624

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance, December 31, 2013
233,789

 
$
2,320

 
$
5,321,286

 
$
(306
)
 
$
(3,966,895
)
 
$
1,356,405

 
$

 
$
1,356,405

 
$

Unrealized holding gains on marketable securities
 
 
 
 
 
 
25

 
 
 
25

 
 
 
25

 
 
Unrealized gains on foreign currency forward contracts
 
 
 
 
 
 
1,713

 
 
 
1,713

 
 
 
1,713

 
 
Foreign currency translation adjustment
 
 
 
 
 
 
(271
)
 
 
 
(271
)
 
 
 
(271
)
 
 
Net loss attributable to Vertex
 
 
 
 
 
 
 
 
(561,899
)
 
(561,899
)
 
 
 
(561,899
)
 
 
Issuance of common stock under benefit plans
6,449

 
55

 
223,812

 
 
 
 
 
223,867

 
 
 
223,867

 
 
Stock-based compensation expense
 
 
 
 
136,065

 
 
 
 
 
136,065

 
 
 
136,065

 
 
Balance, September 30, 2014
240,238

 
$
2,375

 
$
5,681,163

 
$
1,161

 
$
(4,528,794
)
 
$
1,155,905

 
$

 
$
1,155,905

 
$

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


5


VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Statements of Cash Flows
(unaudited)
(in thousands)
 
Nine Months Ended September 30,
 
2014
 
2013
Cash flows from operating activities:
 
 
 
Loss from continuing operations
$
(561,196
)
 
$
(482,702
)
Loss from discontinued operations
(703
)
 
(20,299
)
Net loss
(561,899
)
 
(503,001
)
Adjustments to reconcile net loss to net cash used in operating activities:
 
 
 
Depreciation and amortization expense
46,921

 
30,734

Stock-based compensation expense
135,160

 
103,933

Other non-cash based compensation expense

 
5,856

Intangible asset impairment charge

 
412,900

Deferred income taxes

 
(130,164
)
Impairment of property and equipment
978

 
6,650

Write-down of inventories to net realizable value

 
10,358

Other non-cash items, net
7

 
5,307

Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net
(7,315
)
 
20,737

Inventories
(4,901
)
 
5,212

Prepaid expenses and other assets
(19,110
)
 
(16,477
)
Accounts payable
(5,544
)
 
(46,005
)
Accrued expenses and other liabilities
12,210

 
26,172

Accrued restructuring expense
27,249

 
2,810

Deferred revenues
(15,085
)
 
(15,447
)
Net cash used in operating activities
(391,329
)
 
(80,425
)
Cash flows from investing activities:
 
 
 
Purchases of marketable securities
(1,066,772
)
 
(1,850,015
)
Sales and maturities of marketable securities
1,203,400

 
1,842,361

Expenditures for property and equipment
(36,525
)
 
(36,922
)
Decrease in restricted cash and cash equivalents
9

 
31,807

Decrease in restricted cash and cash equivalents (Alios)

 
18,924

Decrease (increase) in deposits
(92
)
 
1,094

Net cash provided by investing activities
100,020

 
7,249

Cash flows from financing activities:
 
 
 
Issuances of common stock from employee benefit plans
201,274

 
242,360

Payments to redeem secured notes (due 2015)

 
(158
)
Payments on capital lease obligations
(17,215
)
 
(14,601
)
Payments on construction financing lease obligation
(45,438
)
 
(63,242
)
Proceeds from senior secured term loan
294,383

 

Payments returned related to construction financing lease obligation
8,050

 

Net cash provided by financing activities
441,054

 
164,359

Effect of changes in exchange rates on cash
(481
)
 
2,591

Net increase in cash and cash equivalents
149,264

 
93,774

Cash and cash equivalents—beginning of period
569,299

 
489,407

Cash and cash equivalents—end of period
$
718,563

 
$
583,181

Supplemental disclosure of cash flow information:
 
 
 
Cash paid for interest
$
2,817

 
$
7,637

Cash paid for income taxes
$
798

 
$

Conversion of convertible senior subordinated notes (due 2015) for common stock
$

 
$
399,842

Unamortized deferred debt issuance costs exchanged
$

 
$
4,230

Capitalization of costs related to construction financing lease obligation
$
25,564

 
$
176,484

Assets acquired under capital lease
$
8,985

 
$
38,520

Issuances of common stock exercises from employee benefit plans receivable
$
23,035

 
$

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

6

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)


A. Basis of Presentation and Accounting Policies
Basis of Presentation
The accompanying condensed consolidated financial statements are unaudited and have been prepared by Vertex Pharmaceuticals Incorporated ("Vertex" or the "Company") in accordance with accounting principles generally accepted in the United States of America ("GAAP").
The condensed consolidated financial statements reflect the operations of (i) the Company and (ii) its wholly-owned subsidiaries. The condensed consolidated statements of operations in this Quarterly Report on Form 10-Q reflect the operations of Alios BioPharma, Inc. (“Alios”), as well as direct expenses Vertex incurred as a result of the Alios Agreement, as discontinued operations. All material intercompany balances and transactions have been eliminated. The Company operates in one segment, pharmaceuticals.

Certain information and footnote disclosures normally included in the Company's annual financial statements have been condensed or omitted. These interim financial statements, in the opinion of management, reflect all normal recurring adjustments necessary for a fair presentation of the financial position and results of operations for the interim periods ended September 30, 2014 and 2013.
The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full fiscal year. These interim financial statements should be read in conjunction with the audited financial statements for the year ended December 31, 2013, which are contained in the Company's Annual Report on Form 10-K for the year ended December 31, 2013 that was filed with the Securities and Exchange Commission (the “SEC”) on February 11, 2014 (the "2013 Annual Report on Form 10-K").
Use of Estimates and Summary of Significant Accounting Policies
The preparation of condensed consolidated financial statements in accordance with GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements, and the amounts of revenues and expenses during the reported periods. Significant estimates in these condensed consolidated financial statements have been made in connection with the calculation of revenues, inventories, research and development expenses, stock-based compensation expense, restructuring expense, the fair value of intangible assets, noncontrolling interest (Alios), the consolidation and deconsolidation of a VIE, leases, discontinued operations presentation and the provision for or benefit from income taxes. The Company bases its estimates on historical experience and various other assumptions, including in certain circumstances future projections, that management believes to be reasonable under the circumstances. Actual results could differ from those estimates. Changes in estimates are reflected in reported results in the period in which they become known.
The Company's significant accounting policies are described in Note A, "Nature of Business and Accounting Policies," in the 2013 Annual Report on Form 10-K.
Recent Accounting Pronouncements
For a discussion of recent accounting pronouncements please refer to Note A, “Nature of Business and Accounting Policies—Recent Accounting Pronouncements,” in the 2013 Annual Report on Form 10-K. The Company did not adopt any new accounting pronouncements during the nine months ended September 30, 2014 that had a material effect on the Company's condensed consolidated financial statements.
In the second quarter of 2014, the Financial Accounting Standards Board issued amended guidance applicable to revenue recognition that will be effective for the Company for the year ending December 31, 2017. The new guidance must be adopted using either a full retrospective approach for all periods presented or a modified retrospective approach. Early adoption is not permitted. The new guidance applies a more principles-based approach to recognizing revenue. The Company is evaluating the new guidance and the expected effect on the Company’s condensed consolidated financial statements.


7

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

B.
Product Revenues, Net
The Company sells its products principally to a limited number of major and selected regional wholesalers and specialty pharmacy providers in North America as well as government-owned and supported customers in Europe (collectively, its “Customers”). The Company's Customers in North America subsequently resell the products to patients and health care providers. The Company recognizes net revenues from product sales upon delivery as long as (i) there is persuasive evidence that an arrangement exists between the Company and the Customer, (ii) collectibility is reasonably assured and (iii) the price is fixed or determinable.
In order to conclude that the price is fixed or determinable, the Company must be able to (i) calculate its gross product revenues from sales to Customers and (ii) reasonably estimate its net product revenues upon delivery to its Customer's locations. The Company calculates gross product revenues based on the price that the Company charges its Customers. The Company estimates its net product revenues by deducting from its gross product revenues (a) trade allowances, such as invoice discounts for prompt payment and Customer fees, (b) estimated government and private payor rebates, chargebacks and discounts, (c) estimated reserves for expected product returns and (d) estimated costs of incentives offered to certain indirect customers, including patients. The Company makes significant estimates and judgments that materially affect the Company's recognition of net product revenues. In certain instances, the Company may be unable to reasonably conclude that the price is fixed or determinable at the time of delivery, in which case it defers the recognition of revenues. Once the Company is able to determine that the price is fixed or determinable, it recognizes the revenues associated with the units in which revenue recognition was deferred.
The following table summarizes activity in each of the product revenue allowance and reserve categories for the nine months ended September 30, 2014:
 
Trade
Allowances
 
Rebates,
Chargebacks
and Discounts
 
Product
Returns
 
Other
Incentives
 
Total
 
(in thousands)
Balance at December 31, 2013
$
1,535

 
$
68,244

 
$
15,799

 
$
1,555

 
$
87,133

Provision related to current period sales
6,772

 
30,720

 
1,691

 
1,210

 
40,393

Adjustments related to prior period sales
(8
)
 
5,052

 
(2,778
)
 
(72
)
 
2,194

Credits/payments made
(7,255
)
 
(67,557
)
 
(6,052
)
 
(1,808
)
 
(82,672
)
Balance at September 30, 2014
$
1,044

 
$
36,459

 
$
8,660

 
$
885

 
$
47,048

C.
Collaborative Arrangements
Janssen Pharmaceutica NV
In 2006, the Company entered into a collaboration agreement (the “Janssen HCV Agreement”) with Janssen Pharmaceutica NV (“Janssen NV”) for the development, manufacture and commercialization of telaprevir, which Janssen NV began marketing under the brand name INCIVO in certain of its territories in September 2011. Under the Janssen HCV Agreement, Janssen NV agreed to be responsible for 50% of the drug development costs incurred under the development program for the parties’ territories (North America for the Company, and the rest of the world, other than specified countries in Asia, for Janssen NV) and has exclusive rights to commercialize telaprevir in its territories including Europe, South America, the Middle East, Africa and Australia. In November 2013, the Company and Janssen NV amended the collaboration agreement (the "2013 Janssen HCV Amendment").
Janssen NV made a $165.0 million up-front license payment to the Company in 2006. The Company amortized the up-front license payment over the Company’s estimated period of performance under the Janssen HCV Agreement through November 2013. As of November 2013, the effective date of the 2013 Janssen HCV Amendment, there was $32.1 million remaining in deferred revenues related to this up-front license payment.


