UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005

OR

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

FOR THE TRANSITION PERIOD FROM              TO             

COMMISSION FILE NUMBER 000-19319

VERTEX PHARMACEUTICALS INCORPORATED

(Exact name of registrant as specified in its charter)

(617) 444-6100

(Registrant’s telephone number, including area code)

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 is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES  x   NO  o

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.

Vertex Pharmaceuticals Incorporated
Form 10-Q
For the Quarter Ended September 30, 2005
Table of Contents

Part I. Financial Information

Item 1.        Condensed Consolidated Financial Statements

Vertex Pharmaceuticals Incorporated
Condensed Consolidated Balance Sheets
(Unaudited)
(In thousands, except share and per share data)

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

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Vertex Pharmaceuticals Incorporated
Condensed Consolidated Statements of Operations
(Unaudited)
(In thousands, except per share data)

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

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Vertex Pharmaceuticals Incorporated
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(In thousands)

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

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Vertex Pharmaceuticals Incorporated
Notes to Condensed Consolidated Financial Statements

1.   Basis of Presentation

The accompanying condensed consolidated financial statements are unaudited and have been prepared by Vertex Pharmaceuticals Incorporated (“Vertex” or the “Company”) in accordance with accounting principles generally accepted in the United States of America.

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

Certain information and footnote disclosures normally included in the Company’s annual financial statements have been condensed or omitted. The interim financial statements, in the opinion of management, reflect all adjustments (including normal recurring accruals) necessary for a fair statement of the financial position and results of operations for the interim periods ended September 30, 2005 and 2004.

The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the fiscal year, although the Company expects to incur a substantial loss for the year ending December 31, 2005. These interim financial statements should be read in conjunction with the audited financial statements for the year ended December 31, 2004, which are contained in the Company’s 2004 Annual Report to its Stockholders on Form 10-K that was filed with the Securities and Exchange Commission on March 16, 2005.

2.   Accounting Policies

Basic and Diluted Net Loss per Common Share

Basic net loss per share is based upon the weighted average number of common shares outstanding during the period, excluding restricted stock that has been issued but is not yet vested. Diluted net loss per share is based upon the weighted average number of common shares outstanding during the period, plus additional weighted average common equivalent shares outstanding during the period when the effect is dilutive. Common equivalent shares result from the assumed exercise of outstanding stock options (the proceeds of which are then presumed to have been used to repurchase outstanding stock using the treasury stock method), the assumed conversion of convertible notes, and the vesting of unvested restricted shares of common stock. Common equivalent shares have not been included in the net loss per share calculations because their effect would have been anti-dilutive. Total potential gross common equivalent shares consisted of the following (in thousands, except per share amounts):

Stock-Based Compensation

In accordance with Statements of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure”, the Company has adopted the disclosure-only provisions of Statements of Financial Accounting Standards No. 123, “Accounting for Stock-Based

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Compensation” (“SFAS 123”) and also applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations in accounting for all stock awards granted to employees. Under APB 25, provided that other criteria are met, when the exercise price of stock options or the issue price of restricted shares granted to employees equals the market price of the common stock on the date of the grant, no compensation cost is recognized. When the exercise price of stock options or the issue price of restricted shares granted to employees is less than the market price of the common stock on the date of grant, compensation costs are expensed over the vesting period of the grants. Subsequent changes to option terms also can give rise to compensation costs. For stock options granted to non-employees, the Company recognizes compensation costs in accordance with the requirements of SFAS 123, which requires that companies recognize compensation expense for grants of stock, stock options and other equity instruments based on fair value.

At September 30, 2005, the Company had one Employee Stock Purchase Plan (“ESPP”) and three stock-based employee compensation plans: the 1991 Stock Option Plan, the 1994 Stock and Option Plan and the 1996 Stock and Option Plan (collectively, the “Plans”). All options granted under the Plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

At September 30, 2005 and 2004, the Company had approximately 1,717,023 and 1,287,808 restricted shares unvested and outstanding, respectively. During the three and nine months ended September 30, 2005, the Company issued approximately 129,133 and 464,955 shares of restricted stock, net of cancellations, respectively, to employees, not including 30,875 shares cancelled in accordance with an officer’s severance agreement during the nine months ended September 30, 2005. During the three and nine months ended September 30, 2004, the Company issued approximately 31,374 and 1,163,327 shares of restricted stock, net of cancellations, respectively, to employees, including a one-time grant to senior managers and executives in May 2004.

The price per share of restricted stock granted to employees is equal to $0.01, the par value of the Company’s common stock. In general, restricted share awards vest over four years in four equal annual installments, although different vesting schedules are sometimes applied. The Company has recorded deferred compensation, net of cancellations, of approximately $2,545,000 and $6,009,000 for restricted shares issued during the three and nine months ended September 30, 2005, respectively. During the three and nine months ended September 30, 2004, the Company recorded deferred compensation, net of cancellations, of approximately $309,000 and $10,658,000, respectively, for restricted shares issued during these periods.

The Company recorded compensation expense related to restricted stock of approximately $915,000 and $2,982,000 for the three and nine months ended September 30, 2005, respectively. During the three and nine months ended September 30, 2004, the Company recorded compensation expense related to restricted stock of approximately $539,000 and $1,015,000, respectively. The compensation expense of $2,982,000 recorded for the nine months ended September 30, 2005 consisted of approximately $479,000 of expense related to the accelerated vesting of restricted stock awards in accordance with an officer’s severance agreement, and approximately $2,503,000 related to restricted shares outstanding during the period.

