2014 Q2 10-Q
Table of Contents

 
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 JUNE 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
238,081,533
Class
Outstanding at July 25, 2014

 

Table of Contents

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

TABLE OF CONTENTS
 
 
Page
 
 
 
 
 
 
 
 
 
 
“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.


Table of Contents

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
June 30,
 
Six Months Ended
June 30,
 
2014
 
2013
 
2014
 
2013
Revenues:
 
 
 
 
 
 
 
Product revenues, net
$
122,319

 
$
254,789

 
$
225,780

 
$
522,170

Royalty revenues
13,015

 
49,120

 
23,748

 
92,693

Collaborative revenues
3,087

 
6,841

 
7,344

 
24,255

Total revenues
138,421

 
310,750

 
256,872

 
639,118

Costs and expenses:
 
 
 
 
 
 
 
Cost of product revenues
9,655

 
24,695

 
18,227

 
55,650

Royalty expenses
7,645

 
13,236

 
14,549

 
25,024

Research and development expenses
224,780

 
222,455

 
463,743

 
440,550

Sales, general and administrative expenses
77,446

 
106,521

 
151,658

 
199,400

Restructuring expenses
(270
)
 
776

 
5,918

 
815

Intangible asset impairment charge
—

 
—

 
—

 
412,900

Total costs and expenses
319,256

 
367,683

 
654,095

 
1,134,339

Loss from operations
(180,835
)
 
(56,933
)
 
(397,223
)
 
(495,221
)
Interest expense, net
(15,585
)
 
(6,551
)
 
(31,302
)
 
(10,016
)
Other income (expense), net
37,731

 
(27
)
 
38,182

 
(1,214
)
Loss before provision for (benefit from) income taxes
(158,689
)
 
(63,511
)
 
(390,343
)
 
(506,451
)
Provision for (benefit from) income taxes
693

 
(1,799
)
 
1,496

 
(132,112
)
Net loss
(159,382
)
 
(61,712
)
 
(391,839
)
 
(374,339
)
Net loss attributable to noncontrolling interest (Alios)
—

 
4,547

 
—

 
9,158

Net loss attributable to Vertex
$
(159,382
)
 
$
(57,165
)
 
$
(391,839
)
 
$
(365,181
)
Net loss per share attributable to Vertex common shareholders:
 
 
 
 
 
 
 
Basic
$
(0.68
)
 
$
(0.26
)
 
$
(1.68
)
 
$
(1.67
)
Diluted
$
(0.68
)
 
$
(0.26
)
 
$
(1.68
)
 
$
(1.67
)
Shares used in per share calculations:
 
 
 
 
 
 
 
Basic
233,808

 
222,053

 
233,353

 
218,795

Diluted
233,808

 
222,053

 
233,353

 
218,795

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


2
Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Statements of Comprehensive Income (Loss)
(unaudited)
(in thousands)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2014
 
2013
 
2014
 
2013
Net loss
$
(159,382
)
 
$
(61,712
)
 
$
(391,839
)
 
$
(374,339
)
Changes in other comprehensive loss:
 
 
 
 
 
 
 
Unrealized holding gains (losses) on marketable securities
82

 
(170
)
 
55

 
(159
)
Unrealized losses on foreign currency forward contracts
(89
)
 
—

 
(125
)
 
—

Foreign currency translation adjustment
281

 
89

 
353

 
(521
)
Total changes in other comprehensive loss
274

 
(81
)
 
283

 
(680
)
Comprehensive loss
(159,108
)
 
(61,793
)
 
(391,556
)
 
(375,019
)
Comprehensive loss attributable to noncontrolling interest (Alios)
—

 
4,547

 
—

 
9,158

Comprehensive loss attributable to Vertex
$
(159,108
)
 
$
(57,246
)
 
$
(391,556
)
 
$
(365,861
)
The accompanying notes are an integral part of these condensed consolidated financial statements.


3
Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Balance Sheets
(unaudited)
(in thousands, except share and per share amounts)
 
June 30,
 
December 31,
 
2014
 
2013
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
420,558

 
$
569,299

Marketable securities, available for sale
798,603

 
895,777

Accounts receivable, net
81,842

 
85,517

Inventories
11,982

 
14,147

Prepaid expenses and other current assets
34,399

 
23,836

Total current assets
1,347,384

 
1,588,576

Restricted cash
129

 
130

Property and equipment, net
730,000

 
696,911

Goodwill
30,992

 
30,992

Other assets
9,315

 
2,432

Total assets
$
2,117,820

 
$
2,319,041

Liabilities and Shareholders’ Equity
 
 
 
Current liabilities:
 
 
 
Accounts payable
$
55,363

 
$
49,327

Accrued expenses
237,789

 
271,077

Deferred revenues, current portion
27,174

 
21,510

Accrued restructuring expenses, current portion
8,498

 
14,286

Capital lease obligations, current portion
19,707

 
16,893

Other liabilities, current portion
14,442

 
24,736

Total current liabilities
362,973

 
397,829

Deferred revenues, excluding current portion
38,105

 
49,459

Accrued restructuring expenses, excluding current portion
10,486

 
14,067

Capital lease obligations, excluding current portion
45,053

 
48,754

Construction financing lease obligation, excluding current portion
473,268

 
440,937

Other liabilities, excluding current portion
15,666

 
11,590

Total liabilities
945,551

 
962,636

Commitments and contingencies


 


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

 
—

Common stock, $0.01 par value; 300,000,000 shares authorized at June 30, 2014 and December 31, 2013; 237,331,086 and 233,788,852 shares issued and outstanding at June 30, 2014 and December 31, 2013, respectively
2,347

 
2,320

Additional paid-in capital
5,528,679

 
5,321,286

Accumulated other comprehensive loss
(23
)
 
(306
)
Accumulated deficit
(4,358,734
)
 
(3,966,895
)
Total shareholders’ equity
1,172,269

 
1,356,405

Total liabilities and shareholders’ equity
$
2,117,820

 
$
2,319,041


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


4
Table of Contents

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 (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 losses on marketable securities
 
 
 
 
 
 
(159
)
 
 
 
(159
)
 
 
 
(159
)
 
 
Foreign currency translation adjustment
 
 
 
 
 
 
(521
)
 
 
 
(521
)
 