8

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

Janssen NV paid the Company a tiered royalty averaging in the mid-20% range as a percentage of net sales of INCIVO in Janssen NV’s territories through 2013. Janssen NV was, and continues to be, responsible for certain third-party royalties on net sales of INCIVO in its territories.
Pursuant to the 2013 Janssen HCV Amendment, (i) Janssen NV made a payment of $152.0 million to the Company in the fourth quarter of 2013; (ii) Janssen NV's obligations to pay the Company royalties on net sales of INCIVO (telaprevir) terminated after the fourth quarter of 2013; and (iii) Janssen NV received a fully-paid license to commercialize INCIVO in its territories, subject to the continued payment of certain third-party royalties on its net sales of INCIVO.
The Company determined that the 2013 Janssen HCV Amendment was a material modification to the Janssen HCV Agreement because there was a material change to the consideration and deliverables under the agreement and determined that there is one undelivered element under the Janssen HCV Agreement, as amended, which is the continuation of certain telaprevir development activities. The Company recognized $182.4 million of collaborative revenues pursuant to the Janssen HCV Agreement in the fourth quarter of 2013. This amount was primarily attributable to (i) the residual consideration received from Janssen NV, including the $152.0 million fourth quarter 2013 payment and the remaining deferred revenues related to the 2006 up-front payment, less (ii) the best estimate of selling price for the remaining telaprevir development activities. As of September 30, 2014, the remaining deferred revenue balance related to the Janssen NV collaboration was $3.3 million and will be recognized as collaborative revenues as telaprevir development program activities are completed. In addition to the collaborative revenues, the Company will continue to record royalty revenues and corresponding royalty expenses related to third-party royalties that Janssen NV remains responsible for based on INCIVO net sales.
The Janssen HCV Agreement will continue in effect until the expiration of Janssen NV’s third-party royalty obligations, which expire on a country-by-country basis on the later of (a) the last-to-expire patent covering INCIVO or (b) the last required payment by Janssen NV to the Company pursuant to the agreement. In the European Union, the Company has a patent covering the composition-of-matter of INCIVO that expires in 2026.
During the three and nine months ended September 30, 2014 and 2013, the Company recognized the following revenues attributable to the Janssen HCV collaboration:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Royalty revenues (INCIVO)
$
2,284

 
$
20,994

 
$
12,917

 
$
104,108

Collaborative revenues:
 
 
 
 
 
 
 
Up-front and amendment payments revenues
$

 
$
3,107

 
$

 
$
9,321

Net reimbursement for telaprevir development costs
1,390

 
1,413

 
4,262

 
1,422

Reimbursement for manufacturing services

 

 

 
10,299

     Total collaborative revenues attributable to the Janssen HCV collaboration
$
1,390

 
$
4,520

 
$
4,262

 
$
21,042

Total revenues attributable to the Janssen HCV collaboration
$
3,674

 
$
25,514

 
$
17,179

 
$
125,150

Mitsubishi Tanabe Pharma Corporation
The Company has a collaboration agreement (the “MTPC Agreement”) with Mitsubishi Tanabe Pharma Corporation ("Mitsubishi Tanabe") pursuant to which Mitsubishi Tanabe has a fully-paid license to manufacture and commercialize TELAVIC (the brand name under which Mitsubishi Tanabe is marketing telaprevir) in Japan and other specified countries in Asia. The Company recognized no collaborative revenues attributable to the Mitsubishi Tanabe collaboration in the three and nine months ended September 30, 2014 and 2013.
Cystic Fibrosis Foundation Therapeutics Incorporated
In April 2011, the Company entered into an amendment (the “April 2011 Amendment”) to its existing collaboration agreement with Cystic Fibrosis Foundation Therapeutics Incorporated (“CFFT”) pursuant to which CFFT agreed to provide


9

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

financial support for (i) development activities for VX-661, a corrector compound discovered under the collaboration, and (ii) additional research and development activities directed at discovering new corrector compounds. Under the April 2011 Amendment, CFFT agreed to provide the Company with up to $75.0 million in funding over approximately five years for corrector-compound research and development activities. The Company retains the right to develop and commercialize KALYDECO (ivacaftor), lumacaftor (VX-809), VX-661 and any other compounds discovered during the course of the research collaboration with CFFT.
During the three and nine months ended September 30, 2014 and 2013, the Company recognized the following revenues attributable to the CFFT collaboration:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Collaborative revenues attributable to the CFFT collaboration
$
1,983

 
$
3,515

 
$
6,455

 
$
11,318

In the original agreement, as amended prior to the April 2011 Amendment, the Company agreed to pay CFFT tiered royalties calculated as a percentage, ranging from single digits to sub-teens, of annual net sales of any approved drugs discovered during the research term that ended in 2008, including KALYDECO, lumacaftor and VX-661. The April 2011 Amendment provides for a tiered royalty in the same range on net sales of corrector compounds discovered during the research term that began in 2011 and ended in February 2014. In each of the third quarter of 2012 and the first quarter of 2013, CFFT earned a commercial milestone payment of $9.3 million from the Company upon achievement of certain sales levels for KALYDECO. These milestones were reflected in the Company's cost of product revenues. There are no additional commercial milestone payments payable by the Company to CFFT related to sales levels for KALYDECO. The Company also is obligated to make up to two one-time commercial milestone payments to CFFT upon achievement of certain sales levels for corrector compounds such as lumacaftor or VX-661.
The Company began marketing KALYDECO in the United States and certain countries in the European Union in 2012. The Company has royalty obligations to CFFT for each compound commercialized pursuant to this collaboration until the expiration of patents covering that compound. The Company has patents in the United States and European Union covering the composition-of-matter of ivacaftor that expire in 2027 and 2025, respectively, subject to potential patent life extensions. CFFT may terminate its funding obligations under the collaboration, as amended, in certain circumstances, in which case there will be a proportional adjustment to the royalty rates and commercial milestone payments for certain corrector compounds. The collaboration also may be terminated by either party for a material breach by the other, subject to notice and cure provisions.
Alios BioPharma, Inc.
In June 2011, the Company entered into a license and collaboration agreement (the “Alios Agreement”) with Alios, a privately-held biotechnology company. Pursuant to the Alios Agreement, the Company and Alios collaborated on the research, development and commercialization of HCV nucleotide analogues discovered by Alios through April 2014. In April 2014, Vertex and Alios amended the Alios Agreement to eliminate the Company's obligations to conduct further development activities with respect to VX-135. In October 2014, the Company provided notice to Alios that the Alios Agreement would terminate in accordance with its terms in December 2014.
Under applicable accounting guidance, the Company consolidated Alios as a variable interest entity for the period from June 13, 2011 through December 31, 2013. The Company deconsolidated Alios as of December 31, 2013 and recorded a full impairment charge related to the Alios HCV nucleotide analogue program because the Company no longer had a variable interest in Alios as a whole and did not possess the power to direct the activities that most significantly affect the economic performance of Alios based on, among other factors, the decline in significance to Alios of the licensed HCV nucleotide analogue program.