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The following table illustrates the effect on net loss and net loss per common share if the fair value recognition provisions of SFAS 123 had been applied to the Company’s stock-based employee compensation. Employee stock-based compensation expense is amortized on a straight-line basis, since the Company’s valuation of options subject to SFAS 123 assumes a single weighted-average expected life for each award. Included in employee stock-based compensation expense for the nine months ended September 30, 2005 is expense related to the modification of certain stock awards in accordance with an officer’s severance agreement.

Research and Development

All research and development costs, including amounts funded by research collaborators, are expensed as incurred. Research and development expenses are comprised of costs incurred in performing research and development activities, including salaries and benefits; laboratory supplies; contract services, including clinical trial costs; and infrastructure costs, including facilities costs and depreciation. The Company’s collaborators have agreed to fund portions of the Company’s research and development programs related to specific research targets and drug candidates, including, in 2005, VX-950, VX-702, kinases and certain cystic fibrosis research targets, and in 2004, VX-950, kinases, caspase inhibitors, and certain cystic fibrosis research targets. The following table details the collaborator- and Company-sponsored research and development expenses for the three months ended September 30, 2005 and 2004 (in thousands):

The following table details the collaborator- and Company-sponsored research and development expenses for the nine months ended September 30, 2005 and 2004 (in thousands):

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Restructuring Expense

The Company records costs and liabilities associated with exit and disposal activities, as defined in Statements of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”), at fair value in the period the liability is incurred. In periods subsequent to initial measurement, changes to the liability are measured using the credit-adjusted risk-free discount rate applied in the initial period.

Debt Issuance Costs

Debt issuance costs related to expenses incurred in connection with Vertex’s convertible subordinated note offerings are deferred and included in other assets on the condensed consolidated balance sheets. The costs are amortized based on the effective interest method over the term of the related debt issuance. The amortization expense is included in interest expense on the condensed consolidated statements of operations.

Stock Offering Costs

Expenses incurred in connection with common stock issuances are recorded as an offset to additional paid-in capital on the condensed consolidated balance sheets. These expenses consist of underwriters’ discounts and commissions and related offering expenses.

3.   Comprehensive Loss

For the three and nine months ended September 30, 2005 and 2004, comprehensive loss was as follows (in thousands):

4.   Restructuring Expense

On June 10, 2003, Vertex 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 was designed to re-balance the Company’s relative investments in research and development, to better support the Company’s long-term objective of becoming a profitable pharmaceutical company. The restructuring plan included a workforce reduction, write-offs of certain assets and a decision not to occupy approximately 290,000 square feet of specialized laboratory and office space in Cambridge, Massachusetts under lease to Vertex (the “Kendall Square Lease”). The Kendall Square Lease commenced in January 2003 and has a 15-year term. Based on developments in the Company’s clinical pipeline in the second quarter of 2005, the Company revised its assessment of its real estate requirements. The Company now expects to occupy approximately 120,000 square feet of the facility subject to the Kendall Square lease (the “Kendall Square Facility”) in the future. The Company has sublease arrangements in place or commitments, subject to final approvals, to enter into sublease agreements for the remaining rentable square footage of the Kendall Square Facility.

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For the nine months ended September 30, 2005 the Company recorded net restructuring expense of $1.7 million. This net expense includes a $10.0 million credit to the restructuring accrual related to the portion of the Kendall Square Facility that Vertex now expects to occupy, which is offset by (i) the estimated incremental net ongoing lease obligations associated with the portion of the Kendall Square Facility that the Company does not intend to occupy and (ii) imputed interest costs relating to the restructuring accrual.

For the three months ended September 30, 2005, the Company recorded approximately $1.6 million of additional restructuring expense, which was primarily attributable to the imputed interest cost relating to the restructuring accrual.

The activity related to the restructuring accrual and related expense for the three months ended September 30, 2005 is as follows (in thousands):

The activity related to the restructuring accrual and related expense for the nine months ended September 30, 2005 is as follows (in thousands):

During the three and nine months ended September 30, 2004, the Company recorded $1.6 million and $5.2 million, respectively, of additional restructuring expense, which was primarily attributable to the imputed interest cost relating to the restructuring accrual.

The activity related to the restructuring accrual and related expense for the three months ended September 30, 2004 is as follows (in thousands):

The activity related to the restructuring accrual and related expense for the nine months ended September 30, 2004 is as follows (in thousands):

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In accordance with SFAS 146, the Company’s initial estimate of its liability for its net ongoing costs associated with the Kendall Square Lease obligation was recorded in the second quarter of 2003 at fair value. The restructuring accrual will continue to be estimated in accordance with SFAS 146, but will relate only to the portion of the building that the Company still does not intend to occupy. The lease obligations associated with the portion of the Kendall Square Facility that the Company expects to occupy are recorded as rental expense in the period incurred. The Company reviews its assumptions and estimates quarterly and updates its estimates of this liability as changes in circumstances require. As prescribed by SFAS 146, the expense and liability recorded is calculated using probability-weighted discounted cash-flows of the Company’s estimated ongoing lease obligations, including contractual rental and build-out commitments, net of estimated sublease rentals, offset by related sublease costs.

