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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2007

or

For the transition period from_____ to_____.

Commission file number: 000-23265

SALIX PHARMACEUTICALS, LTD.

(Exact name of Registrant as specified in its charter)

1700 Perimeter Park Drive

Morrisville, North Carolina 27560

(Address of principal executive offices, including zip code)

(919) 862-1000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES  [X]                    NO  [    ]

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer  [    ]    Accelerated filer  [X]    Non-accelerated filer  [    ]

Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YES  [ ]                    NO  [X]

The number of shares of the Registrant’s Common Stock outstanding as of November 8, 2007 was 47,589,575.

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SALIX PHARMACEUTICALS, LTD.

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PART I.     FINANCIAL INFORMATION.

Item 1.        Financial Statements

SALIX PHARMACEUTICALS, LTD.

CONDENSED CONSOLIDATED BALANCE SHEETS

(U.S. dollars, in thousands, except share amounts)

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

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SALIX PHARMACEUTICALS, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(U.S. Dollars, in thousands, except per share data)

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

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SALIX PHARMACEUTICALS, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(U.S. dollars, in thousands)

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

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SALIX PHARMACEUTICALS, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2007

(Unaudited)

Salix Pharmaceuticals, Ltd., a Delaware corporation (“Salix” or the “Company”), is a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract.

These consolidated financial statements are stated in United States dollars and are prepared under accounting principles generally accepted in the United States. The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

The accompanying consolidated financial statements include all adjustments that, in the opinion of management, are necessary for a fair presentation of financial position, results of operations and cash flows. These financial statements should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, included elsewhere in this Quarterly Report on Form 10-Q and with the audited consolidated financial statements and MD&A included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006 filed with the Securities and Exchange Commission. The results of operations for interim periods are not necessarily indicative of results to be expected for a full year or any future period. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted in accordance with the SEC’s rules and regulations for interim reporting.

The Company recognizes revenue in accordance with the SEC’s Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” as amended by Staff Accounting Bulletin No. 104 (together, “SAB 101”), and FASB Statement No. 48, “Revenue Recognition When Right of Return Exists” (“SFAS 48”). SAB 101 states that revenue should not be recognized until it is realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: (a) persuasive evidence of an arrangement exists; (b) delivery has occurred or services have been rendered; (c) the seller’s price to the buyer is fixed or determinable; and (d) collectibility is reasonably assured.

SFAS 48 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if (1) the seller’s price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has economic substance apart from that provided by the seller, (5) the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be reasonably estimated. The Company recognizes revenues for product sales at the time title and risk of loss are transferred to the customer, and the other criteria of SAB 101 and SFAS 48 are satisfied, which is generally at the time products are shipped. The Company’s net product revenue represents the Company’s total revenues less allowances for customer credits, including estimated discounts, rebates, chargebacks and product returns.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — Continued

The Company establishes allowances for estimated rebates, chargebacks and product returns based on numerous quantitative and qualitative factors, including:

In its analyses, the Company uses prescription data purchased from a third-party data provider to develop estimates of historical inventory channel pull-through. The Company utilizes an internal analysis to compare historical net product shipments to estimated historical prescriptions written. Based on that analysis, the Company develops an estimate of the quantity of product in the channel which may be subject to various rebate, chargeback and product return exposures. At least quarterly for each product line, the Company prepares an internal estimate of ending inventory units in the distribution channel by adding estimated inventory in the channel at the beginning of the period, plus net product shipments for the period, less estimated prescriptions written for the period. Based on that analysis, the Company develops an estimate of the quantity of product in the channel that might be subject to various rebate, chargeback and product return exposures. This is done for each product line by applying a rate of historical activity for rebates, chargebacks and product returns, adjusted for relevant quantitative and qualitative factors discussed above, to the potential exposed product estimated to be in the distribution channel. Internal forecasts that are utilized to calculate the estimated number of months in the channel are regularly adjusted based on input from members of the Company’s sales, marketing and operations groups. The adjusted forecasts take into account numerous factors including, but not limited to, new product introductions, direct communication with customers and potential product expiry issues.

The Company periodically offers promotional discounts to its existing customer base. These discounts are calculated as a percentage of the current published list price and are treated as off-invoice allowances. Accordingly, the Company records the discounts as a reduction of revenue in the period that the program is offered. In addition to promotional discounts, at the time that the Company implements a price increase, it generally offers its existing customer base an opportunity to purchase a limited quantity of product at the previous list price. Shipments resulting from these programs generally are not in excess of ordinary levels, therefore, the Company recognizes the related revenue upon shipment and includes the shipments in estimating its various product-related allowances. In the event the Company determines that these shipments represent purchases of inventory in excess of ordinary levels for a given wholesaler, the potential impact on product returns exposure would be specifically evaluated and reflected as a reduction in revenue at the time of such shipments

Allowances for estimated rebates and chargebacks were $10.4 million and $6.0 million as of September 30, 2007 and 2006, respectively. These allowances reflect an estimate of the Company’s liability for items such as rebates due to various governmental organizations under the Medicare/Medicaid regulations, rebates due to managed care organizations under specific contracts and chargebacks due to various organizations purchasing our products through federal contracts and/or group purchasing agreements. The Company estimates its liability for rebates and chargebacks at each reporting period based on a methodology of applying quantitative and qualitative assumptions discussed above. Due to the subjectivity of the Company’s accrual estimates for rebates and chargebacks, the Company prepares various sensitivity analyses to ensure the Company’s final estimate is within a

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reasonable range and also reviews prior period activity to ensure that the Company’s methodology continues to be appropriate.

Allowances for product returns were $7.9 million and $4.3 million as of September 30, 2007 and 2006, respectively. These allowances reflect an estimate of the Company’s liability for product that may be returned by the original purchaser in accordance with the Company’s stated return policy. The Company estimates its liability for product returns at each reporting period based on historical return rates, the estimated inventory in the channel, and the other quantitative and qualitative factors discussed above. Due to the subjectivity of the Company’s accrual estimates for product returns, the Company prepares various sensitivity analyses to ensure the Company’s final estimate is within a reasonable range and also reviews prior period activity to ensure the Company’s methodology is still reasonable.

The Company’s provision for revenue-reducing items such as rebates, chargebacks, and product returns as a percentage of gross product revenue in the nine-month period ended September 30, 2007 and 2006 was 9.7% and 9.0% for rebates, chargebacks, and discounts, and 3.2% and 3.6%, for product returns, respectively.

Revenue from collaborative agreements consists of upfront and milestone payments from collaborative partners. To date this revenue has consisted of non-refundable, upfront or milestone payments where we have no significant continuing involvement and is recognized upon receipt. Any future revenue from non-refundable, upfront or milestone payments where we have significant continuing involvement would be recognized ratably over the development period or agreement term.

Purchase Order Commitments

At September 30, 2007, the Company had binding purchase order commitments for inventory purchases expected to be delivered over the next six months aggregating approximately $14.1 million.

Potential Milestone Payments

The Company has entered into collaborative agreements with licensors, licensees and others. Pursuant to the terms of these collaborative agreements, the Company is obligated to make one or more payments upon the occurrence of certain milestones. The following is a summary of the material payments that the Company might be required to make under its collaborative agreements if certain milestones are satisfied.

License Agreement with Dr. Falk Pharma GmbH — In July 2002, the Company and Dr. Falk entered into a license agreement which they amended in November 2003 and February 2005. Pursuant to the license agreement, as amended, the Company acquired the rights to develop and market a granulated formulation of mesalamine. The agreement provides that the Company is obligated to make milestone payments up to an aggregate amount of $11.0 million to Dr. Falk. As of September 30, 2007, the Company had paid $3.0 million of milestone payments. The remaining milestone payments are contingent upon filing a new drug application and regulatory approval.

License and Supply Agreement with Norgine B.V. — In December 2005, the Company entered into a license and supply agreement with Norgine for the rights to sell NRL944, a bowel cleansing product the Company now markets in the United States under the trade name MoviPrep. Pursuant to the terms of this agreement, the Company is obligated to make upfront and milestone payments to Norgine that could total up to $37.0 million over the term of the agreement. As of September 30, 2007, the Company had paid $17.0 million of milestone payments. The remaining milestone payments are contingent upon reaching sales thresholds.