10

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

As of September 30, 2014, the Company concluded that it no longer had significant continuing involvement with Alios due to its intent and ability to terminate the Alios Agreement, among other factors; therefore, the operations of Alios are presented as discontinued operations in these condensed consolidated financial statements.
Noncontrolling Interest (Alios)
Prior to the deconsolidation, the Company recorded net loss (income) attributable to noncontrolling interest (Alios) on its condensed consolidated statements of operations, reflecting Alios' net loss (income) for the reporting period, adjusted for changes in the fair value of contingent milestone payments and royalties payable by the Company to Alios, which was evaluated each reporting period. As noted above, as of September 30, 2014 the operations of Alios are presented as discontinued operations in these condensed consolidated financial statements. A summary of net loss from discontinued operations attributable to noncontrolling interest (Alios) for the three and nine months ended September 30, 2013 is as follows:
 
Three Months Ended
September 30, 2013
 
Nine Months Ended
September 30, 2013
 
(in thousands)
Loss before benefit from income taxes
$
9,056

 
$
21,177

Decrease (increase) in fair value of contingent milestone and royalty payments
(1,220
)
 
1,600

Benefit from income taxes
(3,306
)
 
(9,089
)
Loss from discontinued operations attributable to noncontrolling interest (Alios)
$
4,530

 
$
13,688

The Company used present-value models to determine the estimated fair value of the contingent milestone and royalty payments until it deconsolidated Alios, based on assumptions regarding the probability of achieving the relevant milestones, estimates regarding the time to develop drug candidates, estimates of future product sales and the appropriate discount and tax rates. The Company based its estimate of the probability of achieving the relevant milestones on industry data for similar assets and its own experience. The discount rates used in the valuation model represented a measure of credit risk associated with settling the liability. Significant judgment was used in determining the appropriateness of these assumptions at each reporting period.
The Company's net loss from discontinued operations attributable to noncontrolling interest (Alios) for the three and nine months ended September 30, 2014 was insignificant due to the deconsolidation of Alios effective December 31, 2013.
Outlicense Arrangements
In the ordinary course of the Company's business, the Company has entered into various agreements pursuant to which it has outlicensed rights to certain drug candidates to third-party collaborators. Although, the Company does not consider any of these outlicense arrangements to be material, the most notable of these outlicense arrangements is described below. Pursuant to these outlicense arrangements, our collaborators become responsible for all costs related to the continued development of such drug candidates. Depending on the terms of the arrangements, the Company's collaborators may be required to make upfront payments, milestone payments upon the achievement of certain product research and development objectives and/or pay royalties on future sales, if any, of commercial products resulting from the collaboration.

Janssen Pharmaceuticals, Inc.
In June 2014, the Company entered into an agreement (the “Janssen Influenza Agreement”) with Janssen Pharmaceuticals, Inc. (“Janssen Inc.”), which was amended in October 2014 to clarify certain roles and responsibilities of the parties. The collaboration was subject to the expiration of the waiting period under the Hart–Scott–Rodino Antitrust Improvements Act of 1976. The waiting period expired in July 2014; therefore, there was no accounting impact relating to this agreement during the six months ended June 30, 2014.
Pursuant to the Janssen Influenza Agreement, Janssen Inc. has an exclusive worldwide license to develop and commercialize certain drug candidates for the treatment of influenza, including VX-787. The Company received a non-refundable up-front payment of $30.0 million from Janssen Inc. in the third quarter of 2014 upon expiration of the waiting period under the Hart–Scott–Rodino Antitrust Improvements Act of 1976. Pursuant to the Janssen Influenza Agreement, the


11

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

Company will receive an additional non-refundable payment of $5.0 million in the fourth quarter of 2014 and has the potential to receive development, regulatory and commercial milestone payments as well as royalties on future product sales, if any. Janssen Inc. is responsible for costs related to the development and commercialization of the compounds. Janssen Inc. may terminate the Janssen Influenza Agreement, subject to certain exceptions, upon six months' notice.
The Company evaluated the deliverables, consisting of licenses to intellectual property and the obligation to complete certain fully-reimbursable research and development activities as directed by Janssen Inc., pursuant to the Janssen Influenza Agreement under multiple element arrangement guidance for collaborative arrangements. The Company concluded that the license has stand-alone value from the research and development activities and determined the relative selling price of these deliverables based on the Company's best estimate of selling price. The Company utilized a discounted cash flow model to determine its best estimate of selling price for the licenses to intellectual property and determined the best estimate of selling price for the research and development activities to be the estimated cost to complete the activities plus a commercially reasonable margin. The Company determined the license had stand-alone value based on the resources and know-how possessed by Janssen Inc. The Company concluded that the Janssen Influenza Agreement and the amendment to the Janssen Influenza Agreement should be accounted for as separate contracts due to the fact that the amendment did not impact the Company's obligations under the original agreement. Based on this analysis, the Company recognized $30.0 million in collaborative revenues related to the up-front payment in the three and nine months ended September 30, 2014. The Company is recording the reimbursement for the research and development activities as a reduction to development expense in the Company's condensed consolidated statements of operations primarily due to the fact that Janssen Inc. directs the activities and selects the suppliers associated with these activities.
D.
Net Loss Per Share Attributable to Vertex Common Shareholders
Basic net loss per share attributable to Vertex common shareholders is based upon the weighted-average number of common shares outstanding during the period, excluding restricted stock and restricted stock units that have been issued but are not yet vested. Diluted net loss per share attributable to Vertex common shareholders is based upon the weighted-average number of common shares outstanding during the period plus additional weighted-average common equivalent shares outstanding during the period when the effect is dilutive.
The Company did not include the securities described in the following table in the computation of the net loss per share attributable to Vertex common shareholder calculations because the effect would have been anti-dilutive during each period:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Stock options
13,097

 
16,807

 
13,097

 
16,807

Unvested restricted stock and restricted stock units
2,672

 
2,838

 
2,672

 
2,838

E.
Fair Value Measurements
The fair value of the Company’s financial assets and liabilities reflects the Company’s estimate of amounts that it would have received in connection with the sale of the assets or paid in connection with the transfer of the liabilities in an orderly transaction between market participants at the measurement date. In connection with measuring the fair value of its assets and liabilities, the Company seeks to maximize the use of observable inputs (market data obtained from sources independent from the Company) and to minimize the use of unobservable inputs (the Company’s assumptions about how market participants would price assets and liabilities). The following fair value hierarchy is used to classify assets and liabilities based on the observable inputs and unobservable inputs used in order to value the assets and liabilities:
Level 1:
Quoted prices in active markets for identical assets or liabilities. An active market for an asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis.
Level 2:
Observable inputs other than Level 1 inputs. Examples of Level 2 inputs include quoted prices in active markets for similar assets or liabilities and quoted prices for identical assets or liabilities in markets that are not active.
Level 3:
Unobservable inputs based on the Company’s assessment of the assumptions that market participants would use in pricing the asset or liability.
The Company’s investment strategy is focused on capital preservation. The Company invests in instruments that meet the credit quality standards outlined in the Company’s investment policy. This policy also limits the amount of credit exposure to any one issue or type of instrument. As of September 30, 2014, the Company’s investments were in money market funds, government-sponsored enterprise securities, corporate debt securities and commercial paper.
As of September 30, 2014, all of the Company’s financial assets that were subject to fair value measurements were valued using observable inputs. The Company’s financial assets valued based on Level 1 inputs consisted of money market funds and government-sponsored enterprise securities. The Company’s financial assets valued based on Level 2 inputs consisted of corporate debt securities and commercial paper, which consist of investments in highly-rated investment-grade corporations. During the three and nine months ended September 30, 2014 and 2013, the Company did not record an other-than-temporary impairment charge related to its financial assets.
The following table sets forth the Company’s financial assets subject to fair value measurements:


12

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

 
Fair Value Measurements
as of September 30, 2014
 
 
 
Fair Value Hierarchy
 
Total
 
Level 1
 
Level 2
 
Level 3
 
(in thousands)
Financial assets carried at fair value:
 
 
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
 
 
Money market funds
$
343,129

 
$
343,129

 
$

 
$

Marketable securities:
 
 
 
 
 
 
 
Government-sponsored enterprise securities
467,868

 
467,868

 

 

Commercial paper
46,496

 

 
46,496

 

Corporate debt securities
244,810

 

 
244,810

 

Total
$
1,102,303

 
$
810,997

 
$
291,306

 
$

The fair value of the Company’s foreign currency forward contracts, which were not material as of September 30, 2014, were based on Level 2 inputs and were determined using third party pricing services. Please refer to Note H, "Hedging," for further information regarding the Company’s foreign currency forward contracts.
As of September 30, 2014, the carrying value of the Company's Term Loan was $294.7 million, which was recorded on its condensed consolidated balance sheet. The fair value of the Term Loan was $294.7 million and is based on Level 3 inputs computed using the effective interest rate of the Term Loan. The effective interest rate considers the timing and amount of estimated future interest payments and the discount on the Term Loan. The Level 3 inputs related to the Term Loan are the amounts of the estimated future interest payments. Please refer to Note L, "Long-term Obligations" for further information regarding the Company's Term Loan.