In estimating the expense and liability under its Kendall Square Lease obligation, the Company estimated the costs that would be incurred to satisfy its build-out commitments under the lease, the time necessary to sublease the space, the projected sublease rental rates and the anticipated durations of subleases. The Company validates its estimates and assumptions through consultations with independent third parties having relevant expertise. The Company used a credit-adjusted risk-free rate of approximately 10% to discount the estimated cash flows. The Company will review its estimates and assumptions on at least a quarterly basis, until the termination of the Kendall Square Lease, and will make whatever modifications management believes necessary, based on the Company’s best judgment, to reflect any changed circumstances. The Company’s estimates have changed in the past, and may change in the future, resulting in additional adjustments to the estimate of liability, and the effect of any such adjustments could be material. Because the Company’s estimate of the liability includes the application of a discount rate to reflect the time-value of money, the estimate of the liability will increase each quarter simply as a result of the passage of time. Changes to the Company’s estimate of the liability are recorded as additional restructuring expense or credit.

5.   Convertible Subordinated Notes

On February 13, 2004, the Company issued approximately $153.1 million in aggregate principal amount of 5.75% Convertible Senior Subordinated Notes due in February 2011 (the “February 2011 Notes”) in exchange for an equal principal amount of its outstanding 5% Convertible Subordinated Notes due in September 2007 (the “2007 Notes”). On September 17, 2004, the Company issued approximately $79.3 million in aggregate principal amount of 5.75% Convertible Senior Subordinated Notes due in February 2011 (the “September 2011 Notes”) in exchange for an equal principal amount of its 2007 Notes. The terms of the September 2011 Notes are identical to those of the February 2011 Notes (the February 2011 Notes and the September 2011 Notes are referred to together as the “2011 Notes”).

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The 2011 Notes are convertible, at the option of the holder, into common stock at a price equal to $14.94 per share, subject to adjustment under certain circumstances. The 2011 Notes bear interest at the rate of 5.75% per annum, and the Company is required to make semi-annual interest payments on the outstanding principal balance of the 2011 Notes on February 15 and August 15 of each year. On or after February 15, 2007, the Company may redeem the 2011 Notes at a redemption price equal to the principal amount plus accrued and unpaid interest, if any. The deferred issuance costs associated with the issuance of the 2011 Notes, which are classified as long-term other assets, were approximately $3.0 million for the February 2011 Notes and $1.9 million for the September 2011 Notes.

The 2007 Notes are convertible, at the option of the holder, into common stock at a price equal to $92.26 per share, subject to adjustment under certain circumstances. The 2007 Notes bear interest at the rate of 5% per annum, and the Company is required to make semi-annual interest payments on the outstanding principal balance of the 2007 Notes on March 19 and September 19 of each year. The 2007 Notes are redeemable by the Company at any time at specific redemption prices if the closing price of the Company’s common stock exceeds 120% of the conversion price for at least 20 trading days within a period of 30 consecutive trading days. The deferred issuance costs associated with the original sale of the 2007 Notes were $9.3 million.

As a result of the exchanges of the 2007 Notes for 2011 Notes, the Company recorded a charge on the retirement of $153.1 million in aggregate principal amount of the 2007 Notes in February 2004 in the amount of $2.5 million, and a charge on the retirement of $79.3 million in aggregate principal amount of the 2007 Notes in September 2004 in the amount of $1.0 million. These charges represent that portion of the unamortized deferred issuance costs applicable to the amount of 2007 Notes retired. For the three and nine months ended September 30, 2005, $0.3 million and $0.8 million, respectively, were amortized to interest expense for the issuance costs of the remaining 2007 Notes and the 2011 Notes. For the three and nine months ended September 30, 2004, $0.3 million and $1.0 million, respectively, were amortized to interest expense for the issuance costs of the 2007 Notes and the 2011 Notes.

On September 9, 2005, the Company issued approximately 2,500,000 shares of common stock to certain holders of 2007 Notes in exchange for approximately $40.5 million principal amount of those notes, plus an amount equal to accrued interest. As a result of the exchange, the Company incurred a non-cash charge of $36.3 million. This charge is related to the incremental shares issued in the transaction over the number that would have been issued upon conversion of the 2007 Notes under their original terms, at the original conversion price of $92.26 per share. The following items related to the exchange were recorded as an offset to additional paid-in capital on the condensed consolidated balance sheets: accrued interest of approximately $955,000, remaining unamortized issuance costs of the exchanged 2007 Notes of approximately $341,000, and $29,000 of issuance costs of the common stock. At September 30, 2005, there was approximately $42.1 million in aggregate principal amount of the 2007 Notes and approximately $232.4 million in aggregate principal amount of the 2011 Notes outstanding.

6.   Equity Offering

In June 2005, the Company completed a public offering of 13,512,500 shares of common stock at a price of $13.00 per share, resulting in gross proceeds to the Company of approximately $175.7 million. The Company incurred offering costs of approximately $10.3 million associated with this offering, which were recorded as an offset to additional paid-in-capital on the condensed consolidated balance sheets, resulting in net proceeds to the Company of approximately $165.4 million.