 
 
(521
)
 
 
Net loss
 
 
 
 
 
 
 
 
(365,181
)
 
(365,181
)
 
(9,158
)
 
(374,339
)
 
 
Issuance of common stock under benefit plans
6,614

 
68

 
213,733

 
 
 
 
 
213,801

 
(72
)
 
213,729

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

 
83

 
402,182

 
 
 
 
 
402,265

 
 
 
402,265

 
 
Stock-based compensation expense
 
 
 
 
73,068

 
 
 
 
 
73,068

 
238

 
73,306

 
 
Change in liquidation value of noncontrolling interest
 
 
 
 
 
 
 
 
 
 
 
 
(684
)
 
(684
)
 
684

Balance, June 30, 2013
232,177

 
$
2,300

 
$
5,208,431

 
$
(1,230
)
 
$
(3,887,048
)
 
$
1,322,453

 
$
186,996

 
$
1,509,449

 
$
39,214

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
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
 
 
 
 
 
 
55

 
 
 
55

 
 
 
55

 
 
Unrealized losses on foreign currency forward contracts
 
 
 
 
 
 
(125
)
 
 
 
(125
)
 
 
 
(125
)
 
 
Foreign currency translation adjustment
 
 
 
 
 
 
353

 
 
 
353

 
 
 
353

 
 
Net loss
 
 
 
 
 
 
 
 
(391,839
)
 
(391,839
)
 


 
(391,839
)
 
 
Issuance of common stock under benefit plans
3,542

 
27

 
117,920

 
 
 
 
 
117,947

 


 
117,947

 
 
Stock-based compensation expense
 
 
 
 
89,473

 
 
 
 
 
89,473

 


 
89,473

 
 
Balance, June 30, 2014
237,331

 
$
2,347

 
$
5,528,679

 
$
(23
)
 
$
(4,358,734
)
 
$
1,172,269

 
$
—

 
$
1,172,269

 
$
—

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


5
Table of Contents

VERTEX PHARMACEUTICALS INCORPORATED
Condensed Consolidated Statements of Cash Flows
(unaudited)
(in thousands)
 
Six Months Ended June 30,
 
2014
 
2013
Cash flows from operating activities:
 
 
 
Net loss
$
(391,839
)
 
$
(374,339
)
Adjustments to reconcile net loss to net cash used in operating activities:
 
 
 
Depreciation and amortization expense
29,960

 
21,245

Stock-based compensation expense
89,024

 
72,625

Other non-cash based compensation expense
—

 
5,857

Intangible asset impairment charge
—

 
412,900

Deferred income taxes
—

 
(130,661
)
Write-down of inventories to net realizable value
—

 
5,083

Other non-cash items, net
22

 
7,455

Changes in operating assets and liabilities:
 
 
 
Accounts receivable, net
2,518

 
(18,462
)
Inventories
1,194

 
6,620

Prepaid expenses and other assets
(17,538
)
 
(18,152
)
Accounts payable
7,671

 
(53,374
)
Accrued expenses and other liabilities
(9,459
)
 
4,616

Accrued restructuring expense
(9,369
)
 
(1,276
)
Deferred revenues
(5,866
)
 
(6,842
)
Net cash used in operating activities
(303,682
)
 
(66,705
)
Cash flows from investing activities:
 
 
 
Purchases of marketable securities
(703,977
)
 
(898,706
)
Sales and maturities of marketable securities
801,206

 
830,906

Expenditures for property and equipment
(27,227
)
 
(18,408
)
Decrease in restricted cash and cash equivalents
1

 
31,812

Decrease in restricted cash and cash equivalents (Alios)
—

 
11,695

Decrease (increase) in deposits
(528
)
 
414

Net cash provided by (used in) investing activities
69,475

 
(42,287
)
Cash flows from financing activities:
 
 
 
Issuances of common stock from employee benefit plans
117,947

 
207,872

Payments to redeem secured notes (due 2015)
—

 
(158
)
Payments on capital lease obligations
(11,884
)
 
(12,246
)
Payments on construction financing lease obligation
(30,292
)
 
(44,115
)
Payments returned related to construction financing lease obligation
8,050

 
—

Net cash provided by financing activities
83,821

 
151,353

Effect of changes in exchange rates on cash
1,645

 
(521
)
Net (decrease) increase in cash and cash equivalents
(148,741
)
 
41,840

Cash and cash equivalents—beginning of period
569,299

 
489,407

Cash and cash equivalents—end of period
$
420,558

 
$
531,247

Supplemental disclosure of cash flow information:
 
 
 
Cash paid for interest
$
31,933

 
$
7,142

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

 
$
130,222

Assets acquired under capital lease
$
8,985

 
$
21,576

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

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Table of Contents
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. In addition, the condensed consolidated financial statements for the period from June 13, 2011 through December 31, 2013, reflect the operations of Alios BioPharma, Inc. (“Alios”), a collaborator that was a variable interest entity (a “VIE”) for which the Company was deemed under applicable accounting guidance to have a variable interest and be the primary beneficiary. As of December 31, 2013, the Company deconsolidated Alios, and the Company's consolidated balance sheets as of June 30, 2014 and December 31, 2013 exclude Alios. 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 June 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 and the income tax provision. 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 six months ended June 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


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

Company is evaluating the new guidance and the expected effect on the Company’s condensed consolidated financial statements.
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 six months ended June 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
4,513

 
26,464

 
379

 
859

 
32,215

Adjustments related to prior period sales
(8
)
 
3,861

 
4,124

 
1

 
7,978

Credits/payments made
(5,271
)
 
(57,617
)
 
(4,160
)
 
(1,586
)
 
(68,634
)
Balance at June 30, 2014
$
769

 
$
40,952

 
$
16,142

 
$
829

 
$
58,692

C.
Collaborative Arrangements
Janssen Pharmaceutica NV
In 2006, the Company entered into a collaboration agreement (the “Janssen NV 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 NV 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 NV 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 NV Agreement through November 2013. As of November 2013, the effective date of the 2013 Janssen NV Amendment, there was $32.1 million remaining in deferred revenues related to this up-front license payment.