13

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

F.
Marketable Securities
A summary of the Company’s cash, cash equivalents and marketable securities is shown below:
 
Amortized Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair Value
 
(in thousands)
As of September 30, 2014
 
 
 
 
 
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash and money market funds
$
718,562

 
$
1

 
$

 
$
718,563

Total cash and cash equivalents
$
718,562

 
$
1

 
$

 
$
718,563

Marketable securities:
 
 
 
 
 
 
 
Government-sponsored enterprise securities (due within 1 year)
$
467,857

 
$
27

 
$
(16
)
 
$
467,868

Commercial paper (due within 1 year)
46,402

 
94

 

 
46,496

Corporate debt securities (due within 1 year)
213,352

 
2

 

 
213,354

Corporate debt securities (due after 1 year through 5 years)
31,497

 

 
(41
)
 
31,456

Total marketable securities
$
759,108

 
$
123

 
$
(57
)
 
$
759,174

Total cash, cash equivalents and marketable securities
$
1,477,670

 
$
124

 
$
(57
)
 
$
1,477,737

 
 
 
 
 
 
 
 
As of December 31, 2013
 
 
 
 
 
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash and money market funds
$
569,299

 
$

 
$

 
$
569,299

Total cash and cash equivalents
$
569,299

 
$

 
$

 
$
569,299

Marketable securities:
 
 
 
 
 
 
 
Government-sponsored enterprise securities (due within 1 year)
$
600,496

 
$
7

 
$
(53
)
 
$
600,450

Commercial paper (due within 1 year)
83,384

 
109

 

 
83,493

Corporate debt securities (due within 1 year)
189,674

 
14

 
(34
)
 
189,654

Corporate debt securities (due after 1 year through 5 years)
22,181

 
6

 
(7
)
 
22,180

Total marketable securities
$
895,735

 
$
136

 
$
(94
)
 
$
895,777

Total cash, cash equivalents and marketable securities
$
1,465,034

 
$
136

 
$
(94
)
 
$
1,465,076

The Company has a limited number of marketable securities in insignificant loss positions as of September 30, 2014, which the Company does not intend to sell and has concluded it will not be required to sell before recovery of the amortized costs for the investment at maturity.
G.
Accumulated Other Comprehensive Loss
A summary of the Company's changes in accumulated other comprehensive loss by component is shown below:
 
Foreign Currency Translation Adjustment
 
Unrealized Holding Gains on Marketable Securities
 
Unrealized Gains (Losses) on Foreign Currency Forward Contracts
 
Total
 
(in thousands)
Balance at December 31, 2013
$
(325
)
 
$
42

 
$
(23
)
 
$
(306
)
Other comprehensive income (loss) before reclassifications
(271
)
 
25

 
2,140

 
1,894

Amounts reclassified from accumulated other comprehensive loss

 

 
(427
)
 
(427
)
Net current period other comprehensive income (loss)
$
(271
)
 
$
25

 
$
1,713

 
$
1,467

Balance at September 30, 2014
$
(596
)
 
$
67

 
$
1,690

 
$
1,161



14

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

 
Foreign Currency Translation Adjustment
 
Unrealized Holding Gains (Losses) on Marketable Securities
 
Unrealized Gains (Losses) on Foreign Currency Forward Contracts
 
Total
 
(in thousands)
Balance at December 31, 2012
$
(746
)
 
$
196

 
$

 
$
(550
)
Other comprehensive loss before reclassifications
(7
)
 
7

 

 

Amounts reclassified from accumulated other comprehensive loss

 

 

 

Net current period other comprehensive loss
$
(7
)
 
$
7

 
$

 
$

Balance at September 30, 2013
$
(753
)
 
$
203

 
$

 
$
(550
)
H.
Hedging
In 2013, the Company initiated a hedging program intended to mitigate the effect of changes in foreign exchange rates for a portion of the Company’s forecasted product revenues denominated in certain foreign currencies. The program includes foreign currency forward contracts that are designated as cash flow hedges under GAAP having remaining contractual durations from one to twelve months.
The Company formally documents the relationship between foreign currency forward contracts (hedging instruments) and forecasted product revenues (hedged items), as well as the Company's risk management objective and strategy for undertaking various hedging activities, which includes matching all foreign currency forward contracts that are designated as cash flow hedges to forecasted transactions. The Company also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the foreign currency forward contracts are highly effective in offsetting changes in cash flows of hedged items on a prospective and retrospective basis. If the Company determines that (i) a foreign currency forward contract is not highly effective as a cash flow hedge, (ii) it has ceased to be a highly effective hedge or (iii) a forecasted transaction is no longer probable of occurring, the Company would discontinue hedge accounting treatment prospectively. The Company measures effectiveness based on the change in fair value of the forward contracts and the fair value of the hypothetical foreign currency forward contracts with terms that match the critical terms of the risk being hedged. As of September 30, 2014, all hedges were determined to be highly effective.
The following table summarizes the notional amount of the Company’s outstanding foreign currency forward contracts designated as cash flow hedges:
 
As of September 30, 2014
 
As of December 31, 2013
Foreign Currency
(in thousands)
Euro
$
24,009

 
$
17,468

British pound sterling
18,108

 

Total foreign currency forward contracts
$
42,117

 
$
17,468

Changes in fair value of these foreign currency forward contracts are included in accumulated other comprehensive loss as unrealized gains and losses until the forecasted underlying transaction occurs. Unrealized gains and losses on these foreign currency forward contracts are included in (i) prepaid expenses and other current assets and (ii) other liabilities, current portion, respectively, on the Company's condensed consolidated balance sheets. Realized gains and losses for the effective portion of such contracts are recognized in product revenues, net in the condensed consolidated statement of operations when the contract is settled with the counterparty. Cash flows from foreign currency forward contracts are classified within cash flows from operating activities in the same category as the cash flows from the hedged item.
The following table summarizes the fair value of the Company's outstanding foreign currency forward contracts included on the Company's condensed consolidated balance sheets:


15

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

 
As of September 30, 2014
 
As of December 31, 2013
 
(in thousands)
Fair value - assets
$
1,690

 
$

Fair value - liabilities

 
(23
)
Net carrying value
$
1,690

 
$
(23
)
I. Inventories
The following table sets forth the Company’s inventories by type:
 
As of September 30, 2014
 
As of December 31, 2013
 
(in thousands)
Raw materials
$

 
$
489

Work-in-process
14,302

 
9,981

Finished goods
2,451

 
3,677

Total
$
16,753

 
$
14,147

As of September 30, 2014, the Company has capitalized $1.8 million of inventory costs for lumacaftor manufactured in preparation for its planned product launch in mid-2015 based on its evaluation of, among other factors, information regarding lumacaftor's safety and efficacy. In periods prior to July 1, 2014, the Company expensed costs associated with lumacaftor’s raw materials and work-in-process as a development expense. In November 2014, the Company submitted a New Drug Application to the United States Food and Drug Administration and a Marketing Authorization Application to the European Medicines Agency for lumacaftor in combination with ivacaftor. The Company plans to continue to monitor the status of the lumacaftor regulatory process and the other factors used to determine whether or not to capitalize the lumacaftor inventory and, if there are significant negative developments regarding lumacaftor, the Company could be required to impair previously capitalized costs.
J. Intangible Assets and Goodwill
Intangible Assets
As of September 30, 2014, the Company had no intangible assets recorded on its condensed consolidated balance sheet. The intangible assets that were previously reflected on the Company's condensed consolidated balance sheets related to drug candidates for the treatment of HCV infection. The field of HCV infection treatment is highly competitive and characterized by rapid technological advances and the development of drug candidates for the treatment of HCV infection is subject to numerous risks.
ViroChem Acquisition
The Company determined that the fair value of the VX-222 intangible asset acquired from ViroChem was zero as of March 31, 2013. Accordingly, the Company recorded a $412.9 million impairment charge in the three months ended March 31, 2013 and the nine months ended September 30, 2013.  In connection with this impairment charge, the Company recorded a credit of $127.6 million in its provision for income taxes. In the nine months ended September 30, 2013, the increase to the Company's net loss attributable to Vertex related to this impairment charge, net of the tax credit, was $285.3 million, and the net increase to the Company's net loss per share attributable to Vertex common shareholders was $1.28 per share.
Alios Collaboration
In June 2011, the Company recorded $250.6 million of intangible assets on its condensed consolidated balance sheet based on the Company's estimate of the fair value of Alios' HCV nucleotide analogue program, including the intellectual property related to ALS-2200 and ALS-2158. In the fourth quarter of 2013, the Company determined that the fair value of the HCV nucleotide analogue program was zero as of December 31, 2013. Accordingly, in the fourth quarter of 2013, the Company recorded a $250.6 million impairment charge and a $102.1 million benefit from income taxes.


16

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

Goodwill
As of September 30, 2014 and December 31, 2013, goodwill of $31.0 million was recorded on the Company's condensed consolidated balance sheets. There was no change to goodwill recorded during the three and nine months ended September 30, 2014 or 2013.
K. Convertible Senior Subordinated Notes
In 2010, the Company completed an offering of $400.0 million in aggregate principal amount of 3.35% convertible senior subordinated notes due 2015 (the "2015 Notes"). This offering resulted in $391.6 million of net proceeds to the Company. The underwriting discount and other expenses of $8.4 million were recorded as debt issuance costs and were included in other assets on the Company’s condensed consolidated balance sheets.
The 2015 Notes were convertible at any time, at the option of the holder, into common stock at a price equal to approximately $48.83 per share, or 20.4794 shares of common stock per $1,000 principal amount of the 2015 Notes. If the closing price of the Company’s common stock exceeded 130% of the conversion price for at least 20 trading days within a period of 30 consecutive trading days, the Company had the right to redeem the 2015 Notes at its option at a redemption price equal to 100% of the principal amount of the 2015 Notes to be redeemed.
In the second quarter of 2013, the Company's common stock exceeded 130% of the conversion price of the 2015 Notes for at least 20 trading days within a period of 30 consecutive trading days, and the Company notified the holders of the 2015 Notes that it would redeem the 2015 Notes on June 17, 2013. In response to the Company's call of the 2015 Notes for redemption, in accordance with the provisions of the 2015 Notes, the holders of $399.8 million in aggregate principal amount of 2015 Notes elected to convert their 2015 Notes into the Company's common stock at the conversion price of approximately $48.83 per share. As a result of these conversions, the Company issued 8,188,448 shares of common stock. The remaining $0.2 million in aggregate principal amount of 2015 Notes was redeemed on June 17, 2013.
Pursuant to the terms of the 2015 Notes, the Company made an additional payment of $16.75 per $1,000 principal amount, payable in shares of the Company’s common stock, to the holders of the 2015 Notes that converted or redeemed their 2015 Notes after the Company called the 2015 Notes for redemption. These payments resulted in the issuance of an additional 87,109 shares of the Company's common stock. In the second quarter of 2013, the Company recognized an aggregate of $6.7 million in interest expense related to the 2015 Notes. Unamortized debt issuance costs for the 2015 Notes of $4.2 million were recorded as an offset to additional paid-in capital.
L. Long-term Obligations
Fan Pier Leases
In 2011, the Company entered into two lease agreements, pursuant to which the Company leases approximately 1.1 million square feet of office and laboratory space in two buildings (the “Buildings”) at Fan Pier in Boston, Massachusetts (the “Fan Pier Leases”). The Company commenced lease payments in December 2013, and will make lease payments pursuant to the Fan Pier Leases through December 2028. The Company has an option to extend the term of the Fan Pier Leases for an additional ten years.
Because the Company was involved in the construction project, including having responsibility to pay for a portion of the costs of finish work and structural elements of the Buildings, the Company was deemed for accounting purposes to be the owner of the Buildings during the construction period. Therefore, the Company recorded project construction costs incurred by the landlord as an asset and a related financing obligation during the construction period. The Company evaluated the Fan Pier Leases in the fourth quarter of 2013 and determined that the Fan Pier Leases did not meet the criteria for “sale-leaseback” treatment. This determination was based on, among other things, the Company's continuing involvement with the property in the form of non-recourse financing to the lessor. Accordingly, the Company began depreciating the asset and incurring interest expense related to the financing obligation during the fourth quarter of 2013. The Company bifurcates its lease payments pursuant to the Fan Pier Leases into (i) a portion that is allocated to the Buildings and (ii) a portion that is allocated to the land on which the Buildings were constructed. The portion of the lease obligations allocated to the land is treated as an operating lease that commenced in 2011.