7.   Guarantees

As permitted under Massachusetts law, Vertex’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

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connection with their service as officers or directors. 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 reduce its monetary exposure and enable it to recover a portion of any future amounts paid. The Company believes the estimated fair value of these indemnification arrangements is immaterial.

Vertex customarily agrees in the ordinary course of its business to indemnification provisions in agreements with clinical trials investigators and sites in its drug development programs, in sponsored research agreements with academic and not-for-profit institutions, in various comparable agreements involving parties performing services for the Company in the ordinary course of business, and in its real estate leases. The Company also customarily agrees to certain indemnification provisions in its drug discovery and development 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, but in addition provide some limited indemnification for the 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 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 generally is 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 a portion of any future amounts paid. The Company has never paid any material amount to defend lawsuits or settle claims related to these indemnification provisions. Accordingly, the Company believes the estimated fair value of these indemnification arrangements is immaterial.

On March 28, 2003, the Company sold certain assets of PanVera LLC to Invitrogen Corporation for approximately $97 million. The agreement with Invitrogen requires the Company to indemnify Invitrogen against any loss it may suffer by reason of Vertex’s breach of certain representations and warranties, or failure to perform certain covenants, contained in the agreement. The representations, warranties and covenants are of a type customary in agreements of this sort. The Company’s aggregate obligations under the indemnity are, with a few exceptions that the Company believes are not material, capped at one-half of the purchase price, and apply to claims under representations and warranties made within fifteen months after closing (which period has ended), although there is no corresponding time limit for claims made based on breaches of covenants. Invitrogen has made no claims to date under this indemnity, and the Company believes that the estimated fair value of the remaining indemnification obligation is immaterial.

On December 3, 2003, the Company sold certain instrumentation assets to Aurora Discovery, Inc. for approximately $4.3 million. The agreement with Aurora requires the Company to indemnify Aurora against any loss it may suffer by reason of the Company’s breach of certain representations and warranties, or failure to perform certain covenants, contained in the agreement. The representations, warranties and covenants are of a type customary in agreements of this sort. The Company’s aggregate obligations under the indemnity are capped at one-half of the purchase price, and apply to claims under representations and warranties made within fifteen months after closing (which period has ended), although there is no corresponding time limit for claims made based on breaches of covenants. Aurora has made no claims to

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date under this indemnity, and the Company believes that the estimated fair value of the remaining indemnification obligation is immaterial.

On February 10, 2004, Vertex entered into a Dealer Manager Agreement with UBS Securities LLC in connection with the exchange by the Company of approximately $153.1 million in principal amount of its 2011 Notes for an equal principal amount of its 2007 Notes. On September 13, 2004, the Company entered into a second Dealer Manager Agreement with UBS Securities in connection with the exchange of approximately $79.3 million in principal amount of 2011 Notes for approximately $79.3 million in principal amount of outstanding 2007 Notes. Each of the Dealer Manager Agreements requires the Company to indemnify UBS Securities against any loss UBS Securities may suffer by reason of the Company’s breach of representations and warranties relating to the exchanges of the convertible notes, the Company’s failure to perform certain covenants in those agreements, the inclusion of any untrue statement of material fact in the materials provided to purchasers of the 2011 Notes, the omission of any material fact needed to make those materials not misleading, and any actions taken by the Company or its representatives in connection with the exchanges. The representations, warranties and covenants in the Dealer Manager Agreements are of a type customary in agreements of this sort. The Company believes the estimated fair value of these indemnification obligations is immaterial.

On June 7, 2005, the Company entered into a Purchase Agreement with Merrill Lynch, Pierce, Fenner & Smith Incorporated, as the representative of the several underwriters named therein, relating to the public offering and sale of shares of the Company’s common stock. The Purchase Agreement requires the Company to indemnify the underwriters against any loss they may suffer by reason of the Company’s breach of representations and warranties relating to that public offering, the Company’s failure to perform certain covenants in those agreements, the inclusion of any untrue statement of material fact in the prospectus used in connection with that offering, the omission of any material fact needed to make those materials not misleading, and any actions taken by the Company or its representatives in connection with the offering. The representations, warranties and covenants in the Purchase Agreement are of a type customary in agreements of this sort. The Company believes the estimated fair value of these indemnification obligations is immaterial.

8.   Legal Proceedings

The Company is not a party to any material legal proceedings.

9.   New Accounting Pronouncements

In December 2004, the Financial Accouting Standards Board (“FASB”) issued FASB Statement No. 123(R), “Share-Based Payments” (“FASB 123(R)”). FASB 123(R) revises FASB Statement No. 123, “Accounting for Stock-Based Compensation,” supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends FASB Statement No. 95, “Statement of Cash Flows.” FASB 123(R) requires companies to expense the fair value of employee stock options and other forms of stock-based compensation over the employees’ service periods. Compensation cost is measured at the fair value of the award at the grant date and is adjusted to reflect actual forfeitures and the outcome of certain conditions. The fair value of an award is not re-measured after its initial estimation on the grant date. The FASB has determined that the effective date of FASB 123(R) should be the first interim or annual reporting period that begins after June 15, 2005. Therefore, Vertex is required to comply with FASB 123(R) beginning January 1, 2006. The impact of adopting FASB 123(R) cannot be accurately estimated at this time, as it will depend on the market value and the amount of share-based awards granted in future periods. However, had the Company adopted FASB 123(R) in prior periods, the impact of the standard would have approximated the impact of SFAS 123 as described in “Stock Based Compensation” under Note 2. The Company is currently evaluating the transition methods and option valuation methods for accounting for and reporting stock options in preparation for the adoption of FASB 123(R).