License Agreement with Cedars-Sinai Medical Center — In June 2006, the Company entered into a license agreement with Cedars-Sinai for the right to use a patent and a patent application relating to methods of diagnosing and treating irritable bowel syndrome and other disorders caused by small intestinal bacterial overgrowth. Pursuant to the license agreement, the Company is obligated to pay Cedars-Sinai a license fee of $1.2 million over time. As of September 30, 2007, the Company had paid this license fee in full. The Company may terminate the license agreement upon written notice of not less than 90 days.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — Continued

License and Supply Agreement with the Debiopharm Group– In September 2006, the Company acquired the exclusive right to sell, market and distribute Sanvar in the United States. Pursuant to the terms of this agreement, the Company is obligated to make upfront and milestone payments to Debiopharm that could total up to $7.5 million over the term of the agreement. As of September 30, 2007, the Company had paid $0.5 million of milestone payments. The remaining milestone payment is contingent upon achievement of regulatory approval.

License Agreement with Merck & Co, Inc.—In February 2007, the Company entered into a Master Purchase and Sale and License Agreement with Merck, paying Merck $55.0 million to purchase the U.S. prescription pharmaceutical product rights to Pepcid® Oral Suspension and Diuril® Oral Suspension. Pursuant to the license agreement, the Company is obligated to make additional milestone payments to Merck up to an aggregate of $6.0 million contingent upon reaching certain sales thresholds during any of the five calendar years beginning in 2007 and ending in 2011.

License Agreement with Wilmington Pharmaceuticals, LLC – In September 2007 the Company entered into an Exclusive Sublicense Agreement with Wilmington Pharmaceuticals. The agreement provides that the Company is obligated to make upfront and milestone payments up to an aggregate amount of $8.0 million to Wilmington. As of September 30, 2007, the Company had paid $0.5 million of these milestone payments. The remaining milestone payments are contingent upon filing a new drug application and regulatory approval. The Company also loaned Wilmington $2.0 million which is due December 31, 2009, or earlier based on regulatory approval.

The Company considers all investments that have a maturity of greater than three months and less than one year to be short-term investments. The Company classifies its existing investments as available-for-sale. These investments are carried at fair market value based on current market quotes, with unrealized gains and losses reported in stockholders’ equity as a component of accumulated other comprehensive income (loss). At September 30, 2007 and 2006, there were no unrealized gains or losses because the fair market value of investments was equivalent to their cost. All available-for-sale investments are classified as current, as the Company has the ability to use them for current operating and investing purposes.

Raw materials, work-in-process and finished goods inventories are stated at the lower of cost (which approximates actual cost on a first-in, first-out cost method) or market value. In evaluating whether inventory is stated at the lower of cost or market, management considers such factors as the amount of inventory on hand and in the distribution channel, estimated time required to sell such inventory, remaining shelf life, and current and expected market conditions, including levels of competition. Inventory at September 30, 2007 consisted of $6.4 million of raw materials, $1.4 million of work-in-process and $8.5 million of finished goods. Inventory at December 31, 2006 consisted of $14.4 million of raw materials, $2.5 million of work-in-process and $8.2 million of finished goods. As of September 30, 2007, inventory reserves totaling $0.5 million, compared to $0.7 million as of December 31, 2006, were recorded to reduce inventories to their net realizable value.

The Company’s intangible assets consist of license agreements, product rights and other identifiable intangible assets, which result from product and business acquisitions. Goodwill represents the excess purchase price over the fair value of assets acquired and liabilities assumed in a business combination.

When the Company makes product acquisitions that include license agreements, product rights and other identifiable intangible assets, it records the purchase price of those intangibles, along with the value of the product-related liabilities that it assumes, as intangible assets. The Company allocates the aggregate purchase price to the fair value of the various tangible and intangible assets in order to determine the appropriate carrying value of the acquired assets and then amortizes the cost of the intangible assets as an expense in the consolidated statements of

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operations over the estimated economic useful life of the related assets. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long Lived Assets”, the Company assesses the impairment of identifiable intangible assets whenever events or changes in circumstances indicate that the carrying value might not be recoverable. The Company believes that the following factors could trigger an impairment review: significant underperformance relative to historical or projected future operating results; significant changes in the manner of the Company’s use of the acquired assets or the strategy for the Company’s overall business; and significant negative industry or economic trends.

In assessing the recoverability of its intangible assets, the Company must make assumptions regarding estimated future cash flows and other factors. If the estimated undiscounted future cash flows do not exceed the carrying value of the intangible assets, the Company must determine the fair value of the intangible assets. If the fair value of the intangible assets is less than the carrying value, the Company will recognize an impairment loss equal to the difference. The Company reviews intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable.

The Company assesses impairment of goodwill on an annual basis in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets”.

In November 2003, the Company acquired from aaiPharma LLC for $2.0 million the exclusive right to sell 25, 75 and 100 milligram dosage strengths of azathioprine tablets in North America under the name Azasan. The purchase price was fully allocated to product rights and related intangibles and is being amortized over a period of ten years. Although Azasan does not have any patent protection, the Company believes ten years is an appropriate amortization period based on established product history and management experience. At September 30, 2007, accumulated amortization for Azasan was $0.8 million.

In June 2004, the Company acquired the exclusive U.S. rights to Anusol-HC 2.5% (Hydrocortisone Cream USP), Anusol-HC 25 mg Suppositories (Hydrocortisone Acetate), Proctocort Cream (Hydrocortisone Cream USP) 1% and Proctocort Suppositories (Hydrocortisone Acetate Rectal Suppositories, 30 mg) from King Pharmaceuticals, Inc. for $13.0 million. The purchase price was fully allocated to product rights and related intangibles and is being amortized over a period of ten years. Although Anusol-HC and Proctocort do not have any patent protection, the Company believes ten years is an appropriate amortization period based on established product history and management experience. At September 30, 2007, accumulated amortization for the King products was $4.2 million.

In September 2005, the Company acquired InKine Pharmaceutical Company, Inc. for $210.0 million. The Company allocated $74.0 million of the purchase price to in-process research and development, $9.3 million to net assets acquired and $37.0 million to specifically identifiable product rights and related intangibles with an ongoing economic benefit to the Company. The Company allocated the remaining $89.7 million to goodwill, which is not being amortized. The decrease in goodwill during the nine-month period ended September 30, 2007 was a result of the use of net operating income tax loss carryforwards generated by InKine prior to its acquisition by the Company in 2005. The InKine product rights and related intangibles are being amortized over an average period of 14 years, which the Company believes is an appropriate amortization period due to the products’ patent protection and the estimated economic lives of the product rights and related intangibles. At September 30, 2007, accumulated amortization for the InKine intangibles was $6.0 million.

In December 2005, the Company entered into a License and Supply Agreement with Norgine B.V., which granted Salix the exclusive rights to sell a patent-protected, liquid PEG bowel cleansing product, NRL944, in the United States. In August 2006, the Company received Food and Drug Administration marketing approval for NRL944 under the brand name of MoviPrep. In January 2007, the United States Patent Office issued a patent providing coverage to September 1, 2024. In August 2006, pursuant to the terms of the Agreement, Salix made a $15.1 million milestone payment to Norgine. The Company is amortizing the milestone payment over a period of 17.3 years, which the Company believes is an appropriate amortization period due to the product’s patent protection and the estimated economic life of the related intangible. At September 30, 2007, accumulated amortization for MoviPrep was $1.0 million.

In February 2007, the Company entered into a Master Purchase and Sale and License Agreement with Merck & Co., Inc., to purchase the U.S. prescription pharmaceutical product rights to Pepcid Oral Suspension and Diuril Oral Suspension from Merck. The Company paid Merck $55.0 million at the closing of the transaction. The purchase

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price was fully allocated to product rights and related intangibles, and is being amortized over a period of 15 years. Although Pepcid and Diuril do not have any patent protection, the Company believes 15 years is an appropriate amortization period based on established product history and management experience. At September 30, 2007, accumulated amortization for the Merck products was $2.3 million.

In February 2007, the Company entered into a $100.0 million revolving credit facility that matures in February 2012. At September 30, 2007, $15.0 million was outstanding under the credit facility. Virtually all assets of the Company and its subsidiaries secure the Company’s obligations under the credit facility. Borrowings under the credit facility may be used for working capital, capital expenditures, acquisitions and other general corporate purposes.