17

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

Property and equipment, net, included $518.3 million and $503.4 million as of September 30, 2014 and December 31, 2013, respectively, related to construction costs for the Buildings at Fan Pier in Boston, Massachusetts. The construction financing lease obligation related to the Buildings at Fan Pier was $473.5 million and $440.9 million as of September 30, 2014 and December 31, 2013, respectively.
Term Loan
On July 9, 2014, the Company entered into a credit agreement with the lenders party thereto, and Macquarie US Trading LLC ("Macquarie"), as administrative agent. The credit agreement provides for a $300.0 million senior secured term loan ("Term Loan"). The credit agreement also provides that, subject to satisfaction of certain conditions, the Company may request that the lenders establish an incremental senior secured term loan facility in an aggregate amount not to exceed $200.0 million.
The Term Loan initially bears interest at a rate of 7.2% per annum but shall be reduced to 6.2% per annum on the later to occur of (i) FDA approval in the United States of a product with a label claim for treating patients with cystic fibrosis 12 years of age and older who are homozygous with the F508del mutation ("FDA Approval"), and (ii) the one year anniversary of the closing, in each case, until the second anniversary of the closing. On and after the second anniversary of the closing, the Term Loan will bear interest at a rate per annum equal to LIBOR plus 5.0% to 7.5% depending on the receipt of FDA Approval.
The maturity date of all loans under the facilities is July 9, 2017. Interest is payable quarterly and on the maturity date. The Company is required to repay principal on the Term Loan in installments of $15.0 million per quarter from October 1, 2015 through July 1, 2016 and in installments of $60.0 million per quarter from October 1, 2016 through the maturity date. The Company may prepay the Term Loan, in whole or in part, at any time; provided that prepayments prior to the second anniversary of the closing are subject to a make-whole premium to ensure Macquarie receives approximately the present value of two years of interest payments over the life of the loan.
The Company's obligations under the facilities are unconditionally guaranteed by certain of its domestic subsidiaries. All obligations under the facilities, and the guarantees of those obligations, are secured, subject to certain exceptions, by substantially all of the Company's assets and the assets of all guarantors, including the pledge of all or a portion of the equity interests of certain of its subsidiaries.
The credit agreement requires that the Company maintain, on a quarterly basis, a minimum level of KALYDECO net revenues. Further, the credit agreement includes negative covenants, subject to exceptions, restricting or limiting the Company's ability and the ability of its subsidiaries to, among other things, incur additional indebtedness, grant liens, engage in certain investment, acquisition and disposition transactions, pay dividends, repurchase capital stock and enter into transactions with affiliates. The credit agreement also contains customary representations and warranties, affirmative covenants and events of default, including payment defaults, breach of representations and warranties, covenant defaults and cross defaults. If an event of default occurs, the administrative agent would be entitled to take various actions, including the acceleration of amounts due under outstanding loans. There have been no events of default as of or during the period ended September 30, 2014.
Based on the Company's evaluation of the Term Loan, the Company determined that the Term Loan contains several embedded derivatives. These embedded derivatives are clearly and closely related to the host instrument because they relate to the Company's credit risk; therefore, they do not require bifurcation from the host instrument, the Term Loan.
The Company incurred $5.3 million in fees paid to Macquarie that were recorded as a discount on the Term Loan and that will be recorded as interest expense using the effective interest method over the term of the loan in the Company’s condensed consolidated statements of operations.
Capital Leases
The Company has outstanding capital leases for equipment, leasehold improvements and software licenses with terms through 2019. The following table sets forth the Company’s future minimum payments due under capital leases as of September 30, 2014:


18

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

Year
 
(in thousands)
2014
 
$
4,122

2015
 
20,792

2016
 
14,254

2017
 
13,129

2018
 
13,027

2019
 
3,047

Thereafter
 

Total payments
 
$
68,371

Less: amount representing interest
 
(8,047
)
Present value of payments
 
$
60,324

Financing Arrangements
The Company has outstanding $33.5 million in irrevocable stand-by letters of credit issued in connection with property leases and other similar agreements that currently are supported by an unsecured credit facility that expires in April 2015. The credit facility provides the Company's creditor the ability to subjectively cash collateralize the letters of credit at the conclusion of any month, which is a contingency that the Company considers to have a remote possibility of occurring.
M. Stock-based Compensation Expense
The Company issues stock options, restricted stock and restricted stock units with service conditions, which are generally the vesting periods of the awards. The Company also has issued, to certain members of senior management, restricted stock and restricted stock units that vest upon the earlier of the satisfaction of (i) a performance condition or (ii) a service condition, and stock options that vest upon the earlier of the satisfaction of (a) performance conditions or (b) a service condition. In addition, the Company issues shares pursuant to an employee stock purchase plan ("ESPP").
Effective for equity awards granted on or after February 5, 2014, the Company provides to employees who have rendered significant service to the Company and meet certain age requirements, partial or full acceleration of vesting of these equity awards upon a termination of employment other than for cause.  Less than 5% of the Company’s employees were eligible for partial or full acceleration of any of their equity awards as of September 30, 2014.  The Company typically recognizes stock-based compensation expense related to these awards over the service period from the date of grant until the qualified employees become eligible for partial or full acceleration of vesting.


19

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

During the three and nine months ended September 30, 2014 and 2013, the Company recognized the following stock-based compensation expense included in loss from continuing operations:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Stock-based compensation expense by type of award:
 
 
 
 
 
 
 
Stock options
$
26,291

 
$
18,899

 
$
78,403

 
$
68,285

Restricted stock and restricted stock units
18,418

 
10,998

 
51,431

 
30,108

ESPP share issuances
1,883

 
1,504

 
6,231

 
6,077

Less stock-based compensation expense capitalized to inventories
(456
)
 
(204
)
 
(905
)
 
(885
)
Total stock-based compensation expense included in costs and expenses
$
46,136

 
$
31,197

 
$
135,160

 
$
103,585

 
 
 
 
 
 
 


Stock-based compensation expense by line item:
 
 
 
 
 
 
 
Research and development expenses
$
31,131

 
$
19,155

 
$
91,284

 
$
64,100

Sales, general and administrative expenses
15,005

 
12,042

 
43,876

 
39,485

Total stock-based compensation expense included in costs and expenses
$
46,136

 
$
31,197

 
$
135,160

 
$
103,585

In 2013, the Company also recognized stock-based compensation expense recorded to noncontrolling interest (Alios), which is reflected in the Company's condensed consolidated statements of shareholders equity and noncontrolling interest.
The following table sets forth the Company's unrecognized stock-based compensation expense, net of estimated forfeitures, by type of award and the weighted-average period over which that expense is expected to be recognized:
 
As of September 30, 2014
 
Unrecognized Expense,
Net of
Estimated Forfeitures
 
Weighted-average
Recognition
Period
 
(in thousands)
 
(in years)
Type of award:
 
 
 
Stock options
$
180,746

 
2.28
Restricted stock and restricted stock units
$
116,900

 
2.27
ESPP share issuances
$
1,978

 
0.43


20

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

The following table summarizes information about stock options outstanding and exercisable at September 30, 2014:
 
 
Options Outstanding
 
Options Exercisable
Range of Exercise Prices
 
Number
Outstanding
 
Weighted-average
Remaining
Contractual Life
 
Weighted-average
Exercise Price
 
Number
Exercisable
 
Weighted-average
Exercise Price
 
 
(in thousands)
 
(in years)
 
(per share)
 
(in thousands)
 