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

Overview

We are a biotechnology company in the business of discovering, developing, and commercializing small molecule drugs for serious diseases, including HIV infection, chronic hepatitis C virus (“HCV”) infection, inflammatory and autoimmune disorders, cancer, and pain. We earn a royalty on sales of Lexiva®/Telzir®, a Vertex-discovered product for the treatment of HIV infection, and co-promote this product in collaboration with GlaxoSmithKline plc. Our drug candidate pipeline is principally focused, at present, on the development and commercialization of new treatments for viral diseases, inflammatory and autoimmune diseases, and cancer. We have built a drug discovery capability that integrates biology, chemistry, biophysics, automation and information technologies, with a goal of making the drug discovery process more efficient and productive.

Drug Discovery and Development

Discovery and development of a single new pharmaceutical product is a lengthy and resource-intensive process, which may take ten to fifteen years or more. Throughout this process, potential drug candidates are subjected to rigorous evaluation, driven in part by stringent regulatory considerations. This evaluation process is designed to generate information concerning efficacy, proper dosage levels and a variety of other physical and chemical characteristics that are important in determining whether a proposed drug candidate should be approved for marketing. The toxicity characteristics and profile of drug candidates at varying dose levels administered for varying periods of time are also monitored continually and evaluated during the non-clinical and clinical development process. Most chemical compounds that are investigated as potential drug candidates never progress into formal development, and most drug candidates that do advance into formal development never become commercial products. A drug candidate’s failure to progress or advance may be the result of any one or more of a wide range of adverse experimental outcomes including, for example, the lack of acceptable absorption characteristics or other physical properties, lack of sufficient efficacy against the disease target, difficulties in developing a cost-effective manufacturing or formulation method, or the discovery of toxicities that are unacceptable for the disease indication being treated.

We have a variety of drug candidates in clinical development and a broad-based drug discovery effort. Given the uncertainties of the research and development process, it is not possible to predict with confidence which, if any, of these efforts will result in a marketable pharmaceutical product. We constantly monitor the results of our discovery research and our non-clinical and clinical trials and regularly evaluate our portfolio investments with the objective of balancing risk and potential return in light of new data and scientific, business and commercial insights. This process can result in relatively abrupt changes in focus and priority as new information becomes available and we gain additional insights into ongoing programs and potential new programs.

Business Strategy

We have elected to diversify our research and development activities across a relatively broad array of investment opportunities, due in part to the high risks associated with the biotechnology and pharmaceutical business. We focus our efforts on programs that we expect to control throughout the development and commercialization process in North America, as well as on programs that we anticipate will be controlled principally by a collaborator. This strategy requires more significant financial resources than would be required if we took a more limited approach. Because we have incurred losses from our inception and expect to incur losses for the foreseeable future, we are dependent on our continued ability to raise significant funding to finance our discovery and development operations, including overhead, and to meet our long-term contractual commitments and obligations. In the past, we have secured funds

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principally through capital market transactions, strategic collaborative agreements, proceeds from the disposition of assets, investment income and the issuance of common stock under our employee benefit programs.

On September 9, 2005, we issued approximately 2.5 million shares of common stock to certain holders of our 5% Convertible Subordinated Notes due 2007 (the “2007 Notes”) in exchange for approximately $40.5 million in aggregate principal amount of those notes, plus an amount equal to accrued interest. At September 30, 2005, we had approximately $399.2 million of cash, cash equivalents and available for sale securities, approximately $42.1 million in aggregate principal amount of 2007 Notes and approximately $232.4 million in aggregate principal amount of 5.75% Convertible Senior Subordinated Notes due 2011 (the “2011 Notes”). As part of our strategy for managing our capital structure, we have, from time to time, adjusted the amount and maturity of our debt obligations through new issues, privately negotiated transactions and market purchases. We expect to continue pursuit of a general financial strategy that may lead us to undertake one or more additional capital transactions, which may or may not be similar to transactions in which we have engaged in the past.

Clinical Development Programs

In the second quarter of 2005, we reported positive results from our Phase Ib clinical trial of VX-950, an oral inhibitor of HCV protease, for the treatment of HCV infection. Based on those trial results, we revised our clinical development plans to increase our 2005 investment in VX-950 product development. In October 2005, we initiated a 20-patient Phase Ib clinical trial of VX-950 in combination with pegylated interferon. By the end of 2005, we plan to initiate a one-month Phase II clinical trial in the United States to evaluate VX-950 in combination with pegylated interferon and ribavirin.

In October 2005, we further revised our clinical development plans to increase our 2006 investment in product development for VX-950 and for our p38 MAP kinase inhibitor, VX-702, which is being studied as a treatment for rheumatoid arthritis. We also plan to bring an investigational drug candidate for the treatment of cystic fibrosis into clinical development in 2006. We based our decision to accelerate the clinical development of these three product candidates on an analysis of both commercial opportunity and available clinical data across our portfolio of programs. We currently expect to minimize our future investment in both merimepodib, which currently is being evaluated in the clinic for the treatment of HCV infection, and VX-765, which is being studied as a treatment for psoriasis. While we plan to complete ongoing trials for these two compounds, we do not expect to invest additional significant resources in their development. We are investigating out-licensing opportunities for VX-765 and pralnacasan, another anti-cytokine in our portfolio. This approach anticipates possible success in bringing to product registration VX-950, VX-702 and a cystic fibrosis compound. However, both VX-950 and VX-702 are in the early stages of clinical testing, and we have not yet advanced a cystic fibrosis compound to clinical development. Any or all of these compounds could fail to progress or advance due to a wide range of adverse experimental outcomes, placing our full investment in them at risk.