The credit facility bears interest at a rate per annum equal to, at the Company’s option, either (a) a base rate equal to the higher of (i) the Federal Funds Rate plus 1/2 of 1% and (ii) the Bank of America prime rate, or (b) a Eurodollar rate (based on LIBOR), plus, in each case, a percentage rate that fluctuates, based on the ratio of the Company’s funded debt to EBITDA (income before income taxes plus interest expense and depreciation and amortization), from 0.00% to 0.75% for base rate borrowings and 1.00% to 1.75% for Eurodollar rate borrowings.

The credit facility contains various representations, warranties and affirmative, negative and financial covenants customary for financings of this type. The financial covenants include a leverage test and a fixed charge test. The Company was in compliance with these covenants at September 30, 2007.

In accordance with its policy, the Company expenses research and development costs, both internal and externally contracted, as incurred. The Company estimates certain externally contracted development activities to align the related expense with the level of progress achieved and services rendered during the period. As of September 30, 2007 and 2006, the net asset related to on-going research and development activities was $4.2 million and $5.5 million, respectively.

The Company adopted SFAS No. 130, “Reporting Comprehensive Income”, effective January 1, 1998. SFAS 130 requires that the Company display an amount representing comprehensive income (loss) for the year in a financial statement, which is displayed with the same prominence as other financial statements. The Company elected to present this information in the Consolidated Statements of Stockholders’ Equity. Other comprehensive income (loss) includes foreign currency translation gains and losses, as well as any unrealized gains and losses on investments. For the periods presented, there was no other comprehensive income or loss and therefore comprehensive income for the three-month and nine-month periods ended September 30, 2007 and 2006 is equal to net income.

At September 30, 2007, the Company had one active share-based compensation plan, the 2005 Stock Plan, allowing for the issuance of stock options and restricted shares. Awards granted from this plan are granted at the fair market value on the date of grant, and vest over periods ranging from one to four years.

On December 30, 2005, the Board of Directors approved the acceleration of the vesting of all outstanding unvested stock options. The acceleration was effective for all such options outstanding on December 30, 2005, all of which were granted by the Company when the accounting rules permitted use of the intrinsic-value method of accounting for stock options. All of the other terms and conditions applicable to such outstanding stock option grants still apply. Under APB No. 25, the acceleration resulted in recognition of estimated share-based compensation expense of $0.5 million based on forfeiture assumptions, which may change in future periods. The Board of Directors took the action with the belief that it was in the best interests of stockholders, as it will reduce the Company’s stock compensation expense in future periods regarding existing stock options in light of new

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accounting regulations effective beginning in fiscal year 2006. As a result of the acceleration, options to purchase 3.6 million shares of the Company’s common stock became immediately exercisable.

Prior to January 1, 2006, the Company accounted for stock-based awards to employees under the intrinsic value method in accordance with Accounting Principles Board Opinion, or APB, No. 25, “Accounting for Stock Issued to Employees”, and adopted the disclosure-only alternative of SFAS No. 123, “Accounting for Stock-Based Compensation”.

In December 2004, the Financial Accounting Standards Board issued SFAS No. 123R, “Share-Based Payment”, which requires companies to expense the fair value of employee stock options and other forms of stock-based compensation. This requirement represents a significant change because share-based stock option awards, a historically predominate form of stock compensation for the Company, were not recognized as compensation expense under APB 25. SFAS No. 123R requires the cost of an award, as determined on the date of grant at fair value, to be recognized over the period during which an employee is required to provide service in exchange for the award, usually the vesting period. The grant-date fair value of the award is estimated using an option-pricing model.

The Company adopted SFAS No. 123R effective January 1, 2006 using the modified-prospective transition method. The modified-prospective transition method of SFAS No. 123R requires the presentation of pro forma information, for periods presented prior to the adoption of SFAS No. 123R, regarding net income and net income per share as if the Company had accounted for its stock plans under the fair value method of SFAS No. 123R. For pro forma purposes, the fair value of stock option awards was estimated using the Black-Scholes option valuation model. The fair value of all of the Company’s share-based awards was estimated assuming no expected dividends, and estimates of expected life, volatility and risk-free interest rate at the time of grant.

Starting in 2006, the Company began issuing restricted shares to employees, executives and directors of the Company. The following table summarizes restricted stock outstanding at September 30, 2007 and changes during the nine months then ended:

The restrictions on the restricted stock lapse according to one of two schedules. For employees and executives of the Company, restrictions lapse 25% annually over four years. For board members of the company, restrictions lapse 100% after one year. The compensation expense related to the restricted stock was estimated based on the fair value of the restricted stock on the grant date and an assumed average forfeiture rate of 8.8% and is being expensed on a straight-line basis over the period during which the restrictions lapse. For the nine-month period ended September 30, 2007 the Company recognized $2.6 million in share based-compensation expense related to the restricted shares. As of September 30, 2007, the total amount of unrecognized compensation cost related to nonvested restricted stock awards, to be recognized as expense subsequent to September 30, 2007, was approximately $12.7 million, and the related weighted-average period over which the unrecognized compensation cost is expected to be recognized is approximately 3.22 years.

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The following table summarizes certain information regarding stock options during the nine-month period ended September 30, 2007:

For the nine-month period ended September 30, 2007, 0.3 million shares of the Company’s outstanding stock at a value of $3.8 million were issued upon the exercise of options. The Company recognized no share-based compensation expense during the nine-month period ended September 30, 2007, nor any income tax benefit. The total intrinsic value of options exercised during the nine-month period ended September 30, 2007 was $1.9 million. As of September 30, 2007, there was no unrecognized share-based compensation cost as all stock options were fully vested. Cash received from stock option exercises was $1.6 million during the nine-month period ended September 30, 2007.

The Company provides for income taxes under the liability method in accordance with SFAS No. 109, “Accounting for Income Taxes”. This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of differences between the tax basis of assets or liabilities and their carrying amounts in the consolidated financial statements. The Company provides a valuation allowance for deferred tax assets if it is more likely than not that these items will either expire before the Company is able to realize their benefit or if future deductibility is uncertain.

In June 2006, the FASB issued FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which is an interpretation of SFAS 109 “Accounting for Income Taxes”. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and also provides guidance on derecognizing, classification, interest and penalties, accounting in interim periods, disclosure and transition.

The Company adopted the provisions of FIN 48 on January 1, 2007. The implementation of FIN 48 did not result in any adjustment to the Company’s beginning tax positions. The Company continues to fully recognize its tax benefits which are offset by a valuation allowance to the extent that it is more likely than not that the deferred tax assets will not be realized. The Company does not expect any significant changes in its unrecognized tax benefits for the next twelve months.

The Company files a consolidated U.S. federal income tax return and consolidated and separate company income tax returns in many U.S. state jurisdictions. Generally, the Company is no longer subject to federal and state income tax examinations by U.S. tax authorities for years prior to 2003. The Internal Revenue Service has commenced an examination of the Company’s U.S. income tax return for 2005. The Company anticipates that any adjustments as a result of this examination would not be material to its financial position.

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The Company recognizes any interest accrued related to unrecognized tax benefits in interest expense and penalties in operating expenses. During the nine-month periods ended September 30, 2007 and 2006, there was no such interest or penalties.

The provision for income taxes reflects the Company’s estimate of the effective tax rate expected to be applicable for the full fiscal year. The Company’s effective tax rates for the three-month period and nine-month periods ended September 30, 2007 were 13.4% and 14.7%, respectively, due to the utilization of net operating loss carry-forwards. The Company evaluates this estimate each quarter based on the Company’s estimated tax expense for the year.

The Company computes net income (loss) per share in accordance with SFAS No. 128, “Earnings Per Share” (“SFAS 128”). Under the provisions of SFAS 128, basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding. Diluted net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares and dilutive common share equivalents then outstanding. Common share equivalents consist of the incremental common shares issuable upon the exercise of stock options and the impact of unvested restricted stock grants.