(per share)
$10.41–$20.00
 
297

 
1.97
 
$16.16
 
297

 
$16.16
$20.01–$30.00
 
633

 
4.64
 
$29.32
 
482

 
$29.13
$30.01–$40.00
 
3,458

 
4.75
 
$36.24
 
2,627

 
$35.71
$40.01–$50.00
 
2,934

 
8.11
 
$46.32
 
661

 
$46.67
$50.01–$60.00
 
1,093

 
7.07
 
$54.27
 
655

 
$54.80
$60.01–$70.00
 
126

 
8.92
 
$65.78
 
28

 
$64.76
$70.01–$80.00
 
1,998

 
9.36
 
$76.71
 
360

 
$74.59
$80.01–$90.00
 
1,231

 
8.81
 
$83.09
 
369

 
$82.53
$90.01–$96.87
 
1,327

 
9.80
 
$96.73
 

 
$—
Total
 
13,097

 
7.26
 
$56.20
 
5,479

 
$43.53
N. Sale of HIV Protease Inhibitor Royalty Stream
In 2008, the Company sold to a third party its rights to receive royalty payments from GlaxoSmithKline plc, net of royalty amounts to be earned by and due to a third party, for a one-time cash payment of $160.0 million. These royalty payments relate to net sales of HIV protease inhibitors, which had been developed pursuant to a collaboration agreement between the Company and GlaxoSmithKline plc. As of September 30, 2014, the Company had $49.4 million in deferred revenues related to the one-time cash payment, which it is recognizing over the life of the collaboration agreement with GlaxoSmithKline plc based on the units-of-revenue method. In addition, the Company continues to recognize royalty revenues equal to the amount of the third-party subroyalty and an offsetting royalty expense for the third-party subroyalty payment.
O. Income Taxes
The Company is subject to U.S. federal, state, and foreign income taxes. For the three and nine months ended September 30, 2014, the Company recorded a net provision for income taxes of $3.4 million and $4.9 million, respectively, related to state income taxes and income earned in various foreign jurisdictions. For the three and nine months ended September 30, 2013, the Company recorded a provision for income taxes of $2.6 million and benefit from income taxes $123.8 million, respectively. The benefit from income taxes in the nine months ended September 30, 2013 primarily related to a tax benefit associated with the Company’s impairment of VX-222 in the first quarter of 2013. Please refer to "Note J, "Intangible Assets and Goodwill," for further information regarding the impairment charge.
As of September 30, 2014 and December 31, 2013, the Company had unrecognized tax benefits of $5.7 million and $2.0 million, respectively. The Company recognizes interest and penalties related to income taxes as a component of income tax expense. As of September 30, 2014, no interest and penalties have been accrued. The Company does not expect that its unrecognized tax benefits will materially increase within the next twelve months. The Company did not recognize any material interest or penalties related to uncertain tax positions as of September 30, 2014 and December 31, 2013.
The Company continues to maintain a valuation allowance against certain deferred tax assets where it is more likely than not that the deferred tax asset will not be realized because of its extended history of annual losses.
The Company files U.S. federal income tax returns and income tax returns in various state, local and foreign jurisdictions. The Company is no longer subject to any tax assessment from an income tax examination in the United States before 2011 and any other major taxing jurisdiction for years before 2007, except where the Company has net operating losses or tax credit carryforwards that originated before 2005. During the second quarter of 2014, the Company concluded an


21

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

audit by Revenue Quebec for the year ended December 31, 2011 with no material changes. The Company is currently under examination by Revenue Quebec for the year ended December 31, 2012 as well as the Massachusetts Department of Revenue and the Internal Revenue Service for the year ended December 31, 2011. No adjustments have been reported. The Company is not under examination by any other jurisdictions for any tax year.
The Company currently intends to reinvest the total amount of its unremitted earnings, which have not been significant to date, in the local international jurisdiction or to repatriate the earnings only when tax-effective. As a result, the Company has not provided for U.S. federal income taxes on the unremitted earnings of its international subsidiaries. Upon repatriation of those earnings, in the form of dividends or otherwise, the Company would be subject to U.S. federal income taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to the various foreign countries. At September 30, 2014, foreign earnings, which were not significant, have been retained indefinitely by foreign subsidiary companies for reinvestment; therefore, no provision has been made for income taxes that would be payable upon the distribution of such earnings, and it would not be practicable to determine the amount of the related unrecognized deferred income tax liability.
P. Restructuring Liabilities
2003 Kendall Restructuring
In 2003, the Company adopted a plan to restructure its operations to coincide with its increasing internal emphasis on advancing drug candidates through clinical development to commercialization. The restructuring liability relates to specialized laboratory and office space that is leased to the Company pursuant to a 15-year lease that terminates in 2018. The Company has not used more than 50% of this space since it adopted the plan to restructure its operations in 2003. This unused laboratory and office space currently is subleased to third parties.
The activities related to the restructuring liability for the three and nine months ended September 30, 2014 and 2013 were as follows:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Liability, beginning of the period
$
14,936

 
$
22,052

 
$
19,115

 
$
23,328

Cash payments
(4,249
)
 
(3,902
)
 
(12,071
)
 
(11,323
)
Cash received from subleases
2,689

 
2,670

 
8,067

 
8,000

Restructuring (income) expense
(464
)
 
524

 
(2,199
)
 
1,339

Liability, end of the period
$
12,912

 
$
21,344

 
$
12,912

 
$
21,344

Fan Pier Move Restructuring
In connection with the relocation of its Massachusetts operations to Fan Pier in Boston, Massachusetts, which commenced in 2013, the Company is incurring restructuring charges related to its remaining lease obligations at its facilities in Cambridge, Massachusetts, which include lease obligations related to the 120,000 square feet of the Kendall Square facility that the Company continued to use for its operations following its 2003 Kendall Restructuring. The majority of these restructuring charges were recorded in the third quarter of 2014 upon decommissioning three facilities in Cambridge. To record the restructuring expense and related liability on the cease use date for these facilities, the Company estimated (i) its remaining lease obligations including operating costs for these facilities, (ii) the lead-time necessary to sublease the facilities, (iii) projected sublease rental rates and (iv) the anticipated duration of the subleases.  The Company discounted the estimated cash flows related to the facilities using a credit-adjusted risk-free rate of 9%. The Company will continue to incur charges through April 2018 related to the difference between the Company’s estimated future cash flows related to its lease obligations, which include an estimate for sublease income to be received if applicable, and its actual cash flows.
The activities related to the restructuring liability for the three and nine months ended September 30, 2014 were as follows:


22

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Liability, beginning of the period
$
3,256

 
$

 
$
797

 
$

Cash payments
(2,266
)
 
(80
)
 
(6,643
)
 
(80
)
Restructuring expense
39,752

 
80

 
46,588

 
80

Liability, end of the period
$
40,742

 
$

 
$
40,742

 
$

Other Restructuring Activities
The Company has incurred several other restructuring activities that are unrelated to its 2003 Kendall Restructuring and the Fan Pier Move Restructuring. The most significant activity commenced in October 2013 when the Company adopted a restructuring plan that included (i) a workforce reduction primarily related to the commercial support of INCIVEK following the continued and rapid decline in the number of patients being treated with INCIVEK as new medicines for the treatment of HCV infection neared approval and (ii) the write-off of certain assets. This action resulted from the Company's decision to focus its investment on future opportunities in cystic fibrosis and other research and development programs.
The activities related to the Company's other restructuring liabilities for the three and nine months ended September 30, 2014 were as follows:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Liability, beginning of the period
$
792

 
$

 
$
8,441

 
$

Cash payments
(399
)
 

 
(8,865
)
 

Impairment of property and equipment

 
(6,650
)
 