We also have a number of compounds being developed in the clinic by collaborators, including VX-385 for the treatment of HIV infection (GlaxoSmithKline), VX-680 for the treatment of cancer (Merck & Co., Inc.), and VX-944 for the treatment of cancer (Avalon Pharmaceuticals Inc.).

The value of each of our assets currently in clinical development will be significantly driven by the information we obtain from clinical trials in upcoming months. Accordingly, the results of these trials have the potential to significantly affect the Company’s value.

Collaborative Revenue

Collaborations have been and will continue to be an important component of our business strategy. Based on the value that we believe we have built through research and development investments in certain

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of our drug discovery and development programs, and our perception of the level of interest in certain of our programs among some potential collaborators, we believe that we could enter into an additional collaborative agreement or agreements by the end of 2005 that would be material to our business. In future periods, we expect to identify collaborative development and commercialization opportunities for certain of our other drug candidates, in order to continue their clinical advancement as we maintain focus on controlling clinical development of particular drug candidates, such as VX-950 in North America.

Liquidity and Capital Resources

We have incurred operating losses since our inception. Historically we have financed our operations principally through public stock offerings; private placements of our equity and debt securities; strategic collaborative agreements that include research and development funding, development milestones and royalties on the sales of products; proceeds from the disposition of assets of our Discovery Tools and Service business, which we sold in 2003; investment income and proceeds from the issuance of common stock under our employee benefit programs.

At September 30, 2005, we had cash, cash equivalents and available-for-sale securities of $399.2 million, which is an increase of $6.9 million from $392.3 million at December 31, 2004. The increase reflects net proceeds of approximately $165.4 million from our public offering of common stock, which closed in June 2005, offset by cash used in operations of $165.1 million, which includes the net loss of $165.3 million and net cash payments of $18.3 million made against the restructuring accrual. The net loss of $165.3 million includes a $36.3 million non-cash charge relating to the issuance of common stock in exchange for approximately $40.5 million in principal amount of the 2007 Notes plus an amount equal to the accrued interest on those 2007 Notes. Expenditures for property and equipment during the nine months ended September 30, 2005 were $11.8 million. Additionally, we received net proceeds of $16.5 million from the issuance of common stock under our employee benefit plans.

At September 30, 2005, the Company had approximately $232.4 million in principal amount of 2011 Notes and approximately $42.1 million in principal amount of 2007 Notes outstanding. The 2011 Notes are convertible, at the option of the holder, into common stock at a price equal to $14.94 per share, subject to adjustment under certain circumstances. The 2007 Notes are convertible, at the option of the holder, into common stock at a price equal to $92.26 per share, subject to adjustment under certain circumstances.

We expect to continue to make significant investments in our pipeline, particularly in clinical trials for certain of our product candidates, in our ion channel and kinase discovery efforts and in our effort to prepare for potential registration, regulatory approval and commercial launch of our existing and future product candidates. Consequently, we expect to incur losses on a quarterly and annual basis for the foreseeable future.

In the first quarter of 2005, we entered into a commitment to purchase $4.8 million of drug substance to be used for future clinical studies and formulation development. This obligation will be discharged in 2005. Of this obligation, $2.5 million was paid during the third quarter of 2005, and at September 30, 2005, approximately $2.3 million was included in accrued expenses and other current liabilities on our condensed consolidated balance sheets. There have been no other significant changes to our commitments and obligations as reported in our 2004 Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 16, 2005.

In 2005 and in future periods, the adequacy of our available funds to meet our future operating and capital requirements, including repayment of the 2007 Notes and the 2011 Notes, will depend on many factors, including the number, breadth and prospects of our discovery and development programs and the costs and timing of obtaining regulatory approvals for any of our product candidates. Collaborations have been and will continue to be an important component of our business strategy. We will continue to rely on cash receipts from our existing research and development collaborations, including research funding,

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development reimbursements and potential milestone payments, and from new collaborations, in order to partially fund our research and development efforts.

As part of our strategy for managing our capital structure, we have from time to time adjusted the amount and maturity of our debt obligations through new debt issues, privately negotiated exchange transactions and market purchases, depending on market conditions and our perceived needs at the time. During the remainder of 2005, we expect to continue pursuing a general financial strategy that may lead us to undertake one or more additional capital transactions, which may or may not be similar to transactions in which we have engaged in the past.

To the extent that our current cash and marketable securities, in addition to the above-mentioned sources, are not sufficient to fund our activities, it will be necessary to raise additional funds through public offerings or private placements of our securities or other methods of financing. We will also continue to manage our capital structure and consider all financing opportunities, whenever they may occur, that could strengthen our long-term liquidity profile. There can be no assurance that any such financing opportunities will be available on acceptable terms, if at all.