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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 NV 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 NV Amendment was a material modification to the Janssen NV 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 NV 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 NV 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 June 30, 2014, the remaining deferred revenue balance related to the Janssen NV collaboration was $4.2 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 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 six months ended June 30, 2014 and 2013, the Company recognized the following revenues attributable to the Janssen NV collaboration:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Royalty revenues (INCIVO)
$
5,698

 
$
44,070

 
$
10,633

 
$
83,114

Collaborative revenues:
 
 
 
 
 
 
 
Up-front and amendment payments revenues
$
—

 
$
3,107

 
$
—

 
$
6,214

Net reimbursement for telaprevir development costs
1,483

 
37

 
2,872

 
9

Reimbursement for manufacturing services
—

 
—

 
—

 
10,299

        Total collaborative revenues attributable to the Janssen NV collaboration
$
1,483

 
$
3,144

 
$
2,872

 
$
16,522

Total revenues attributable to the Janssen NV collaboration
$
7,181

 
$
47,214

 
$
13,505

 
$
99,636

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 six months ended June 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 financial support for (i) development activities for VX-661, a corrector compound discovered under the collaboration, and


9
Table of Contents
VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

(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 six months ended June 30, 2014 and 2013, the Company recognized the following revenues attributable to the CFFT collaboration:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Collaborative revenues attributable to the CFFT collaboration
$
1,604

 
$
4,244

 
$
4,472

 
$
7,803

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 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 in the first quarter of 2012 and began marketing KALYDECO in certain countries in the European Union in the third quarter of 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.
License and Collaboration Agreement
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. The Company does not expect to conduct any further development activities with respect to VX-135 and plans to seek to outlicense its rights to VX-135.
Under the terms of the Alios Agreement, the Company received exclusive worldwide rights to ALS-2200 (now formulated as VX-135) and ALS-2158, a second HCV nucleotide analogue discovered by Alios that was developed pursuant to the Alios agreement through the third quarter of 2012. Alios and the Company began clinical development of ALS-2200 (VX-135) and ALS-2158 in December 2011. The Company is responsible for all costs related to development, commercialization and manufacturing of each compound licensed to the Company pursuant to the Alios Agreement and provided funding to Alios to conduct the Phase 1 clinical trials for ALS-2200 and ALS-2158. In addition, the Company provided funding for a research program, which ended in 2013, directed to the discovery of additional HCV nucleotide analogues that act on the HCV polymerase.


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

Upon entering into the Alios Agreement, the Company paid Alios a $60.0 million up-front payment. As of June 30, 2014, Alios also had earned an aggregate of $60.0 million in development milestone payments pursuant to the Alios Agreement. The Alios Agreement provides for development milestone payments if VX-135 is approved and commercialized. In addition, Alios is eligible to receive commercial milestone payments, as well as tiered royalties on net sales of VX-135.
The Company may terminate the Alios Agreement upon 60 days’ notice to Alios. The Alios Agreement also may be terminated by either party for a material breach by the other, or if the Company challenges certain Alios patents, in each case subject to notice and cure provisions. Unless earlier terminated, the Alios Agreement will continue in effect until the expiration of the Company’s royalty obligations, which expire on a country-by-country basis on the later of (a) the date the last-to-expire patent covering a licensed product expires or (b) 10 years after the first commercial sale in the applicable country.
Under applicable accounting guidance, the Company determined that Alios was a VIE, its license to VX-135 and ALS-2158 was a variable interest in Alios, that Alios was a business and that the Company was Alios’ primary beneficiary for the period from June 13, 2011 through December 31, 2013. The Company based these determinations on, among other factors, the significance to Alios of the licensed compounds and on the Company’s power, through the joint steering committee for the licensed compounds established under the Alios Agreement, to direct the activities that most significantly affect the economic performance of Alios.
Accordingly, the Company consolidated Alios’ financial statements with the Company’s condensed consolidated financial statements from June 13, 2011 through December 31, 2013. However, the Company’s interests in Alios were limited to those accorded to the Company in the Alios Agreement. In particular, the Company did not acquire any equity interest in Alios, any interest in Alios’ cash and cash equivalents or any control over Alios’ activities that do not relate to the Alios Agreement. Alios does not have any right to the Company’s assets except as provided in the Alios Agreement.
As of December 31, 2013, the Company determined that it 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. The Company deconsolidated Alios based on this conclusion as of December 31, 2013.
The Company continues to have significant continuing involvement with Alios due to the Alios Agreement, as amended; therefore, the deconsolidation of Alios is not presented as discontinued operations in the Company's condensed consolidated financial statements as of June 30, 2014. The Company will evaluate whether it continues to have significant continuing involvement with Alios for a period of one year from the December 31, 2013 deconsolidation date.
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. A summary of net loss attributable to noncontrolling interest (Alios) for the three and six months ended June 30, 2013 is as follows:
 
Three Months Ended
June 30, 2013
 
Six Months Ended
June 30, 2013
 
(in thousands)
Loss before benefit from income taxes
$
6,824

 
$
12,121

Decrease in fair value of contingent milestone and royalty payments
80

 
2,820

Benefit from income taxes
(2,357
)
 
(5,783
)
Net loss attributable to noncontrolling interest (Alios)
$
4,547

 
$
9,158

The Company did not have a corresponding net loss (income) attributable to noncontrolling interest (Alios) for the three and six months ended June 30, 2014 due to the deconsolidation of Alios.


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

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.
Janssen Pharmaceuticals, Inc.
On June 11, 2014, the Company entered into a license, development and commercialization agreement (the "Janssen Inc. Agreement") with Janssen Pharmaceuticals, Inc. (“Janssen Inc.”) pursuant to which it granted Janssen Inc. an exclusive worldwide license to develop and commercialize VX-787 and a backup compound referred to as VX-353, for the treatment of influenza. In connection with the execution of the Janssen Inc. Agreement, the Company received from Janssen Inc. an up-front payment of $30.0 million in the third quarter of 2014. In addition, Vertex has the potential to receive development and commercial milestone payments as well as royalties on any future product sales.
Janssen Inc. will be responsible for costs related to the development and commercialization of the compounds. Janssen Inc. may terminate the Janssen Inc. Agreement, subject to certain exceptions, upon six months' notice. The Janssen Inc. Agreement also may be terminated by either party for a material breach by the other, subject to notice and cure provisions. Unless earlier terminated, the Janssen Inc. Agreement will continue in effect until the expiration of Janssen Inc.'s royalty obligations, which expire on a country-by-country basis on the later of (i) the date the last-to-expire patent covering a licensed product expires or (ii) ten years after the first commercial sale in the applicable country.
The Company will evaluate the deliverables pursuant to the Janssen Inc. Agreement under multiple element arrangement guidance for collaborative arrangements during the third quarter of 2014. The collaboration with Janssen Inc. 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 for the three and six months ended June 30, 2014.
D.
Net Loss Per Share Attributable to Vertex Common Shareholders
Basic net loss attributable to Vertex per common share 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 attributable to Vertex per common share calculations because the effect would have been anti-dilutive during each period:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Stock options
14,549