 
(6,650
)
Restructuring expense
1,555

 
11,444

 
2,372

 
11,444

Liability, end of the period
$
1,948

 
$
4,794

 
$
1,948

 
$
4,794

Q. Other Income (Expense), Net
In April 2014, the Company received a one-time cash payment of $36.7 million from its landlord pursuant to the Fan Pier Leases.  This payment related to bonds issued pursuant to an Infrastructure Development Assistance Agreement between The Commonwealth of Massachusetts and the Company’s landlord.  The bonds were issued in connection with the landlord’s contribution to infrastructure improvements and also were dependent upon employment levels at the Company through the bond issuance date.  The Company accounted for the cash payment as a government grant as it was provided in part related to the Company's employment level in Massachusetts. Such grants are recognized in income in the period in which the conditions of the grant are met and there is reasonable assurance that the grant will be received, provided it is not subject to refund. In the second quarter of 2014, the Company recorded $36.7 million as a credit to other income (expense), net in its condensed consolidated statements of operations because the Company's employment obligations related to these funds were satisfied as of the date of issuance of the bonds and the payment received is not subject to refund.
R. Legal Proceedings
Local No. 8 IBEW Retirement Plan & Trust v. Vertex Pharmaceuticals Incorporated, et al.
On May 28, 2014, a purported shareholder class action Local No. 8 IBEW Retirement Plan & Trust v. Vertex Pharmaceuticals Incorporated, et al. was filed in the United States District Court for the District of Massachusetts, naming the Company and certain of the Company's current and former officers and directors as defendants. The lawsuit alleged that the Company made material misrepresentations and/or omissions of material fact in the Company's disclosures during the period from May 7, 2012 through May 29, 2012, all in violation of Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder. The purported class consists of all persons (excluding defendants) who purchased the Company’s common stock between May 7, 2012 and May 29, 2012. The plaintiffs seek unspecified monetary damages, costs and attorneys’ fees as well as disgorgement of the proceeds from certain individual defendants’ sales of the Company’s stock. On October 8, 2014, the Court approved Local No. 8 IBEW Retirement Fund as lead plaintiff, and Scott and Scott LLP as lead counsel for the plaintiff and the putative class. The Company believes the claims to be without merit and intends to vigorously defend the litigation. As of September 30, 2014, the Company has not recorded any reserves for this purported class action.
S. Contingencies
The Company has certain contingent liabilities that arise in the ordinary course of its business activities. The Company accrues a reserve for contingent liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. There were no material contingent liabilities accrued as of September 30, 2014 or December 31, 2013.
T. Guarantees
As permitted under Massachusetts law, the Company’s Articles of Organization and By-laws provide that the Company will indemnify certain of its officers and directors for certain claims asserted against them in connection with their service as an officer or director. The maximum potential amount of future payments that the Company could be required to make under these indemnification provisions is unlimited. However, the Company has purchased directors’ and officers’ liability insurance policies that could reduce its monetary exposure and enable it to recover a portion of any future amounts paid. No indemnification claims currently are outstanding, and the Company believes the estimated fair value of these indemnification arrangements is minimal.
The Company customarily agrees in the ordinary course of its business to indemnification provisions in agreements with clinical trial investigators and sites in its drug development programs, sponsored research agreements with academic and not-for-profit institutions, various comparable agreements involving parties performing services for the Company, and its real estate leases. The Company also customarily agrees to certain indemnification provisions in its drug discovery, development and commercialization collaboration agreements. With respect to the Company’s clinical trials and sponsored research agreements, these indemnification provisions typically apply to any claim asserted against the investigator or the investigator’s institution relating to personal injury or property damage, violations of law or certain breaches of the Company’s contractual obligations arising out of the research or clinical testing of the Company’s compounds or drug candidates. With respect to lease agreements, the indemnification provisions typically apply to claims asserted against the landlord relating to personal injury or property damage caused by the Company, to violations of law by the Company or to certain breaches of the Company’s contractual obligations. The indemnification provisions appearing in the Company’s collaboration agreements are similar to those for the other agreements discussed above, but in addition provide some limited indemnification for its collaborator in the event of third-party claims alleging infringement of intellectual property rights. In each of the cases above, the indemnification obligation generally survives the termination of the agreement for some extended period, although the Company believes the obligation typically has the most relevance during the contract term and for a short period of time thereafter. The maximum potential amount of future payments that the Company could be required to make under these provisions is generally unlimited. The Company has purchased insurance policies covering personal injury, property damage and general liability that reduce its exposure for indemnification and would enable it in many cases to recover all or a portion of any future amounts paid. The Company has never paid any material amounts to defend lawsuits


23

VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

or settle claims related to these indemnification provisions. Accordingly, the Company believes the estimated fair value of these indemnification arrangements is minimal.


24


Item 2.     Management's Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
We are in the business of discovering, developing, manufacturing and commercializing small molecule drugs. We invest in scientific innovation to create transformative medicines for patients with serious diseases in specialty markets. Our business is focused on developing and commercializing therapies for the treatment of cystic fibrosis, or CF, and advancing our other research and early-stage development programs, while maintaining our financial strength.
We have marketed KALYDECO (ivacaftor) in the United States, European Union and Canada since it was approved in 2012 for the treatment of patients six years of age and older with CF who have specific genetic mutations in their cystic fibrosis transmembrane conductance regulator, or CFTR, gene. In June 2014, we announced data from two Phase 3 clinical trials, referred to as TRAFFIC and TRANSPORT, of lumacaftor, a CFTR corrector compound, in combination with ivacaftor, a CFTR potentiator compound. In TRAFFIC and TRANSPORT, we evaluated the combination regimen in patients 12 years of age and older with CF who have two copies (homozygous) of the F508del mutation in their CFTR gene, which is the most prevalent form of CF. All four treatment arms in TRAFFIC and TRANSPORT met their primary endpoints of mean absolute improvement in lung function as compared to placebo. In November 2014, we submitted a New Drug Application, or NDA, to the United States Food and Drug Administration, or FDA, and a Marketing Authorization Application, or MAA, to the European Medicines Agency, or EMA, for lumacaftor in combination with ivacaftor.
Cystic Fibrosis
Our plan is to (i) increase the number of patients eligible for treatment with ivacaftor, (ii) seek marketing approval for lumacaftor in combination with ivacaftor for the treatment of patients with CF who have two copies of the F508del mutation in their CFTR gene and (iii) research and develop earlier-stage compounds for the treatment of CF.
Ivacaftor
KALYDECO was approved in 2012 in the United States, European Union and Canada as a treatment for patients with CF six years of age and older who have the G551D mutation in their CFTR gene. We believe that most patients with CF six years of age and older who have the G551D mutation in the United States, Europe and Canada are being treated with KALYDECO. In Australia, we expect KALYDECO to be listed on the Pharmaceutical Benefits Scheme as of December 1, 2014. We believe there are approximately 250 patients six years of age and older who will be eligible for treatment with KALYDECO in Australia. In February 2014, the FDA approved KALYDECO for the treatment of patients with CF six years of age and older who have one of eight other mutations in their CFTR gene, which were studied in our first Phase 3 label-expansion clinical trial for ivacaftor. In July 2014, the European Commission approved KALYDECO for this patient group.
We are seeking to further expand the number of patients eligible for treatment with ivacaftor by (i) evaluating ivacaftor as a potential treatment for patients with CF who have residual CFTR function, including patients with CF who have the R117H mutation in their CFTR gene and (ii) evaluating ivacaftor as a potential treatment for patients with CF two to five years of age with specific mutations in their CFTR gene.
We have completed a Phase 3 clinical trial to evaluate ivacaftor as a treatment for children with CF two to five years of age with specific gating mutations in their CFTR gene, including the G551D mutation, and have submitted an NDA and an MAA line extension application based on this clinical trial. We believe there are approximately 300 children with CF two to five years of age who have gating mutations in North America, Europe and Australia.
Our Phase 3 clinical trial to evaluate ivacaftor in patients with the R117H mutation in their CFTR gene did not meet its primary endpoint of a statistically significant absolute change from baseline in percent predicted forced expiratory volume in one second, or ppFEV1. However, a pre-specified subgroup analysis demonstrated a statistically significant clinical benefit in patients with CF 18 years of age and older who have the R117H mutation on at least one allele. Based on these data, we submitted a supplemental New Drug Application, or sNDA, to the FDA and an MAA variation to the EMA seeking approval of KALYDECO in patients with CF who have the R117H mutation on at least one allele in their CFTR gene. In October 2014, the FDA's Pulmonary Allergy Drugs Advisory Committee voted 13-2 to recommend approval of KALYDECO in patients with CF six years of age and older who have the R117H mutation in their CFTR gene. The FDA is not bound by the committee's recommendation, but often follows its advice. The FDA is expected to make a decision on the sNDA by December 30, 2014 under the Prescription Drug User Fee Act.
Lumacaftor in Combination with Ivacaftor
In the second quarter of 2014, we completed TRAFFIC and TRANSPORT, which were Phase 3 randomized, double-blind, placebo-controlled clinical trials of lumacaftor in combination with ivacaftor. All four treatment arms in TRAFFIC and