The following table reconciles the numerator and denominator used to calculate diluted net income per share (in thousands):

For the nine-month periods ended September 30, 2007 and 2006, there were 3,883,644 and 4,011,133, respectively, potential common shares outstanding that were excluded from the diluted net income per share calculation because their effect would have been anti-dilutive.

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The Company operates in a single industry acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract. Accordingly, the Company’s business is classified as a single reportable segment.

The following table presents net product revenues by product category (in thousands):

In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“SFAS 157”). The statement provides guidance for using fair value to measure assets and liabilities. SFAS 157 references fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts. The statement applies whenever other standards require or permit assets or liabilities to be measured at fair value. SFAS 157 does not expand the use of fair value to any new circumstances. It is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company does not believe adoption of SFAS 157 will have a material impact on the Company’s consolidated financial statements.

In February 2007, the FASB issued Statement No. 159, “Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits entities to choose, at specified election dates, to measure eligible items at fair value (the “Fair Value Option”). Unrealized gains and losses on items for which the Fair Value Option has been elected are reported in earnings. The Fair Value Option is applied instrument by instrument (with certain exceptions), is irrevocable (unless a new election date occurs) and is applied only to an entire instrument. The effect of the first remeasurement to fair value is reported as a cumulative-effect adjustment to the opening balance of retained earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company does not believe adoption of SFAS 159 will have a material impact on the Company’s consolidated financial statements.

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

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are subject to risks and uncertainties, including those set forth under “Part I. Item 1A. Risk Factors” below and “Cautionary Statement” included in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report, that could cause actual results to differ materially from historical or anticipated results. The following discussion should be read in conjunction with our Condensed Consolidated Financial Statements and notes thereto included elsewhere in this report.

Overview

We are a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract. Our strategy is to:

Our current products demonstrate our ability to execute this strategy. As of September 30, 2007, our primary products were:

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We currently market our products, and intend, if approved by the FDA, to market future products to U.S. gastroenterologists through our own direct sales force. We enter into distribution relationships outside the United States and in markets where a larger sales organization is appropriate. Currently, our sales and marketing staff consists of approximately 150 people.

We generate revenue primarily by selling our products, namely prescription drugs, to pharmaceutical wholesalers. These direct customers resell and distribute our products to and through pharmacies to patients who have had our products prescribed by doctors. Because demand for our products originates with doctors, our sales force calls on high-prescribing specialists, primarily gastroenterologists, and we monitor new and total prescriptions for our products as key performance indicators for our business.

Prescriptions result in our products being used by patients, requiring our direct customers to purchase more products to replenish their inventory. However, our revenue might fluctuate from quarter to quarter due to other factors, such as increased buying by wholesalers in anticipation of a price increase or because of the introduction of new products. Revenue could be less than anticipated in subsequent quarters as wholesalers’ increased inventory is used up. For example, wholesalers made initial stocking purchases of Osmoprep when it was launched in the second quarter of 2006 and MoviPrep when it was launched in the third quarter of 2006. Also, 2006 Colazal revenue was lower than in the comparable periods in 2005 even though prescriptions increased in 2006.

In December 2000, we established our own field sales force to market Colazal in the United States. Currently, this sales force has approximately 100 sales representatives in the field. Although the creation of an independent sales organization involved substantial costs, we believe that the financial returns from our direct product sales have been and will continue to be more favorable to us than those from the indirect sale of products through marketing partners. In addition, we intend to enter into distribution relationships outside the United States and in markets where a larger sales organization is appropriate.

Consistent with this strategy, in September 2007 we entered into a multi–year co–promotion agreement with Eisai Inc. relating to COLAZAL® (balsalazide disodium) Capsules 750 mg. This agreement also includes balsalazide disodium tablets 1100 mg, if and when approved by the FDA. Under the terms of the agreement Eisai’s primary care and specialty sales forces will promote these products to select primary care physicians and gastroenterologists. Payment to Eisai will be based on a split of profit generated by prescriptions above a predetermined baseline. We believe Eisai’s primary care sales effort should capture additional business that is available outside the scope of our gastroenterologist-focused sales strategy, and therefore increase product revenue without incurring significant incremental expenses. Approximately 600 of Eisai’s sales representatives will begin promoting COLAZAL in late October 2007.

Our primary product candidates under development and their status are as follows:

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Critical Accounting Policies

In our Annual Report on Form 10-K for the fiscal year ended December 31, 2006, we identified our most critical accounting policies and estimates upon which our financial status depends as those relating to revenue recognition, allowance for product returns, allowance for rebates, chargebacks and coupons, inventory, intangible assets and goodwill, allowance for uncollectible accounts, investments, and research and development costs. We reviewed our policies and determined that those policies remained our most critical accounting policies for the nine-month period ended September 30, 2007. We did not make any changes in those policies during the quarter.

We recognize revenue in accordance with the SEC’s Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” as amended by Staff Accounting Bulletin No. 104 (together, “SAB 101”), and FASB Statement No. 48, “Revenue Recognition When Right of Return Exists” (“SFAS 48”). SAB 101 states that revenue should not be recognized until it is realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: (a) persuasive evidence of an arrangement exists; (b) delivery has occurred or services have been rendered; (c) the seller’s price to the buyer is fixed or determinable; and (d) collectibility is reasonably assured.

SFAS 48 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if (1) the seller’s price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product, (3) the buyer’s obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has economic substance apart from that provided by the seller, (5) the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be reasonably estimated. We recognize revenues for product sales at the time title and risk of loss are transferred to the customer, and the other criteria of SAB 101 and SFAS 48 are satisfied, which is generally at the time products are shipped. Our net product revenue represents our total revenues less allowances for customer credits, including estimated discounts, rebates, chargebacks and product returns.

We establish allowances for estimated rebates, chargebacks and product returns based on numerous quantitative and qualitative factors, including:

In our analyses, we utilize prescription data purchased from a third-party data provider to develop estimates of historical inventory channel pull-through. We utilize an internal analysis to compare historical net product

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shipments to estimated historical prescriptions written. Based on that analysis, we develop an estimate of the quantity of product in the channel which may be subject to various rebate, chargeback and product return exposures. At least quarterly for each product line, we prepare an internal estimate of ending inventory units in the distribution channel by adding estimated inventory in the channel at the beginning of the period, plus net product shipments for the period, less estimated prescriptions written for the period. Based on that analysis, we develop an estimate of the quantity of product in the channel that might be subject to various rebate, chargeback and product return exposures. This is done for each product line by applying a rate of historical activity for rebates, chargebacks and product returns, adjusted for relevant quantitative and qualitative factors discussed above, to the potential exposed product estimated to be in the distribution channel. Internal forecasts that are utilized to calculate the estimated number of months in the channel are regularly adjusted based on input from members of our sales, marketing and operations groups. The adjusted forecasts take into account numerous factors including, but not limited to, new product introductions, direct communication with customers and potential product expiry issues.

Consistent with industry practice, we periodically offer promotional discounts to our existing customer base. These discounts are calculated as a percentage of the current published list price and are treated as off-invoice allowances. Accordingly, we record the discounts as a reduction of revenue in the period that the program is offered. In addition to promotional discounts, at the time that we implement a price increase, we generally offer our existing customer base an opportunity to purchase a limited quantity of product at the previous list price. Shipments resulting from these programs generally are not in excess of ordinary levels, therefore, we recognize the related revenue upon shipment and include the shipments in estimating our various product-related allowances. In the event we determine that these shipments represent purchases of inventory in excess of ordinary levels for a given wholesaler, the potential impact on product returns exposure would be specifically evaluated and reflected as a reduction in revenue at the time of such shipments

Allowances for estimated rebates and chargebacks were $10.4 million and $6.0 million as of September 30, 2007 and 2006, respectively. These allowances reflect an estimate of our liability for items such as rebates due to various governmental organizations under the Medicare/Medicaid regulations, rebates due to managed care organizations under specific contracts and chargebacks due to various organizations purchasing our products through federal contracts and/or group purchasing agreements. We estimate our liability for rebates and chargebacks at each reporting period based on a methodology of applying the relevant quantitative and qualitative assumptions discussed above. Due to the subjectivity of our accrual estimates for rebates and chargebacks, we prepare various sensitivity analyses to ensure our final estimate is within a reasonable range and also review prior period activity to ensure that our methodology continues to be appropriate. Had a change in one or more variables in the analyses (utilization rates, contract modifications, etc.) resulted in an additional percentage point change in the trailing average of estimated chargeback and rebate activity in 2006, we would have recorded an adjustment to revenues of approximately $2.1 million, or 1.0%, for the year.