 
16,802

 
14,549

 
16,802

Unvested restricted stock and restricted stock units
2,584

 
2,600

 
2,584

 
2,600

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


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

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 June 30, 2014, the Company’s investments were in money market funds, government-sponsored enterprise securities, corporate debt securities and commercial paper.
As of June 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 six months ended June 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:
 
Fair Value Measurements
as of June 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
$
123,469

 
$
123,469

 
$
—

 
$
—

Marketable securities:
 
 
 
 
 
 
 
Government-sponsored enterprise securities
497,587

 
497,587

 
—

 
—

Commercial paper
69,243

 
—

 
69,243

 
—

Corporate debt securities
231,773

 
—

 
231,773

 
—

Total
$
922,072

 
$
621,056

 
$
301,016

 
$
—

The fair value of the Company’s foreign currency forward contracts, which were not material as of June 30, 2014, were based on Level 2 inputs. The fair value of the outstanding foreign currency forward contract were determined using third party pricing services. Please refer to Note H, "Hedging," for further information regarding the Company’s foreign currency forward contracts.


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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 June 30, 2014
 
 
 
 
 
 
 
Cash and cash equivalents:
 
 
 
 
 
 
 
Cash and money market funds
$
420,558

 
$
—

 
$
—

 
$
420,558

Total cash and cash equivalents
$
420,558

 
$
—

 
$
—

 
$
420,558

Marketable securities:
 
 
 
 
 
 
 
Government-sponsored enterprise securities (due within 1 year)
$
497,601

 
$
8

 
$
(22
)
 
$
497,587

Commercial paper (due within 1 year)
69,144

 
99

 
—

 
69,243

Corporate debt securities (due within 1 year)
216,426

 
33

 
(26
)
 
216,433

Corporate debt securities (due after 1 year through 5 years)
15,335

 
5

 
—

 
15,340

Total marketable securities
$
798,506

 
$
145

 
$
(48
)
 
$
798,603

Total cash, cash equivalents and marketable securities
$
1,219,064

 
$
145

 
$
(48
)
 
$
1,219,161

 
 
 
 
 
 
 
 
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

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 Losses on Foreign Currency Forward Contracts
 
Total
 
(in thousands)
Balance at December 31, 2013
$
(325
)
 
$
42

 
$
(23
)
 
$
(306
)
Other comprehensive income (loss) before reclassifications
353

 
55

 
(108
)
 
300

Amounts reclassified from accumulated other comprehensive loss
—

 
—

 
(17
)
 
(17
)
Net current period other comprehensive income (loss)
$
353

 
$
55

 
$
(125
)
 
$
283

Balance at June 30, 2014
$
28

 
$
97

 
$
(148
)
 
$
(23
)


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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
(521
)
 
(159
)
 
—

 
(680
)
Amounts reclassified from accumulated other comprehensive loss
—

 
—

 
—

 
—

Net current period other comprehensive loss
$
(521
)
 
$
(159
)
 
$
—

 
$
(680
)
Balance at June 30, 2013
$
(1,267
)
 
$
37

 
$
—

 
$
(1,230
)
H.
Hedging
In December 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 included foreign currency forward contracts that were 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 June 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 June 30, 2014
 
As of December 31, 2013
Foreign Currency
(in thousands)
Euro
$
23,334

 
$
17,468

British pound sterling
16,921

 
—

Total foreign currency forward contracts
$
40,255

 
$
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:


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

 
As of June 30, 2014
 
As of December 31, 2013
 
(in thousands)
Fair value - assets
$
50

 
$
—

Fair value - liabilities
(198
)
 
(23
)
Net carrying value
$
(148
)
 
$
(23
)
I. Inventories
The following table sets forth the Company’s inventories by type:
 
As of June 30, 2014
 
As of December 31, 2013
 
(in thousands)
Raw materials
$
—

 
$
489

Work-in-process
11,013

 
9,981

Finished goods
969

 
3,677

Total
$
11,982

 
$
14,147

J. Intangible Assets and Goodwill
Intangible Assets
As of June 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. Two of the Company's competitors received approval in the fourth quarter of 2013 for new treatment regimens for HCV infection that include pegylated-interferon and ribavirin, and several of the Company's competitors are conducting Phase 3 clinical trials evaluating all-oral combinations of their drug candidates for the treatment of HCV infection.
ViroChem Acquisition
The Company determined that the fair value of the VX-222 intangible asset of $412.9 million 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 six months ended June 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 six months ended June 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 $1.30 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.
Goodwill
As of June 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 six months ended June 30, 2014 or 2013.


16
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VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

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 leases, 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.
Property and equipment, net, included $522.2 million and $503.4 million as of June 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 $473.6 million and $440.9 million as of June 30, 2014 and December 31, 2013, respectively.


17
Table of Contents
VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

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 June 30, 2014:
Year
 
(in thousands)
2014
 
$
9,519

2015
 
20,792

2016
 
14,254

2017
 
13,129

2018
 
13,027

2019
 
3,047

Thereafter
 
—

Total payments
 
$
73,768

Less: amount representing interest
 
(9,008
)
Present value of payments
 
$
64,760

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 September 2014.
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 certain 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 their equity awards as of June 30, 2014.  The Company 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.