25


TRANSPORT met their primary endpoints of mean absolute improvement in ppFEV1 as compared to placebo. In October 2014, we obtained the first interim data from a rollover clinical trial in which patients from TRAFFIC and TRANSPORT received a combination regimen. At the time of the interim analysis, approximately 25% of patients within each arm of the rollover clinical trial had received an additional 24 weeks of treatment. The first interim data from this clinical trial showed that the initial improvements in lung function observed in the 24-week TRAFFIC and TRANSPORT clinical trials were sustained through 48 weeks of treatment with lumacaftor in combination with ivacaftor. The pattern of response observed after the initiation of combination dosing across all patients who received placebo in TRAFFIC and TRANSPORT and subsequently received a combination regimen in the rollover clinical trial was similar to that seen in patients who received a combination regimen in TRAFFIC and TRANSPORT. At the time of the interim analysis, the safety and tolerability results, including the rate of serious adverse events, were consistent with those observed in the TRAFFIC and TRANSPORT. Based on the data from TRAFFIC and TRANSPORT, in November 2014, we submitted an NDA to the FDA and an MAA to the EMA for lumacaftor in combination with ivacaftor in patients with CF twelve years of age and older who have two copies (homozygous) of the F508del mutation in their CFTR gene. The FDA submission includes a request for Priority Review and the European Committee for Medicinal Products for Human Use has granted our request for Accelerated Assessment of the MAA. We believe that there are approximately 22,000 patients twelve years of age and older who have two copies of the F508del mutation in North America, Europe and Australia, including approximately 8,500 in the United States and approximately 12,000 in Europe.
Ivacaftor in Combination with VX-661
We are evaluating VX-661, a second investigational CFTR corrector, in combination with ivacaftor, in Phase 2 clinical development. VX-661 was granted Orphan Drug Designation by the FDA in 2014. In May 2014, we announced data from a Phase 2 double-blind clinical trial evaluating VX-661 in combination with KALYDECO in patients with CF 12 years of age and older who have one copy of the G551D mutation and one copy of the F508del mutation in their CFTR gene. VX-661 currently is being evaluated in combination with ivacaftor as part of a fully-enrolled 12-week Phase 2b clinical trial in patients 18 years of age and older who have two copies of the F508del mutation in their CFTR gene. This clinical trial is designed to evaluate safety, efficacy and pharmacokinetics to characterize VX-661 for further development.
Based on the data from the clinical trial evaluating VX-661 in combination with KALYDECO in patients who have the G551D mutation in their CFTR gene and pending data from the ongoing 12-week clinical trial in patients homozygous for the F508del mutation and discussions with regulatory authorities, we plan to initiate Phase 3 clinical trials in the first half of 2015 to evaluate VX-661 in combination with ivacaftor. In these Phase 3 clinical trials, we expect to evaluate patients with CF who have (i) two copies of the F508del mutation, (ii) one copy of the F508del mutation and a second mutation in their CFTR gene known to result in a gating defect in the CFTR protein, (iii) one copy of the F508del mutation and a second mutation in their CFTR gene that is known to result in residual function in the CFTR protein and (iv) one copy of the F508del mutation and a second mutation in their CFTR gene that results in minimal CFTR function. As part of the Phase 3 program, we also plan to evaluate ivacaftor monotherapy in patients with a mutation in their CFTR gene that is known to result in residual function in the CFTR protein.
Next-generation CFTR Corrector Compounds
We also are seeking to identify and develop next-generation CFTR corrector compounds that could be evaluated in regimens combining ivacaftor with two CFTR corrector compounds. We have multiple next-generation correctors in the lead-optimization stage of research and expect to begin clinical development of a next-generation corrector in 2015.
HCV Infection
In 2013, in response to declining sales of INCIVEK (telaprevir), our product for the treatment of genotype 1 HCV infection and increased competition, we reduced our focus on marketing INCIVEK and eliminated the U.S. field-based sales force that had been promoting INCIVEK. In addition, in the first quarter of 2013 and fourth quarter of 2013, we incurred intangible asset impairment charges of $412.9 million and $250.6 million, respectively, related to drug candidates for the treatment of HCV infection. In the fourth quarter of 2014, we provided notice of termination of the collaboration with Alios BioPharma, Inc. that related to the development of HCV nucleotide analogues, and we are in the process of winding-down all remaining activities relating to the field of HCV infection.
Research and Early-Stage Development
We are engaged in a number of other research and early-stage development programs, including programs in the areas of oncology, neurology and other serious and rare diseases. We plan to continue investing in our research programs as well as our early-stage development programs and fostering scientific innovation in order to identify and develop transformative


26


medicines. We believe that pursuing research in diverse areas allows us to balance the risks inherent in drug development and may provide drug candidates that will form our pipeline in future years.
Drug Discovery and Development
Discovery and development of a new pharmaceutical product is a difficult and lengthy process that requires significant financial resources along with extensive technical and regulatory expertise and can take 10 to 15 years or more. Potential drug candidates are subjected to rigorous evaluations, driven in part by stringent regulatory considerations, designed to generate information concerning efficacy, side-effects, proper dosage levels and a variety of other physical and chemical characteristics that are important in determining whether a drug candidate should be approved for marketing as a pharmaceutical product. Most chemical compounds that are investigated as potential drug candidates never progress into development, and most drug candidates that do advance into development never receive marketing approval. Because our investments in drug candidates are subject to considerable risks, we closely monitor the results of our discovery research, clinical trials and nonclinical studies and frequently evaluate our drug development programs in light of new data and scientific, business and commercial insights, with the objective of balancing risk and potential. This process can result in abrupt changes in focus and priorities as new information becomes available and as we gain additional understanding of our ongoing programs and potential new programs, as well as those of our competitors.
If we believe that data from a completed registration program support approval of a drug candidate, we submit an NDA to the FDA requesting approval to market the drug candidate in the United States and seek analogous approvals from comparable regulatory authorities in foreign jurisdictions. To obtain approval, we must, among other things, demonstrate with evidence gathered in nonclinical studies and well-controlled clinical trials that the drug candidate is safe and effective for the disease it is intended to treat and that the manufacturing facilities, processes and controls for the manufacture of the drug candidate are adequate. The FDA and foreign regulatory authorities have substantial discretion in deciding whether or not a drug candidate should be granted approval based on the benefits and risks of the drug candidate in the treatment of a particular disease, and could delay, limit or deny regulatory approval. If regulatory delays are significant or regulatory approval is limited or denied altogether, our financial results and the commercial prospects for the drug candidate involved will be harmed.
Regulatory Compliance
Our marketing of pharmaceutical products is subject to extensive and complex laws and regulations. We have a corporate compliance program designed to actively identify, prevent and mitigate risk through the implementation of compliance policies and systems, and through the promotion of a culture of compliance. Among other laws, regulations and standards, we are subject to various U.S. federal and state laws, and comparable foreign laws pertaining to health care fraud and abuse, including anti-kickback and false claims statutes, and laws prohibiting the promotion of drugs for unapproved or off-label uses. Anti-kickback laws make it illegal for a prescription drug manufacturer to solicit, offer, receive or pay any remuneration in exchange for, or to induce, the referral of business, including the purchase or prescription of a particular drug. False claims laws prohibit anyone from presenting for payment to third-party payors, including Medicare and Medicaid, claims for reimbursed drugs or services that are false or fraudulent, claims for items or services not provided as claimed, or claims for medically unnecessary items or services. We expect to continue to devote substantial resources to maintain, administer and expand these compliance programs globally.


27


RESULTS OF OPERATIONS
 
Three Months Ended
September 30,
 
Increase/(Decrease)
 
Nine Months Ended
September 30,
 
Increase/(Decrease)
 
2014
 
2013
 
$
 
%
 
2014
 
2013
 
$
 
%
 
(in thousands)
 
 
 
(in thousands)
 
 
Revenues
$
178,987

 
$
221,700

 
$
(42,713
)
 
(19
)%
 
$
435,859

 
$
860,818

 
$
(424,959
)
 
(49
)%
Operating costs and expenses
$
321,190

 
$
345,256

 
$
(24,066
)
 
(7
)%
 
$
974,646

 
$
1,460,545

 
$
(485,899
)
 
(33
)%
Other items, net
$
(27,857
)
 
$
(576
)
 
N/A

 
N/A

 
$
(23,112
)
 
$
110,414

 
N/A

 
N/A

Net loss attributable to Vertex
$
(170,060
)
 
$
(124,132
)
 
$
45,928

 
37
 %
 
$
(561,899
)
 
$
(489,313
)
 
$
72,586

 
15
 %
Net Loss Attributable to Vertex
Net loss attributable to Vertex was $170.1 million in the third quarter of 2014 compared to a net loss attributable to Vertex of $124.1 million in the third quarter of 2013. Our revenues decreased in the third quarter of 2014 as compared to the third quarter of 2013 due to decreased INCIVEK net product revenues partially offset by increased KALYDECO net product revenues and increased collaborative revenues. Our operating costs and expenses decreased in the third quarter of 2014 as compared to the third quarter of 2013 primarily due to reductions in research and development expenses, sales, general and administrative expenses and cost of product revenues.
Net loss attributable to Vertex was $561.9 million in the nine months ended September 30, 2014 compared to a net loss attributable to Vertex of $489.3 million in the nine months ended September 30, 2013. Our revenues decreased in the nine months ended September 30, 2014 as compared to the nine months ended September 30, 2013 due to decreased INCIVEK net product revenues partially offset by increased KAYDECO net product revenues. Our operating expenses decreased in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013 primarily due to (i) reductions in research and development expenses, sales, general and administrative expenses and cost of product revenues and (ii) a $412.9 million impairment charge that we recorded in the first quarter of 2013. In connection with this impairment charge, we recorded a benefit from income taxes of $127.6 million in the first quarter of 2013, which was included in other items, net. The net effect of the impairment charge and the benefit from income taxes was to increase net loss attributable to Vertex in the nine months ended September 30, 2013 by $285.3 million.

We have incurred and expect to continue to incur net losses on a quarterly basis. In order to execute our business plan and become profitable, we need to obtain approval to market lumacaftor in combination with ivacaftor on a timely basis and to effectively market this combination in the United States and international markets.
 
Diluted Net Loss Per Share Attributable to Vertex Common Shareholders
Diluted net loss per share attributable to Vertex common shareholders was $0.72 in the third quarter of 2014 as compared to a diluted net loss per share attributable to Vertex common shareholders of $0.54 in the third quarter of 2013. Diluted net loss per share attributable to Vertex common shareholders was $2.40 in the nine months ended September 30, 2014 as compared to a diluted net loss per share attributable to Vertex common shareholders of $2.20 in the nine months ended September 30, 2013.


28


Revenues
 
Three Months Ended
September 30,
 
Increase/(Decrease)
 
Nine Months Ended
September 30,
 
Increase/(Decrease)
 
2014
 
2013
 
$
 
%
 
2014
 
2013
 
$
 
%
 
(in thousands)
 
 
 
(in thousands)
 
 
Product revenues, net
$
137,099

 
$
186,653

 
$
(49,554
)
 
(27
)%
 
$
362,879

 
$
708,823

 
$
(345,944
)
 
(49
)%
Royalty revenues
8,386

 
27,012

 
(18,626
)
 
(69
)%
 
32,134

 
119,705

 
(87,571
)
 
(73
)%
Collaborative revenues
33,502

 
8,035

 
25,467

 
317
 %
 
40,846

 
32,290