Allowances for product returns were $7.9 million and $4.3 million as of September 30, 2007 and 2006, respectively. These allowances reflect an estimate of our liability for product that may be returned by the original purchaser in accordance with our stated return policy. We estimate our liability for product returns at each reporting period based on historical return rates, the estimated inventory in the channel, and the other factors discussed above. Due to the subjectivity of our accrual estimates for product returns, we prepare various sensitivity analyses to ensure our final estimate is within a reasonable range and also review prior period activity to ensure that our methodology is still reasonable. A change in assumptions that resulted in a 10% change in forecast return rates would have resulted in a change in total product returns liability at December 31, 2006 of approximately $0.6 million and a corresponding change in 2006 net product revenue of less than 1%.

For the nine-month periods ended September 30, 2007 and 2006, our absolute exposure for rebates, chargebacks and product returns has grown primarily as a result of increased sales of our existing products, the approval of new products and the acquisition of products. Accordingly, reductions to revenue and corresponding increases to allowance accounts have likewise increased. The estimated exposure to these revenue-reducing items as a percentage of gross product revenue in the nine-month periods ended September 30, 2007 and 2006 was 9.7% and 9.0% for rebates, chargebacks and discounts and was 3.2% and 3.6%% for product returns, respectively.

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Results of Operations

Three-month and Nine-month Periods Ended September 30, 2007 and 2006

Revenues

The following table summarizes net product revenues for the three-month and nine-month periods ended September 30, 2007 and 2006:

Net product revenues for the three-month period ended September 30, 2007 were $67.4 million, compared to $51.2 million for the corresponding three-month period in 2006, a 32% increase. This net product revenue increase was due to increased sales of Colazal and Xifaxan, a full quarter of sales for MoviPrep, which was launched during the fourth quarter of 2006, a full quarter of sales for Pepcid, which was acquired and launched during February 2007, and increased sales from OsmoPrep which was launched in June 2006.

Net product revenues for the nine-month period ended September 30, 2007 were $193.8 million, compared to $145.9 million for the corresponding nine-month period in 2006, a 33% increase. This net product revenue increase was due to increased sales of Colazal and Xifaxan, a full nine months of sales for MoviPrep, which was launched during the fourth quarter of 2006, a full nine months of sales for OsmoPrep, which was launched in June 2006, and twenty-nine weeks of sales for Pepcid, which was acquired during February 2007. These increases were partially offset by a decrease in revenue from sales of Visicol. As planned, Colazal’s contribution as a percentage of total product revenue continued to decrease during the nine-month period ended September 30, 2007 compared to the nine-month period ended September 30, 2006 due to the expansion of our product portfolio with the launch of our bowel cleansing products, the acquisition of Pepcid, and the continued increase in Xifaxan sales.

Revenues from collaborative agreements for the nine-month period ended September 30, 2007 consists of an upfront payment of $1.5 million upon execution of an agreement to license exclusive rights to market DIACOL™ in 28 territories in Europe to Dr. Falk Pharma GmbH of Freiberg, Germany; and a $1.0 million milestone payment from Zeria Pharmaceutical Co., Ltd. of Tokyo, Japan as a result of their receipt of marketing approval of Visiclear® Tablets for colon cleansing in Japan. Revenues from collaborative agreements for the three-month period and nine-month period ended September 30, 2007 include $12,000 in royalty income from the sale of Visiclear®. We did not receive any revenues from collaborative agreements during the three-month period or nine-month period ended September 30, 2006.

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Costs and Expenses

Costs and expenses for the three-month periods ended September 30, 2007 and 2006 were $52.4 million and $44.8 million, respectively. Costs and expenses for the nine-month periods ended September 30, 2007 and 2006 were $167.0 million and $129.4 million, respectively. Higher operating expenses in absolute terms were due primarily to increased research and development activities; increased cost of products sold related to the corresponding increase in product revenue; increased selling, general and administrative expenses due to the expansion of our infrastructure; costs related to OsmoPrep and MoviPrep, which were launched during the second and fourth quarters of 2006, respectively; and the acquisition of Pepcid during February 2007.

Cost of Products Sold

Cost of products sold for the three-month periods ended September 30, 2007 and 2006 were $13.1 million and $11.7, respectively. Cost of products sold for the nine-month periods ended September 30, 2007 and 2006 were $38.1 million and $29.2 million, respectively. The increase in cost of products sold for the three-month and nine-month periods ended September 30, 2007 compared to the three-month and nine-month periods ended September 30, 2006 was due primarily to increased sales of Colazal and Xifaxan, a full nine months of sales for OsmoPrep and MoviPrep which were launched during the second and fourth quarters of 2006, respectively, and the acquisition of Pepcid during February 2007. Gross margin on total product revenue, excluding $2.3 million and $1.3 million in amortization of product rights and intangibles for the three-month periods ended September 30, 2007 and 2006, respectively, was 80.6% for the three-month period ended September 30, 2007 compared to 77.2% for the three-month period ended September 30, 2006. Lower margin for the three-month period ended September 30, 2006 was primarily due to increased reserves and the launch of MoviPrep. Gross margin on total product revenue, excluding $6.4 million and $3.6 million in amortization of product rights and intangibles for the nine-month periods ended September 30, 2007 and 2006, respectively, was 80.3% for the nine-month period ended September 30, 2007 compared to 80.0% for the nine-month period ended September 30, 2006.

Fees and Costs Related to License Agreements

Fees and costs related to license agreements for the three-month period and nine-month period ended September 30, 2007 relates to payments made to Cedars-Sinai Medical Center under the terms of the related license agreements and payments of $1.1 million to Clinical Development Capital, the successor licensor of DIACOL™ and Visiclear®, for its share of the German and Japanese milestone revenue of $2.5 million recognized during the nine-month period ended September 30, 2007.

Amortization of Product Rights and Intangible Assets

Amortization of product rights and intangible assets consists of amortization of the costs of license agreements, product rights and other identifiable intangible assets, which result from product and business acquisitions. The increase in this non-cash expense for the three-month period and nine-month period ended September 30, 2007 compared to the corresponding periods in 2006 is primarily a result of the acquisition of Pepcid in February 2007.

Research and Development

Research and development expenses for the three-month periods ended September 30, 2007 and 2006 were $16.0 million and $10.3 million, respectively. Research and development expenses for the nine-month periods ended September 30, 2007 and 2006 were $56.8 million and $32.1 million, respectively. The increase in research and development expenses was due primarily to the expansion of our Colazal life cycle management program through initiatives to strengthen and support our 1100mg balsalazide tablet submission completed in July 2007, studies of granulated mesalamine, and ongoing late-stage studies to expand the Xifaxan label. To date, we have incurred research and development expenditures of approximately $60.4 million for balsalazide, $66.6 million for rifaximin and $24.1 million for granulated mesalamine. Due to the risks and uncertainties of the drug development and regulatory approval process, research and development expenditures are difficult to forecast and subject to unexpected increases. As disclosed in Note 2 in the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2006, due to increased development activities and the way in

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which many of our long-term development contracts are structured, we have refined our process of estimating development activities to more closely align expenses with the level of progress achieved. We have recently substantially completed several clinical trials in our development programs and expect research and development costs to be lower for the remaining three months of 2007 compared to the first nine months of 2007. However, in future years we expect research and development costs to increase in absolute terms as we pursue additional indications and formulations for balsalazide and rifaximin, and continue to develop granulated mesalamine, and if and when we acquire new products.

Selling, General and Administrative

Selling, general and administrative expenses for the three-month periods ended September 30, 2007 and 2006 were $20.9 million and $20.7 million, respectively. Selling, general and administrative expenses for the nine-month periods ended September 30, 2007 and 2006 were $64.1 million and $63.5 million, respectively. These slight increases in absolute dollars were primarily due to the expansion of our infrastructure related to OsmoPrep and MoviPrep which were launched during the second and fourth quarters of 2006, respectively, and the acquisition of Pepcid during February 2007, offset by reduced spending on the launch of OsmoPrep.