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

During the three and six months ended June 30, 2014 and 2013, the Company recognized the following stock-based compensation expense:
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Stock-based compensation expense by type of award:
 
 
 
 
 
 
 
Stock options
$
26,985

 
$
29,949

 
$
52,112

 
$
49,623

Restricted stock and restricted stock units
14,020

 
9,732

 
33,013

 
19,110

ESPP share issuances
1,681

 
2,051

 
4,348

 
4,573

Less stock-based compensation expense capitalized to inventories
(242
)
 
(382
)
 
(449
)
 
(681
)
Total stock-based compensation expense included in costs and expenses
$
42,444

 
$
41,350

 
$
89,024

 
$
72,625

 
 
 
 
 
 
 
 
Stock-based compensation expense by line item:
 
 
 
 
 
 
 
Research and development expenses
$
27,253

 
$
25,740

 
$
60,153

 
$
45,089

Sales, general and administrative expenses
15,191

 
15,610

 
28,871

 
27,536

Total stock-based compensation expense included in costs and expenses
$
42,444

 
$
41,350

 
$
89,024

 
$
72,625

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 June 30, 2014
 
Unrecognized Expense,
Net of
Estimated Forfeitures
 
Weighted-average
Recognition
Period
 
(in thousands)
 
(in years)
Type of award:
 
 
 
Stock options
$
158,362

 
2.33
Restricted stock and restricted stock units
$
102,006

 
2.14
ESPP share issuances
$
4,082

 
0.58
The following table summarizes information about stock options outstanding and exercisable at June 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
 
368

 
2.01
 
$15.59
 
368

 
$15.59
$20.01–$30.00
 
889

 
5.42
 
$29.46
 
708

 
$29.35
$30.01–$40.00
 
4,876

 
5.17
 
$36.20
 
3,758

 
$35.73
$40.01–$50.00
 
3,508

 
8.37
 
$46.32
 
890

 
$46.55
$50.01–$60.00
 
1,348

 
7.34
 
$54.11
 
800

 
$54.63
$60.01–$70.00
 
129

 
9.15
 
$65.71
 
20

 
$64.33
$70.01–$80.00
 
2,095

 
9.60
 
$76.73
 
308

 
$74.18
$80.01–$88.18
 
1,336

 
9.02
 
$83.11
 
375

 
$82.53
Total
 
14,549

 
7.10
 
$49.77
 
7,227

 
$41.65


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

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 June 30, 2014, the Company had $53.9 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 six months ended June 30, 2014, the Company recorded a net provision for income taxes of $0.7 million and $1.5 million, respectively, related to state income taxes and income earned in various foreign jurisdictions. For the three and six months ended June 30, 2013, the Company recorded a benefit from income taxes of $1.8 million and $132.1 million, respectively. The benefit from income taxes in the six months ended June 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 June 30, 2014 and December 31, 2013, the Company had unrecognized tax benefits of $3.0 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 June 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 June 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 2010 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. The Company concluded an 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 June 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

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

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 six months ended June 30, 2014 and 2013 were as follows:
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2014
 
2013
 
2014
 
2013
 
(in thousands)
Liability, beginning of the period
$
18,324

 
$
22,459

 
$
19,115

 
$
23,328

Cash payments
(3,960
)
 
(3,849
)
 
(7,822
)
 
(7,422
)
Cash received from subleases
2,689

 
2,666

 
5,378

 
5,331

Restructuring (income) expense
(2,117
)
 
776

 
(1,735
)
 
815

Liability, end of the period
$
14,936

 
$
22,052

 
$
14,936

 
$
22,052

Fan Pier Move Restructuring
In connection with the relocation of its Massachusetts operations to Fan Pier in Boston, Massachusetts, the Company is incurring restructuring charges related to its remaining lease obligations at its facilities in Cambridge, Massachusetts, which will 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 Company started incurring these charges in the fourth quarter of 2013 and expects them to continue through April 2018. The majority of these restructuring charges relate to cease use charges that the Company expects to incur in the third quarter of 2014 once it has vacated the buildings in Cambridge in their entirety. Once the Company completes the relocation, the continuing charges will relate to the difference between the Company’s estimated future cash flows related to its lease obligations and its actual cash flows.
The activities related to the restructuring liability for the three and six months ended June 30, 2014 were as follows:
 
Three Months Ended June 30, 2014
 
Six Months Ended June 30, 2014
 
(in thousands)
Liability, beginning of the period
$
3,722

 
$
797

Cash payments
(2,143
)
 
(4,377
)
Restructuring expense
1,677

 
6,836

Liability, end of the period
$
3,256

 
$
3,256

Strategic Restructuring
In October 2013, the Company adopted a restructuring plan. The restructuring plan 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.


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

The activities related to the restructuring liability for the three and six months ended June 30, 2014 were as follows:
 
Three Months Ended June 30, 2014

Six Months Ended June 30, 2014
 
(in thousands)
Liability, beginning of the period
$
1,821

 
$
8,441

Cash payments
(1,199
)
 
(8,466
)
Restructuring expense
170

 
817

Liability, end of the period
$
792

 
$
792

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 for the three and six months ended June 30, 2014 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
City of Bristol Pension Fund v. Vertex Pharmaceuticals Incorporated, et al.
On September 6, 2012, a purported shareholder class action, City of Bristol Pension Fund 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 June 28, 2012, all in violation of Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder. By order dated December 12, 2012, the court appointed the City of Bristol lead plaintiff and appointed the City of Bristol's attorneys lead counsel. The plaintiffs filed an amended complaint on February 11, 2013. The Company filed a motion to dismiss the complaint on April 12, 2013. On May 28, 2013, the plaintiffs filed an opposition to the Company's motion to dismiss the complaint. On June 27, 2013, the Company filed a reply in further support of the Company's motion to dismiss the plaintiffs' complaint. The court conducted a hearing on the Company's motion to dismiss on November 25, 2013, and the court dismissed the plaintiffs' complaint on March 31, 2014. The plaintiffs filed a motion (i) for reconsideration and (ii) to file a second amended complaint on April 28, 2014. On May 23, 2014, the court denied the plaintiffs' motion and dismissed the complaint with prejudice.
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. The Company believes the claims to be without merit and intends to vigorously defend the litigation. As of June 30, 2014, the Company has not recorded any reserves for this purported class action.


22
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VERTEX PHARMACEUTICALS INCORPORATED
Notes to Condensed Consolidated Financial Statements
(unaudited)

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

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

Company may prepay the loans, 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.
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.