Critical Accounting Policies and Estimates

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

We believe that the application of our accounting policies for restructuring expense, revenue recognition, research and development expense and investments, all of which are important to our financial position and results of operations, require significant judgments and estimates on the part of management. Our accounting polices, including the ones discussed below, are more fully described in Note B, “Accounting Policies”, to our consolidated financial statements included in our Annual Report on Form 10-K that was filed with the Securities and Exchange Commission on March 16, 2005.

Restructuring Expense

We record liabilities associated with restructuring activities based on estimates of fair value in the period the liabilities are incurred, in accordance with SFAS 146. As prescribed by SFAS 146, we use a probability-weighted discounted cash-flow analysis to calculate the amount of the liability. The probability-weighted discounted cash-flow analysis is based on management’s assumptions and estimates of our ongoing lease obligations, including contractual rental and build-out commitments and income from sublease rentals, including estimates of sublease timing and sublease rental terms. We applied a discount rate of approximately 10% to estimated cash flows. These estimates are reviewed and may be adjusted in subsequent periods. Adjustments are based, among other things, on management’s assessment of changes in factors underlying the estimates. Because our estimate of the liability includes the application of a discount rate to reflect the time-value of money, the estimate will increase simply as a result of the passage of time, even if all other factors remain unchanged.

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Our estimates of this liability have changed in the past, and it is possible that our estimates and assumptions will change in the future, resulting in additional adjustments to the amount of the estimated liability, and the effect of any adjustments could be material. For example, we currently have subleases and sublease commitments for portions of the Kendall Square Facility with terms ranging from six to seven years, and we have made certain estimates and assumptions relating to future sublease terms following the expiration of the current subleases and sublease commitments. As a result, we may be exposed to market variability in the future. We will review our assumptions and judgments related to the lease restructuring on at least a quarterly basis until the Kendall Square Lease is terminated, and make whatever modifications we believe are necessary, based on our best judgment, to reflect any changed circumstances.

The accrual for restructuing expense of $39.3 million at September 30, 2005 is related to the portion of the Kendall Square Facility that we do not intend to occupy. This estimate represents our best judgment of the assumptions and estimates most appropriate in measuring the ongoing obligation.

Revenue Recognition

Our revenue recognition policies are in accordance with the SEC’s Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” (“SAB 101”) as amended by SEC Staff Accounting Bulletin No. 104, “Revenue Recognition” (“SAB 104”) and for revenue arrangements entered into after June 30, 2003, Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”).

Our collaborative research and development revenue is generated primarily through collaborative research and development agreements with strategic collaborators. The terms of these agreements typically include payment to us of non-refundable up-front license fees, funding for research and development efforts, payments to us based upon achievement of certain milestones, and royalties payable on product sales.

We recognize revenue from non-refundable, up-front license fees and milestones that are not specifically tied to a separate earnings process, ratably over the contracted or estimated period of performance. Changes in estimates could materially affect revenue in the remainder of the performance period. For example, if our estimate of the period of performance shortens or lengthens, the amount of revenue we recognize from non-refundable, up-front license fees and milestones could increase or decrease beginning in the period the change in estimate becomes known. Future related revenues would be adjusted accordingly. To date, changes to our estimates have not had a material impact on our financial position or results of operations. Research funding is recognized ratably over the period of effort, as earned. Milestones that are based on designated achievement points and that are considered at-risk and substantive at the inception of the collaboration agreement are recognized as earned when management considers the corresponding payment to be reasonably assured. We evaluate whether milestones are at-risk and substantive based on the contingent nature of the milestone, specifically reviewing factors such as the technological and commercial risk that must be overcome and the level of investment required.

Under EITF 00-21, in multiple-element arrangements, license payments are recognized together with any up-front payment and the research and development funding as a single unit of accounting, unless the delivered technology has stand-alone value to the customer and we have objective and reliable evidence of fair value of the undelivered elements in the arrangement. License payments received during the course of a collaboration that do not meet the separation criteria above are recognized, ratably over the period of performance. Payments received after performance obligations are complete are recognized when earned.

Royalty revenue is recognized based upon actual and estimated net sales of licensed products in licensed territories, as provided by our collaborator GlaxoSmithKline, and is recognized in the period the sales occur. Differences between actual royalty revenues and estimated royalty revenues, which have not historically been significant, are reconciled and adjusted for in the quarter in which they become known.

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Research and Development Costs

All research and development costs, including amounts funded by research and development collaborations, are expensed as incurred. Research and development expenses are comprised of costs incurred in performing research and development activities, including salaries and benefits; laboratory supplies; contract services, including clinical trial costs; and infrastructure costs, including facilities cost and depreciation. Accounting for clinical trial, contract services and other outside costs requires that we make estimates of the costs incurred in a given accounting period and record accruals at period-end, because the third party service periods and billing terms do not always coincide with our period-end. We base our estimates on our knowledge of the research and development programs, services performed for the period, past history for related activities and the expected duration of the third party service contract, where applicable.

Altus Investment

We assess our investment in Altus Pharmaceuticals, Inc., for which we account using the cost method, on a quarterly basis to determine if there has been any estimated decrease in the fair value of the asset below its $18.9 million carrying value that might require us to write down the cost basis of the asset. If any adjustment to the fair value of an investment reflects a decline in the value of that investment below its cost, we consider the evidence available to us, including the duration and extent to which the decline is other than temporary. If the decline is considered other than temporary, the cost basis of the investment is written down to fair value as a new cost basis and the amount of the write-down is included in the consolidated statement of operations. We have not identified facts or circumstances which would cause us to determine that the investment basis of our investment in Altus should be changed.