Interest and Other Income, Net

Interest and other income, net for the three-month periods ended September 30, 2007 and 2006 was $1.4 million and $0.8 million, respectively. Interest and other income, net for the nine-month periods ended September 30, 2007 and 2006 was $2.6 million and $2.5 million, respectively. Interest and other income, net for the three-month period and nine-month period ended September 30, 2007 includes $1.2 million received as final settlement of a legal matter initiated by InKine prior to our acquisition of InKine. This increase in interest and other income, net is offset by a decrease in interest and other income, net primarily due to interest expense of $0.2 million and $0.9 million incurred in the three-month and nine-month periods ended September 30, 2007 on our credit facility discussed below.

Realized Loss on Foreign Currency Translation

During the nine-months ended September 30, 2006, we recorded a non-cash charge under other comprehensive loss related to deferred revenue from the Shire Pharmaceuticals Group plc purchase from us in 2000 of exclusive rights to balsalazide for northern Europe. We expect no further charges or income from Shire, nor related payments to Biorex, our licensor for balsalazide.

Provision for Income Tax

Income tax expense for the three-month periods ended September 30, 2007 and 2006 was $2.2 million and $0.2 million, respectively. Income tax expense for the nine-month periods ended September 30, 2007 and 2006 was $4.7 million and $0.7 million, respectively. Our effective tax rate was 13.4% and 14.7%, respectively for the three-month and nine-month periods ended September 30, 2007, and 2.8% and 3.6% for the comparable periods in 2006. The increased effective tax rate in 2007 is primarily due to the increased utilization of acquired net operating loss carry-forwards in 2007 compared to 2006.

Net Income

Net income for the three-month periods ended September 30, 2007 and 2006 was $14.2 million and $7.0 million, respectively. Net income for the nine-month periods ended September 30, 2007 and 2006 was $27.3 million and $17.6 million, respectively.

Liquidity and Capital Resources

From inception until first achieving profitability in the third quarter of 2004, we financed product development, operations and capital expenditures primarily from public and private sales of equity securities and from funding arrangements with collaborative partners. Since launching Colazal in January 2001, net product revenue has been a growing source of cash, a trend that we expect to continue. As of September 30, 2007, we had approximately $70.2 million in cash, cash equivalents and investments, compared to $76.5 million as of December 31, 2006.

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Cash provided by operating activities was $36.0 million for the nine-month period ended September 30, 2007, compared with $5.3 million in the corresponding period in 2006. The increase in cash provided by operations during the nine-month period ended September 30, 2007 was primarily due to increased net income.

Cash used by investing activities was $59.2 million for the nine-month period ended September 30, 2007, compared with $12.2 million in the corresponding nine-month period in 2006. Cash used in investing activities for the nine-month period ended September 30, 2007 was primarily related to the acquisition of Pepcid in February 2007. Cash used in investing activities for the nine-month period ended September 30, 2006 was primarily related to a $15.1 million milestone payment made to Norgine in August 2006 upon the receipt of marketing approval from the FDA for MoviPrep.

Cash provided by financing activities was $16.9 million for the nine-month period ended September 30, 2007, compared to $2.4 million for the corresponding nine-month period in 2006. The increase was a result of borrowings during the nine-month period ended September 30, 2007 under our credit facility entered into in February 2007.

As of September 30, 2007, we had non-cancelable purchase order commitments for inventory purchases of approximately $14.1 million over six months. We anticipate significant expenditures related to our on-going sales, marketing, product launch and development efforts associated with Colazal, Xifaxan, Visicol, Azasan, Anusol-HC, Proctocort, OsmoPrep, MoviPrep, Pepcid Oral Suspension, and granulated mesalamine. To the extent we acquire rights to additional products, we will incur additional expenditures.

In February 2007, we entered into a $100.0 million revolving credit facility that matures in February 2012. At September 30, 2007, $15.0 million was outstanding under the credit facility. Virtually all of our assets and those of our subsidiaries secure our obligations under the credit facility. The credit facility may be used for working capital, capital expenditures, acquisitions and other general corporate purposes.

The credit facility bears interest at a rate per annum equal to, at our option, either (a) a base rate equal to the higher of (i) the Federal Funds Rate plus 1/2 of 1% and (ii) the Bank of America prime rate, or (b) a Eurodollar rate (based on LIBOR), plus, in each case, a percentage rate that fluctuates, based on the ratio of our funded debt to EBITDA (income before income taxes plus interest expense and depreciation and amortization), from 0.00% to 0.75% for base rate borrowings and 1.00% to 1.75% for Eurodollar rate borrowings. The rate as of September 30, 2007 on our outstanding borrowings was 6.5%.

The credit facility contains various representations, warranties and affirmative, negative and financial covenants customary for financings of this type. The financial covenants include a leverage test and a fixed charge test. We were in compliance with these covenants at September 30, 2007.

As of September 30, 2007, we had an accumulated deficit of $85.7 million. We believe cash flow from operations and our cash and cash equivalent balances, together with amounts available under our credit facility, should be sufficient to satisfy our cash requirements for the foreseeable future. However, our actual cash needs might vary materially from those now planned because of a number of factors, including the status of competitive products, including potential generics, whether we acquire rights to additional products, our success selling products, the results of research and development activities, FDA and foreign regulatory processes, establishment of, success with, and change in collaborative relationships, and technological advances by us and other pharmaceutical companies. We might seek additional debt or equity financing or both to fund our operations or acquisitions. If we incur debt, we might be restricted in our ability to raise additional capital and might be subject to financial and restrictive covenants. If we issued additional equity, our stockholders could suffer dilution. We might also enter into additional collaborative arrangements that could provide us with additional funding in the form of equity, debt, licensing, milestone and/or royalty payments. We might not be able to enter into such arrangements or raise any additional funds on terms favorable to us or at all.

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Cautionary Statement

We operate in a highly competitive environment that involves a number of risks, some of which are beyond our control. The following statement highlights some of these risks. For more detail, see “Part I. Item 1A. Risk Factors” below.

Statements contained in this Form 10-Q that are not historical facts are or might constitute forward-looking statements under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Although we believe the expectations reflected in such forward-looking statements are based on reasonable assumptions, our expectations might not be attained. Forward-looking statements involve known and unknown risks that could cause actual results to differ materially from expected results. Factors that could cause actual results to differ materially from our expectations expressed in the report include, among others: intense competition, including potential generics; the unpredictability of the duration and results of regulatory review of New Drug Applications and Investigational New Drug Applications; management of growth; the high cost and uncertainty of the research, clinical trials and other development activities involving pharmaceutical products; our dependence on our first 10 pharmaceutical products, particularly Colazal and Xifaxan, and the uncertainty of market acceptance of our products; risks associated with acquisitions; the uncertainty of obtaining, and our dependence on, third parties to manufacture and sell our products; the possible impairment of, or inability to obtain, intellectual property rights and the costs of obtaining such rights from third parties; and results of future litigation and other risk factors detailed from time to time in our other SEC filings.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Although as of September 30, 2007 we had $15.0 million outstanding under our credit facility, our cash and accounts receivable balances totaled $141.6 million, so we face no material interest rate exposure. Our purchases of raw materials are denominated in Euros. Translation into our reporting currency, the U.S. dollar, has not historically had a material impact on our financial position. Additionally, our net assets denominated in currencies other than the U.S. dollar have not historically exposed us to material risk associated with fluctuations in currency rates. Given these facts, we have not considered it necessary to use foreign currency contracts or other derivative instruments to manage changes in currency rates. However, these circumstances may change.

Item 4. Controls and Procedures

Disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) are designed only to provide reasonable assurance that information to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and accumulated and communicated to the issuer’s management, including its principal financial officer, or persons performing similar functions, as appropriate to allow timely decision regarding required disclosure. As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer and Senior VP, Finance and Administration and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, our President and Chief Executive Officer and Senior VP, Finance and Administration and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to provide the reasonable assurance discussed above.

There was no change in our internal control over financial reporting in the quarter ended September 30, 2007 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1A. Risk Factors

This report contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed in this report. Factors that could cause or contribute to these differences include, but are not limited to, those discussed below and elsewhere in this report and in any documents incorporated in this report by reference.