24
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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 positive 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. We plan to submit a New Drug Application, or NDA, to 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 in the fourth quarter of 2014.
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 and Europe are being treated with KALYDECO. In June 2014, we signed a letter of intent with the pan-Canadian Pricing Alliance to enable the public reimbursement of KALYDECO for the treatment of eligible Canadians with CF six years of age and older who have the G551D mutation in their CFTR gene. Patients in the Canadian provinces of Ontario and Alberta are now able to receive KALYDECO under public reimbursement programs, and discussions are ongoing in the remaining Canadian provinces and territories. KALYDECO also is approved in Australia for the treatment of patients with CF six years of age and older who have the G551D mutation in their CFTR gene, and we are in discussions with Australia's Therapeutic Goods Administration regarding public reimbursement of KALYDECO.
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. In Canada, we also recently received approval for KALYDECO for the treatment of this patient group and patients with CF who have the G970R mutation in their CFTR gene.
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.
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 in June 2014 and an MAA variation to the EMA in July 2014 seeking approval of KALYDECO in patients with CF 18 years of age and older who have the R117H mutation on at least one allele in their CFTR gene. We believe there are approximately 700 patients with CF 18 years of age or older who have the R117H mutation in their CFTR gene in North America, Europe and Australia.
Our 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, is complete, and we expect data from this clinical trial in the third quarter of 2014. The primary endpoint of this clinical trial is safety, and secondary endpoints


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include pharmacokinetics, change in sweat chloride and change in weight. If this clinical trial is successful, we plan to submit an NDA and an MAA variation based on this clinical trial in the fourth quarter of 2014. We believe there are approximately 300 children with CF two to five years of age who have the mutations evaluated in this clinical trial in North America, Europe and Australia.
In the second quarter of 2014, we announced data from a two-part proof-of-concept clinical trial of ivacaftor in 24 patients with CF who have a residual function mutation. This clinical trial was the first to evaluate the use of ivacaftor in multiple residual function mutations in their CFTR gene. Based on the data from the clinical trial, we plan to initiate a larger Phase 3 clinical trial in patients with residual function mutations that will evaluate longer-duration treatment with ivacaftor, subject to discussions with regulatory authorities. In North America, Europe and Australia, more than 3,000 patients with CF six years of age and older have non-R117H mutations that result in residual function.
Lumacaftor in Combination with Ivacaftor
We are evaluating combinations of lumacaftor and ivacaftor, our most advanced investigational CFTR corrector compound. 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. Based on the data from TRAFFIC and TRANSPORT, we plan to submit an NDA to the FDA and an MAA to the EMA for lumacaftor in combination with ivacaftor in patients with CF 12 years of age and older who have two copies (homozygous) of the F508del mutation in their CFTR gene in the fourth quarter of 2014. In June 2014, the FDA granted the combination of lumacaftor and ivacaftor Orphan Drug Designation. The combination of lumacaftor and ivacaftor also recently received Orphan designation in Europe. We believe that there are more than 22,000 patients with CF 12 years of age and older who have two copies of the F508del mutation in North America, Europe and Australia.
TRAFFTIC and TRANSPORT
TRAFFIC and TRANSPORT evaluated patients with CF 12 years of age and older who have two copies (homozygous) of the F508del mutation in their CFTR gene and included two combination treatment groups and one placebo group. The combination treatment groups evaluated lumacaftor dosed at either 600 mg once daily or 400 mg every 12 hours (q12h) in combination with ivacaftor dosed at 250 mg q12h. 1,108 patients enrolled and received at least one dose of study drug in the two clinical trials. The primary endpoint of TRAFFIC and TRANSPORT was the mean absolute change from baseline in ppFEV1 at the end of the 24-week treatment period as assessed by the average change in lung function at Week 16 and at Week 24.
All four treatment arms within TRAFFIC and TRANSPORT met their primary endpoint. Additionally, statistically significant mean absolute and relative improvements in lung function were observed for all four treatment groups, both within group and versus placebo, at all time points within the clinical trials (Weeks 2, 4, 8, 16 and 24). As patients in the clinical trials continued to be treated with their standard CF medicines, improvements observed for patients in the combination treatment arms were in addition to any benefits experienced with the use of other CF medicines. The mean baseline lung function of patients was approximately 61 ppFEV1 for patients who received the combination regimen and for patients who received placebo. Detailed data from each arm of TRAFFIC and TRANSPORT are provided below:
Change in ppFEV1
TRAFFIC Trial
TRANSPORT Trial
Placebo (n=184)
Lumacaftor (600 mg once daily) + Ivacaftor (250 mg q12h) (n=183)
Lumacaftor (400 mg q12h) + Ivacaftor (250 mg q12h) (n=182)
Placebo (n=187)
Lumacaftor (600 mg once daily) + Ivacaftor (250 mg q12h) (n=185)
Lumacaftor (400 mg q12h) + Ivacaftor (250 mg q12h)
(n=187)
Mean Absolute Change (percentage points)
Treatment Difference
N/A
4.0 (p<0.0001)
2.6 (p=0.0003)
N/A
2.6
(p=0.0004)
3.0 (p<0.0001)
Within Group
-0.44
(p=0.4002)
3.6
(p<0.0001)
2.2
(p<0.0001)
-0.15
(p=0.7744)
2.5
(p<0.0001)
2.9
(p<0.0001)
Mean Relative Change
(%)
Treatment Difference
N/A
6.7% (p<0.0001)
4.3% (p=0.0006)
N/A
4.4%
(p=0.0007)
5.3% (p<0.0001)
Within Group
-0.34%
(p=0.7113)
6.4%
(p<0.0001)
4.0%
(p<0.0001)
0.0%
(p=0.9983)
4.4%
(p<0.0001)
5.3%
(p<0.0001)

Within TRAFFIC and TRANSPORT, patients who received the combination regimens experienced a 28 to 43 percent decrease in the rate of pulmonary exacerbations (events of worsening signs and symptoms of the disease requiring