Results of Operations

Three Months Ended September 30, 2005 Compared with Three Months Ended September 30, 2004

Our net loss for the three months ended September 30, 2005 was $79,578,000, or $0.84 per basic and diluted common share, compared to net loss of $38,771,000, or $0.49 per basic and diluted common share, for the three months ended September 30, 2004. Included in the net loss for the quarter ended September 30, 2005 is restructuring expense of $1,565,000 and a charge for the issuance of common stock in exchange for a portion of our 2007 Notes of $36,324,000. Our loss for the quarter ended September 30, 2004 includes net restructuring expense of $1,561,000 and a charge for retirement of a portion of our 2007 Notes of $993,000. Although revenue increased during the three months ended September 30, 2005, it was offset by increased development expense related to our proprietary drug candidates.

Revenues

Total revenues increased $9,379,000 to $36,207,000 for the three months ended September 30, 2005, compared to $26,828,000 for the three months ended September 30, 2004. In the third quarter of 2005, revenue was comprised of $9,466,000 in royalties and $26,741,000 in collaborative research and development revenue, as compared with $4,403,000 in royalties and $22,425,000 in collaborative research and development revenue in the third quarter of 2004.

Royalties consist of Lexiva®/Telzir® (fosamprenavir calcium) and Agenerase® royalty revenue. Fosamprenavir calcium is marketed under the trade name Lexiva in the United States and Telzir in the European Union. Royalty revenue is based on actual and estimated worldwide net sales of Lexiva/Telzir and Agenerase. We began earning royalties on sales of Lexiva in the United States in November 2003 and on Telzir in the European Union in November 2004. The increase in royalty revenue is due to the increase in Lexiva/Telzir sales. In 2005, Lexiva/Telzir largely replaced Agenerase in worldwide markets. As a result,

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we expect that royalty revenue in the foreseeable future will consist primarily of Lexiva/Telzir royalty revenue. We pay a royalty to a third party on sales of Agenerase and Lexiva/Telzir.

Collaborative research and development revenue increased $4,316,000, or 19%, for the three months ended September 30, 2005, as compared with the same period in 2004. The increase in collaborative research and development revenue is primarily due to the execution of new collaboration agreements in mid-2004 and early 2005. The revenue recognized under the new collaborations was $9,776,000 in the third quarter of 2005, compared with $6,892,000 for the same period in 2004. Additionally, we recorded increased revenue from our collaboration with Kissei Pharmaceuticals Co. Ltd. (“Kissei”) relating to reimbursement of a portion of our development costs for VX-702 and a $2,500,000 million milestone payment for the completion of regulatory filings in preparation for Phase I clinical development of VX-702 in Japan. The increase in collaborative research and development revenue was offset by a decrease in revenue from our collaboration with Serono S.A., which terminated on September 30, 2004. We recorded $2,280,000 of revenue related to the Serono collaboration during the third quarter of 2004.

Costs and Expenses

Research and development expenses increased $14,800,000, or 30%, to $63,590,000 for the three months ended September 30, 2005 from $48,790,000 for the same period in 2004. The increase in research and development expenses was driven primarily by investment in our clinical development programs for VX-950 and VX-702. Development expenses accounted for 91%, or $13,501,000, of the aggregate increase in research and development expenses. During the third quarter of 2005, we incurred costs from Phase II-enabling activities for VX-950, we completed enrollment in a 315-patient Phase II clinical trial of VX-702 for the treatment of rheumatoid arthritis, and we continued a Phase IIb clinical study (called the “METRO” study) of merimepodib in combination with peginterferon and ribavirin for the treatment of HCV infection.

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Research and development expenses consist primarily of salary and benefits, laboratory supplies, contractual services and infrastructure costs, including facilities costs and depreciation. Set forth below is a summary that reconciles our total research and development expenses for the three months ended September 30, 2005 and 2004 (in thousands):

Our collaborators have agreed to fund portions of our research and development programs related to specific drug candidates. The following table details our collaborator-and Company-sponsored research and development expenses for the three months ended September 30, 2005 and 2004 (in thousands):

The increase in the collaborator-sponsored expenses to $36,883,000 for the three months ended September 30, 2005 from $18,164,000 for the same period in 2004 is primarily due to the performance under collaboration agreements with Merck & Co. Inc., Mitsubishi Pharma Corporation and The Cystic Fibrosis Foundation Therapeutics Incorporated (“CFFT”).

Sales, general and administrative expenses increased slightly to $10,738,000 for the three months ended September 30, 2005, compared to $10,600,000 for the same period in 2004.

Restructuring expense for the three months ended September 30, 2005 was $1,565,000 compared to a restructuring expense for the three months ended September 30, 2004 of $1,561,000. The charge in both periods resulted primarily from an imputed interest cost related to the restructuring accrual.

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The activity related to the restructuring accrual and related expense for the three months ended September 30, 2005 is as follows (in thousands):

The activity related to the restructuring accrual and related expense for the three months ended September 30, 2004 is as follows (in thousands):