If any of the following risks, or other risks not presently known to us or that we currently believe to not be significant, develop into actual events, then our business, financial condition, results of operations or prospects could be materially adversely affected. If that happens, the market price of our common stock could decline, and stockholders may lose all or part of their investment.

Future sales of Colazal, Xifaxan and our other marketed products might be less than expected.

We currently market and sell nine primary products, with a majority of our historical revenue derived from sales of Colazal. We expect Xifaxan, which was launched in mid-2004, OsmoPrep, which we acquired in connection with our acquisition of InKine in September 2005, and MoviPrep, which we acquired from Norgine in December 2005, to be a growing and significant source of revenue in the future. If sales of our marketed products decline or if we experience product returns significantly in excess of estimated amounts recorded, particularly Colazal, Xifaxan, OsmoPrep and MoviPrep, it would have a material adverse effect on our business, financial condition and results of operations.

The degree of market acceptance of our products among physicians, patients, healthcare payors and the medical community will depend upon a number of factors including:

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Our ability to increase revenue in the future will depend in part on our success in in-licensing or acquiring additional pharmaceutical products.

We currently intend to in-license or acquire pharmaceutical products, like Sanvar and Metaclopramide - Zydis®, that have been developed beyond the initial discovery phase and for which late-stage human clinical data is already available, or like Pepcid Oral Suspension, that have already received regulatory approval. These kinds of pharmaceutical products might not be available to us on attractive terms or at all. To the extent we acquire rights to additional products, we might incur significant additional expense in connection with the development and, if approved by the FDA, marketing of these products. In addition, our license agreement with Alfa Wassermann provides that we may not promote, distribute or sell any antibiotic product that competes with Xifaxan in the United States and Canada until mid-2009, thereby limiting our ability to acquire, develop or market other antibiotic products.

Regulatory approval of our product candidates is time-consuming, expensive and uncertain, and could result in unexpectedly high expenses and delay our ability to sell our products.

Development, manufacture and marketing of our products are subject to extensive regulation by governmental authorities in the United States and other countries. This regulation could require us to incur significant unexpected expenses or delay or limit our ability to sell our product candidates, including specifically Sanvar, our product candidate that is farthest along in the regulatory approval process. As an example, FDA approval of MoviPrep was delayed from May until August 2006 to resolve regulatory issues.

Our clinical studies might be delayed or halted, or additional studies might be required, for various reasons, including:

If regulatory approval of any product is granted, it will be limited to those indications for which the product has been shown to be safe and effective, as demonstrated to the FDA’s satisfaction through clinical studies. We are developing granulated mesalamine as a treatment for ulcerative colitis and Sanvar as a treatment for acute esophageal variceal bleeding, as well as studying Xifaxan for other indications. We might not ever receive FDA approval for these compounds in these indications, and without FDA approval, we cannot market or sell these compounds for use in these indications.

Approval might entail ongoing requirements for post-marketing studies. Even if regulatory approval is obtained, such as with Colazal, Xifaxan Visicol, OsmoPrep, and MoviPrep, labeling and promotional activities are subject to continual scrutiny by the FDA and state regulatory agencies and, in some circumstances, the Federal Trade Commission. FDA enforcement policy prohibits the marketing of approved products for unapproved, or off-label, uses. These regulations and the FDA’s interpretation of them might impair our ability to effectively market our products.

    We and our third-party manufacturers are also required to comply with the applicable FDA current Good Manufacturing Practices, or cGMP, regulations, which include requirements relating to quality control and quality assurance, as well as the corresponding maintenance of records and documentation. Further, manufacturing facilities must be approved by the FDA before they can be used to manufacture our products, and they are subject to additional FDA inspection. If we fail to comply with any of the FDA’s continuing regulations, we could be subject to reputational harm and sanctions, including:

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In addition, identification of side effects after a drug is on the market or the occurrence of manufacturing problems could cause subsequent withdrawal of approval, reformulation of the drug, additional testing or changes in labeling of the product.

Our intellectual property rights might not afford us with meaningful protection.

Our intellectual property rights with respect to our products might not afford us with meaningful protection from generic and other competition. In addition, because our strategy is to in-license or acquire pharmaceutical products which typically have been discovered and initially researched by others, future products might have limited or no remaining patent protection due to the time elapsed since their discovery. Competitors could also design around any of our intellectual property or otherwise design competitive products that do not infringe our intellectual property.

Upon patent expiration, our drugs could be subject to generic competition. That could negatively affect our pricing and sales volume. The patents for the balsalazide composition of matter and method of treating ulcerative colitis with balsalazide expired in July 2001 in the United States and our extension of the patents under the Waxman-Hatch Act expired in July 2006. Patent extensions for the composition of balsalazide in Italy and the United Kingdom also expired in July 2006. The patents for the rifaximin composition of matter (also covering a process of making rifaximin and using rifaximin to treat gastrointestinal infectious diseases) expired in May 2001 in the United States and Canada. We filed applications for patents for additional indications using balsalazide and related chemical substances. Applications for patents for additional compositions of rifaxamin and related chemical substances we filed together with Alfa Wasserman were issued in May 2006 and extend patent coverage to 2024. In January 2007, the United States Patent Office issued a patent covering composition of matter and kit claims for MoviPrep. The MoviPrep patent provides coverage to September 2024. The patents for Visicol and OsmoPrep will expire in 2013. Additional patent protection is being sought for OsmoPrep that, if approved, will expire in 2024. The patent for the treatment of the intestinal tract with the granulated mesalamine product will expire in 2018. The patent for Sanvar expired in 2006; however, we will be applying for patent Term Restoration. There is no assurance that these patents or the patent term restoration will be issued.

In 2000, the FDA granted us new chemical entity data exclusivity for balsalazide to July 2006. In August 2006, this data exclusivity was extended for six months, until January 8, 2007, based upon the FDA’s acceptance of the clinical package the Company submitted in response to a Written Request received from the FDA. Consequently, the FDA could not approve an application for a competitive version of balsalazide which relies upon data included in our NDA. Therefore, unless an applicant for a competitive version of balsalazide were to develop its own data supporting approval of our NDA, this data exclusivity had the effect of preventing generic competition for balsalazide until at least January 8, 2007. Because rifaximin is a new chemical entity, the FDA granted us similar five-year exclusivity for it when it was approved in May 2004. Therefore, rifaximin has data exclusivity through May 2009. Because Sanvar is a new chemical entity, the product is entitled to data exclusivity for five years beginning from the date of the approval of our NDA for Sanvar. In April 2005, the Company submitted a Citizen Petition and subsequent supplements in July and November 2006, respectively, requesting that the director of the Office of Generic Drugs of the Food and Drug Administration adopt guidance applicable to orally administered, locally-acting gastrointestinal drug products prior to approval of any generic versions of such drugs.

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Because Pepcid, Azasan, Anusol-HC and Proctocort are older products, there are no patents or data exclusivity rights available, subjecting us to greater risk of generic competition for those products.

We also rely on trade secrets, proprietary know-how and technological advances, which we seek to protect, in part, through confidentiality agreements with collaborative partners, employees and consultants. These agreements might be breached and we might not have adequate remedies for any breach. In addition, our trade secrets and proprietary know-how might otherwise become known or be independently developed by others.

Any litigation that we become involved in to enforce intellectual property rights could result in substantial cost to us. In addition, claims by others that we infringe their intellectual property could be costly. Our patent or other proprietary rights related to our products might conflict with the current or future intellectual property rights of others. Litigation or patent interference proceedings, either of which could result in substantial cost to us, might be necessary to defend any patents to which we have rights and our other proprietary rights or to determine the scope and validity of other parties’ proprietary rights. The defense of patent and intellectual property claims is both costly and time-consuming, even if the outcome is favorable. Any adverse outcome could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties, or require us to cease selling one or more of our products. We might not be able to obtain a license to any third-party technology that we require to conduct our business, or, if obtainable, that technology might not be available at a reasonable cost.

We could be exposed to significant product liability claims that could prevent or interfere with our product commercialization efforts.