26
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treatment with antibiotics) over the 24-week treatment period compared to placebo. Detailed data for all key secondary endpoints from each arm of the clinical trials are provided below:
Key Secondary Endpoints
TRAFFIC Trial
TRANSPORT Trial
Placebo (n=184)
Lumacaftor (600 mg once daily) + Ivacaftor (250 mg q12h) (n=183)
Lumacaftor (400 mg q12h) + Ivacaftor (250 mg q12h) (n=182)
Placebo (n=187)
Lumacaftor (600 mg once daily) + Ivacaftor (250 mg q12h) (n=185)
Lumacaftor (400 mg q12h) + Ivacaftor (250 mg q12h)
(n=187)
Change in Body Mass Index
Treatment Difference
N/A
+0.16
(p=0.1122)
+0.13
(p=0.1938)
N/A
+0.41
(p<0.0001)
+0.36
(p=0.0001)
Within Group
+0.19
(p=0.0065)
+0.35
(p<0.0001)
+0.32
(p<0.0001)
+0.07
(p=0.2892)
+0.48
(p<0.0001)
+0.43
(p<0.0001)
Change in CFQ-R
Treatment Difference
N/A
+3.9
(p=0.0168)
+1.5
(p=0.3569)
N/A
+2.2
(p=0.1651)
+2.9
(p=0.0736)
Within Group
+1.1
(p=0.3423)
+5.0
(p<0.0001)
+2.6
(p=0.0295)
+2.8
(p=0.0152)
+5.0
(p<0.0001)
+5.7
(p<0.0001)
Patients with 5% or Greater Relative Improvement in ppFEV1
%
22%
46%
37%
23%
46%
41%
Odds Ratio
N/A
2.94 (p<0.0001)
2.06 (p=0.0023)
N/A
2.96 (p<0.0001)
2.38
(p=0.0001)
Number of Pulmonary Exacerbations
Number of Events (rate per 48 weeks)
112 (1.07)
79 (0.77)
73 (0.71)
139 (1.18)
94 (0.82)
79 (0.67)
Rate Ratio
N/A
 0.72
(p=0.0491)
 0.66
(p=0.0169)
N/A
0.69
(p=0.0116)
0.57
(p=0.0002)

The combination regimens were generally well tolerated. The most common adverse events, regardless of treatment group, were infective pulmonary exacerbation, cough, headache and increased sputum, and adverse events that occurred more frequently in patients who received the combination regimens than those who received placebo were generally respiratory in nature and included dyspnea and respiration abnormal. 4.2 percent of all patients who received combination therapy, regardless of dosing group, discontinued treatment because of adverse events compared to 1.6 percent of those who received placebo. Across TRAFFIC and TRANSPORT, elevated liver enzymes (greater than three times the upper limit of normal) were observed in 5.2 percent of patients who received combination therapy compared to 5.1 percent of those who received placebo. Seven patients who received combination therapy experienced serious adverse events related to abnormal liver function tests, compared to zero patients who received placebo. Following discontinuation or interruption of the combination treatment, liver function tests returned to baseline for six of the seven patients and the seventh patient’s liver function tests improved substantially.
Exploratory Clinical Trial in Patients Heterozygous for the F508del Mutation
In the third quarter of 2014, we completed a Phase 2, 8-week exploratory clinical trial of lumacaftor in combination with ivacaftor in 125 patients with CF 18 years of age and older who have one copy (heterozygous) of the F508del mutation and a second mutation in their CFTR gene that is not expected to respond to either ivacaftor or VX-809 alone.
The clinical trial evaluated a twice daily (q12h) combination of VX-809 (400mg) and ivacaftor (250mg) compared to placebo. The primary endpoints were safety, tolerability and mean absolute change in ppFEV1 from baseline at Day 56, and key secondary endpoints included absolute change in body mass index (BMI), absolute change in patient-reported respiratory symptoms as reported in the CF questionnaire-revised (CFQ-R) and absolute change in sweat chloride, among others.
In the clinical trial, the within-group mean absolute change in ppFEV1 for the patients who received the combination regimen was -0.62 percentage points (p=0.4550) compared to -1.23 percentage points (p=0.1287) for those who received placebo. The mean absolute treatment difference was 0.61 percentage points (p=0.5978) at day 56. The clinical trial did not meet its primary efficacy endpoint. For patients who received the combination, the mean absolute improvement in CFQ-R at day 56 was +6.48 points (p=0.0131) versus placebo. Additionally, there was a -11.03 mmol/L (p < 0.0001) decrease in sweat chloride at day 56 for those who received the combination compared to those who received placebo. There was no increase observed in body mass index, or BMI.


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Safety results from this clinical trial were consistent with the Phase 3 TRAFFIC and TRANSPORT clinical trials in patients with two copies of the F508del mutation. The combination regimen was generally well tolerated. The most common adverse events, regardless of treatment group, were respiration abnormal, infective pulmonary exacerbation, cough, increased sputum and headache, and adverse events that occurred more frequently in patients who received the combination regimen than those who received placebo were generally respiratory in nature and included dyspnea and respiration abnormal, as well as gastroesophagael reflux. 6.5 percent of patients who received combination therapy discontinued treatment because of adverse events compared to 0.0 percent of those who received placebo.
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. In this clinical trial, VX-661 was generally well-tolerated when dosed in combination with KALYDECO, and all 18 patients completed the clinical trial. The most common adverse events in the treatment group were cough, pulmonary exacerbation, headache and upper respiratory tract infection. One serious adverse event of arthritis occurred in the VX-661 treatment arm and was deemed unrelated to VX-661 or KALYDECO.
The baseline lung function and sweat chloride levels for patients who were randomized to receive VX-661 and KALYDECO were 59.1 ppFEV1 and 52.9 mmol/L, respectively. A summary of the lung function and sweat chloride data for patients who received VX-661 in combination with KALYDECO is provided below:
VX-661 + KALYDECO
 (Within-Group; n=14)
Day 0 Through Day 28
(End of VX-661 Treatment)
Day 28 to Day 56
(4 Weeks Following the End of VX-661 Treatment)
Mean Absolute Change in Lung Function (ppFEV1)
+4.6 percentage points (p=0.012)
-3.4 percentage points (p=0.010)
Mean Relative Change in Lung Function (ppFEV1)
+7.3% (p=0.012)
-5.4% (p=0.008)
Sweat Chloride
-7.02 mmol/L (p=0.053)
+12.26 mmol/L (p=0.001)
Additional clinical trials of longer duration and with additional patients will be required to further validate the results of this clinical trial in patients with CF who have the G551D mutation in their CFTR gene.
We are dosing patients in a 12-week clinical trial of VX-661 in combination with ivacaftor in patients with CF who are homozygous for 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 evaluate multiple development pathways for VX-661 in combination with ivacaftor, including the potential evaluation of this combination in patients with one copy of the F508del mutation and one copy of a mutation in their CFTR gene known to respond to ivacaftor and in patients with CF who have two copies of the F508del mutation. Additionally, VX-661 and ivacaftor may be evaluated in combination with, or without, a next-generation corrector in patients with one copy of the F508del mutation and a mutation that is not expected to respond to ivacaftor or a first-generation corrector alone.

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 2012 and 2013, we recognized most of our product revenues based on INCIVEK sales and focused a large portion of our resources on commercializing INCIVEK and seeking to develop other drug candidates for the treatment of HCV infection. Our INCIVEK net product revenues declined rapidly over the course of 2013 and represented approximately 8% of our net product revenues in the second quarter of 2014. In 2013, in response to declining sales of INCIVEK and increased competition, we reduced our focus on marketing INCIVEK, eliminating the U.S. field-based sales force that had


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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 April 2014, we amended our collaboration with Alios BioPharma, Inc., or Alios, and following this amendment, we have no further obligations to continue development of VX-135. We do not plan to further develop VX-135 independently and are seeking to outlicense our rights to VX-135.
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, multiple sclerosis 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 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 priority as new information becomes available and 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 the promotion of a culture of compliance. Among other laws, regulations and standards, we are subject to various U.S. federal and state 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.
Recent Financing and Business Development Activities
Business Development
In June 2014, we entered into a license, development and commercialization agreement with Janssen Pharmaceuticals, Inc., or Janssen Inc., pursuant to which we granted Janssen Inc. an exclusive worldwide license to develop and commercialize VX-787 and a backup compound referred to as VX-353, for the treatment of influenza.


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Pursuant to this agreement, Janssen Inc. paid us an up-front payment of $30.0 million in the third quarter of 2014. In addition, we have the potential to receive development and commercial milestone payments as well as royalties on any future product sales. Janssen Inc. is responsible for costs related to the development and commercialization of the compounds.
We are seeking to license or acquire drugs, drug candidates and other technologies that have the potential to add to our pipeline, enhance research and development programs or to provide us with new commercial opportunities. We also are planning to seek to outlicense our rights to VX-135 and VX-509, our JAK3 inhibitor, which we have evaluated as a potential treatment for patients with rheumatoid arthritis in a Phase 2 clinical trial.
Credit Agreement
In July 2014, we entered into a credit agreement that provides for a $300.0 million senior secured term loan. The credit agreement also provides that, subject to satisfaction of certain conditions, we may request that the lenders establish an incremental senior secured term loan facility in an aggregate amount not to exceed $200.0 million. The loan initially bears interest at a rate of 7.2% per annum but is subject to adjustment over the course of the loan and matures in July 2017. Interest is payable quarterly and on the maturity date. We are required to repay principal on the 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.



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RESULTS OF OPERATIONS
 
Three Months Ended
June 30,
 
Increase/(Decrease)
 
Six Months Ended
June 30,
 
Increase/(Decrease)
 
2014
 
2013
 
$
 
%
 
2014
 
2013
 
$
 
%
 
(in thousands)
 
 
 
(in thousands)
 
 
Revenues
$
138,421

 
$
310,750

 
$
(172,329
)
 
(55
)%
 
$
256,872

 
$
639,118

 
$
(382,246
)
 
(60
)%
Operating costs and expenses
$
319,256

 
$
367,683

 
$
(48,427
)
 
(13
)%
 
$
654,095

 
$
1,134,339

 
$
(480,244
)
 
(42
)%
Other items, net
$
21,453

 
$
(4,779
)
 
N/A

 
N/A

 
$
5,384

 
$
120,882

 
$
(115,498
)
 
(96
)%
Net loss attributable to noncontrolling interest (Alios)
$
—

 
$
4,547

 
$
(4,547
)
 
(100
)%
 
$
—

 
$
9,158

 
$
(9,158
)
 
(100
)%
Net loss attributable to Vertex
$
(159,382
)
 
$
(57,165
)
 
$
102,217

 
179
 %
 
$
(391,839
)
 
$
(365,181
)
 
$
26,658

 
7
 %
Net Loss Attributable to Vertex
Net loss attributable to Vertex was $159.4 million in the second quarter of 2014 compared to a net loss attributable to Vertex of $57.2 million in the second quarter of 2013. Our revenues decreased in the second quarter of 2014 as compared to the second quarter of 2013 due to decreased INCIVEK net product revenues partially offset by increased KALYDECO net product revenues. Our operating costs and expenses decreased in the second quarter of 2014 as compared to the second quarter of 2013 primarily due to reductions in sales, general and administrative expenses and cost of product revenues.
Net loss attributable to Vertex was $391.8 million in the first half of 2014 compared to net loss attributable to Vertex of $365.2 million in the first half of 2013. Our revenues decreased in the first half of 2014 as compared to the first half of 2013 due to decreased INCIVEK net product revenues partially offset by increased KAYDECO net product revenues. Our operating costs and expenses decreased from $1.1 billion in the first half of 2013 to $654.1 million in the first half of 2014. The decrease in operating expenses in the first half of 2014 compared to the first half of 2013 was primarily due to a $412.9 million impairment charge related to VX-222, a non-nucleoside HCV polymerase inhibitor, we recorded in the first quarter of 2013, which was included in operating costs and expenses. 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 first half of 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.
 
Net Loss Attributable to Vertex per Diluted Share
Net loss attributable to Vertex was $0.68 per diluted share in the second quarter of 2014 as compared to net loss attributable to Vertex of $0.26 per diluted share in the second quarter of 2013. Net loss attributable to Vertex was $1.68 per diluted share in the first half of 2014 as compared to net loss attributable to Vertex of $1.67 per diluted share in the first half of 2013.


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Revenues
 
Three Months Ended
June 30,
 
Increase/(Decrease)
 
Six Months Ended
June 30,
 
Increase/(Decrease)
 
2014
 
2013
 
$
 
%
 
2014
 
2013
 
$
 
%
 
(in thousands)
 
 
 
(in thousands)
 
 
Product revenues, net
$
122,319