We might be subjected to product liability claims that arise through the testing, manufacturing, marketing and sale of our products. These claims could expose us to significant liabilities that could prevent or interfere with our product commercialization efforts. Product liability claims could require us to spend significant time and money in litigation or to pay significant damages. Although we currently maintain liability coverage for both clinical trials and the commercialization of our products, it is possible that this coverage will be insufficient to satisfy any liabilities that may arise. In the future, we might not be able to obtain adequate coverage at an acceptable cost or might be unable to obtain adequate coverage at all.

Intense competition might render our products noncompetitive or obsolete.

Competition in our business is intense and characterized by extensive research efforts and rapid technological progress. Technological developments by competitors, regulatory approval for marketing competitive products, including potential generic or over-the-counter products, or superior marketing resources possessed by competitors could adversely affect the commercial potential of our products and could have a material adverse effect on our revenue and results of operations. We believe that there are numerous pharmaceutical and biotechnology companies, including large well-known pharmaceutical companies, as well as academic research groups throughout the world, engaged in research and development efforts with respect to pharmaceutical products targeted at gastrointestinal diseases and conditions addressed by our current and potential products. In particular, we are aware of products in research or development by competitors that address the diseases being targeted by our products. Developments by others might render our current and potential products obsolete or noncompetitive. Competitors might be able to complete the development and regulatory approval process sooner and, therefore, market their products earlier than we can.

Many of our competitors have substantially greater financial, marketing and personnel resources and development capabilities than we do. For example, many large, well-capitalized companies already offer products in the United States and Europe that target the indications for:

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Trilyte (Schwarz Pharma) and Fleets Phospho-Soda.

In addition, other products are in research or development by competitors that address the diseases and diagnostic procedures being targeted by these and our other products.

If third-party payors do not provide coverage or reimburse patients for our products, our ability to derive revenues will suffer.

Our success will depend in part on the extent to which government and health administration authorities, private health insurers and other third-party payors will pay for our products. Reimbursement for newly approved healthcare products is uncertain. In the United States and elsewhere, third-party payors, such as Medicaid, are increasingly challenging the prices charged for medical products and services. Government and other third-party payors are increasingly attempting to contain healthcare costs by limiting both coverage and the level of reimbursement for new therapeutic products. In the United States, a number of legislative and regulatory proposals aimed at changing the healthcare system have been proposed in recent years. In addition, an increasing emphasis on managed care in the United States has and will continue to increase pressure on pharmaceutical pricing. While we cannot predict whether legislative or regulatory proposals will be adopted or what effect those proposals or managed care efforts, including those relating to Medicaid payments, might have on our business, the announcement and/or adoption of such proposals or efforts could increase costs and reduce or eliminate profit margins. Third-party insurance coverage might not be available to patients for our products. If government and other third-party payors do not provide adequate coverage and reimbursement levels for our products, the market acceptance of these products might be reduced.

We are dependent on third parties to manufacture our products.

We have limited experience and capabilities in manufacturing pharmaceutical products. We do not generally expect to engage directly in the manufacturing of products, but instead contract with others for these services. A limited number of manufacturers exist which are capable of manufacturing our marketed products and our product candidates. We might fail to contract with the necessary manufacturers or might contract with manufacturers on terms that may not be entirely acceptable to us. Our manufacturing strategy presents the following risks:

Failure to manage growth could increase expenses faster than revenue.

We have experienced significant growth in the number of our employees and the scope of our operations in recent years and moved our headquarters in mid-2005. The number of employees has increased from approximately 25 on September 30, 2000 to approximately 240 on December 31, 2006. This growth placed, and continues to place,

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a significant strain on our management and operations. For example, in mid-2001 we doubled the size of our sales force, which we believe contributed to a temporary slowdown in the growth of sales, in part due to the distractions in training and territory realignment. Our continued growth might place further strains on our management and operations. Our ability to manage growth effectively will depend upon our ability to attract, hire and retain skilled employees, particularly in sales and marketing. Our success will also depend on the ability of our officers and key employees to continue to implement and improve our operational, management information and financial control systems and to expand, train and manage our employee base.

We rely on third parties for sales outside the United States and in other markets.

Our strategy for the sale of our products outside the United States and in markets where a larger sales organization is appropriate is to enter into distribution relationships. As a result, a portion of our revenue depends on relationships with third parties, including Eisai under our recent Colazal co-promote agreement. We hope for incremental revenue from the Eisai arrangement without significant expense, but this might not turn out to be the case. For example, a previous co-promotion arrangement with Altana was not successful, in that it generated expense without significant revenue. In addition, we have entered into a number of foreign distribution relationships, including the new French OsmoPrep license with Mayoly-Spindler, but might not receive significant or predictable royalty or milestone payments from them in the future. The amount and timing of resources to be devoted to distribution of our products outside the United States in most instances will not be within our control, which could limit sales. Upon the expiration or termination of these agreements, we might not be able to negotiate new distribution arrangements and any new arrangements might not be successful.

If we do not maintain our profitability or if we incur losses in the future, then the value of our common stock is likely to fall.

We have a significant accumulated deficit, and incurred losses and negative cash flow from operations in each year from our inception in 1992 through December 31, 2004. We achieved profitability and positive cash flow from operations for the years ended December 31, 2005 and 2006. We incurred a loss of $60.6 million on a GAAP basis for the year ended December 31, 2005, which includes a $74.0 million charge related to our September 2005 acquisition of InKine. Our continued success and growth is dependent on the marketing and sales of our current products and the sale of newly acquired or developed products. If we are unsuccessful in achieving increased revenues through the sale of our current products or through the sale of newly acquired or developed products, especially after incurring costs of the merger and increasing expenses as a result of the larger combined operations, we will not be able to operate profitably in the future. Our common stock is likely to decrease in value if we fail to maintain profitability or if the market believes that we are unable to maintain profitability.

Our results of operations might fluctuate from period to period, and a failure to meet the expectations of investors or the financial community at large could result in a decline in our stock price.

Our results of operations might fluctuate significantly on a quarterly and annual basis due to, among other factors:

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Our stock price is volatile.

Our stock price has been extremely volatile and might continue to be, making owning our stock risky. Between January 1, 2004 and September 30, 2007, the price of a share of our common stock varied from a low of $9.77 to a high of $24.38, as adjusted for the 3-for-2 stock split effected in July 2004.

The securities markets have experienced significant price and volume fluctuations unrelated to the performance of particular companies, including for example the approximate 4% single-day drop on February 27, 2007. In addition, the market prices of the common stock of many publicly traded pharmaceutical and biotechnology companies have in the past been and can in the future be expected to be especially volatile. Announcements of prescription trends, technological innovations or new products by us or our competitors, developments or disputes concerning proprietary rights, publicity regarding actual or potential medical results relating to products under development by us or our competitors, regulatory developments in both the United States and other countries, public concern as to the safety of pharmaceutical products, and economic and other external factors, as well as period-to-period fluctuations in financial results, might have a significant impact on the market price of our common stock.

Antitakeover provisions could discourage a takeover that stockholders consider to be in their best interests or prevent the removal of our current directors and management.

We have adopted a number of provisions that could have antitakeover effects or prevent the removal of our current directors and management. We have adopted a stockholder protection rights plan, commonly referred to as a poison pill. The rights plan is intended to deter an attempt to acquire us in a manner or on terms not approved by our board of directors. The rights plan will not prevent an acquisition that is approved by our board of directors. We believe our rights plan assisted in our successful defense against a hostile takeover bid earlier in 2003. Our charter authorizes our board of directors to determine the terms of up to 5,000,000 shares of undesignated preferred stock and issue them without stockholder approval. The issuance of preferred stock could make it more difficult for a third party to acquire, or discourage a third party from acquiring, voting control in order to remove our current directors and management. Our bylaws also eliminate the ability of the stockholders to act by written consent without a meeting or make proposals at stockholder meetings without giving us advance written notice, which could hinder the ability of stockholders to quickly take action that might be opposed by management. These provisions could make more difficult the removal of current directors and management or a takeover of Salix, even if these events could be beneficial to stockholders. These provisions could also limit the price that investors might be willing to pay for our common stock.

Item 5.      Exhibits

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* The registrant has requested confidential treatment with respect to certain provisions of this exhibit. Such portions have been omitted from this exhibit and have been filed separately with the United States Securities and Exchange Commission.

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SIGNATURES

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

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