Summary of QUESTCOR PHARMACEUTICALS INC

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Except for the historical information contained herein, the following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this section, as well as those discussed in our Annual Report on Form 10-K for the year ended December 31, 2008, including Item 1 "Business of Questcor," and Item 1A "Risk Factors," as well as factors discussed in any documents incorporated by reference herein or therein. Whenever used in this Quarterly Report, the terms "Questcor," "Company," "we," "our," "ours," and "us" refer to Questcor Pharmaceuticals, Inc. and its consolidated subsidiary.
Overview
We market H.P. Acthar Gel (repository corticotropin injection), an injectable drug that is approved for the treatment of certain disorders with an inflammatory component, including the treatment of exacerbations associated with multiple sclerosis ("MS"), and the treatment of nephrotic syndrome. H.P. Acthar Gel ("Acthar") is not indicated for, but is also used in treating patients with infantile spasms ("IS"), a rare form of refractory childhood epilepsy, and opsoclonus myoclonus syndrome, a rare autoimmune-related childhood neurological disorder. From time to time we receive prescriptions for Acthar for other conditions. We also market Doral (quazepam), which is indicated for the treatment of insomnia characterized by difficulty in falling asleep, frequent nocturnal awakenings, and/or early morning awakenings.
In August 2007, we announced our Acthar-centric business strategy, which included a new pricing level for Acthar effective August 27, 2007. The strategy was adopted in order to best position Acthar to benefit patients, advance our product development programs and ensure that the company become economically viable. Since the adoption of the strategy, we have expanded our sponsorship of Acthar patient assistance and co-pay assistance programs, which provide an important safety net for uninsured and under-insured patients using Acthar, and have established a group of representatives and medical science liaisons to work with healthcare providers who administer Acthar. We continue to support the Acthar patient assistance programs, administered by the National Organization for Rare Disorders ("NORD"). These and other patient-oriented support programs have now provided free drug with commercial value of over $37 million to patients since September 2007. In addition to the free drug program, significant financial support continues to be provided to needy patients through NORD's co-pay assistance programs that we sponsor. Because we are now economically viable, we have significantly improved our ability to maintain the long-term availability of Acthar and fund important medical research projects that have the goal of improving patient care, despite the deterioration of the current U.S. economic environment. We have been working closely with the neurology community to identify promising new projects for which we can provide needed financial support. We are providing support to leading researchers in their efforts to better understand the underlying disease processes that cause infantile spasms, a subject for which there has been little research funding in recent decades, as well as to better understand the drug's mechanisms of action.
Acthar is currently approved in the U.S. for the treatment of exacerbations associated with MS, nephrotic syndrome and many other conditions with an inflammatory component. Pursuant to guidelines published by the American Academy of Neurology and the Child Neurology Society, many child neurologists use Acthar to treat infants afflicted with IS even though it is not approved for this indication. In March 2009, we submitted our supplemental New Drug Application ("sNDA") to the U.S. Food and Drug Administration ("FDA") to add the treatment of infantile spasms to the list of approved indications on the Acthar label. In May 2009, we were informed by the FDA that in order for our sNDA to be considered a complete submission, we must perform additional statistical analyses relating to data from one secondary study within the filing and provide the data to the FDA. On October 15, 2009 we resubmitted our sNDA to the FDA. The resubmission included additional statistical analyses requested by the FDA. If the sNDA is approved, such approval could require various actions by Questcor, including modification of the existing Acthar label and/or the adoption of FDA-mandated risk evaluation and mitigation strategies. Previously, the FDA granted Orphan Designation to the active ingredient in Acthar for the treatment of IS. As a result of this Orphan Designation, if we are successful in obtaining FDA approval for the IS indication, we believe we will also qualify for a seven-year exclusivity period during which the FDA is prohibited from approving any other adrenocorticotropic hormone (ACTH) formulation for IS unless the other formulation is demonstrated to be

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clinically superior to Acthar or is considered by the FDA to have an active ingredient that is different from the active ingredient of Acthar.
In the first quarter of 2009, we completed the initial phase of our MS sales force expansion plan, hiring and training our sales force as well as completing all territorial realignments. A second phase of our sales force expansion was completed in the third quarter of 2009. Our expanded sales force of 38 representatives allows us to build upon continued positive growth trends in prescriptions of Acthar for the treatment of exacerbations associated with MS, an indication for which Acthar is already approved.
We are also in discussions with experts in other disease states with high unmet medical needs for which there is a potential therapeutic role for Acthar. As a result of these initiatives, we are currently funding 25 pre-clinical and clinical studies. Many of these studies are examining the use of Acthar in the treatment of nephrotic syndrome, a disorder involving deterioration of kidney function that often leads to the need for renal dialysis or transplant. We are also now beginning to fund exploratory pre-clinical research evaluating whether Acthar could have potential value in the management of amyotrophic lateral sclerosis (also known as ALS or Lou Gehrig's Disease) and traumatic brain injury.
From January 1, 2009 through November 9, 2009, we have repurchased a total of 2.4 million shares of our common stock for $11.2 million under our stock repurchase plan, at an average price of $4.70 per share. In May 2009, our board of directors increased our common share repurchase program authorization by an additional 6.5 million shares. As of November 9, 2009, there are a total of 7.6 million shares authorized remaining under the revised stock repurchase plan. Since the initiation of this program in early 2008, we have returned approximately $57 million to shareholders through our common and preferred stock buyback efforts.
Our results of operations may vary significantly from quarter to quarter depending on, among other factors, demand for our products by patients, inventory levels of our products held by third parties, the amount of Medicaid rebates on our products dispensed to Medicaid eligible patients, the amount of chargebacks on the sale of our products by our specialty distributor to government-supported entities, the availability of finished goods from our sole-source manufacturers, the timing of certain expenses, the introduction of a competitive product, and our ability to develop growth opportunities for Acthar. Critical Accounting Policies
Our management's discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. On an on-going basis, we evaluate our estimates, including those related to our Medicaid rebate obligation related to our products dispensed to Medicaid eligible patients, other government rebate programs and chargebacks on sales of our products by wholesalers and our specialty distributor to government-supported entities, inventories, intangible assets, share-based compensation, lease termination liability and income taxes. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
Sales Reserves
For the three and nine month periods ended September 30, 2009 and 2008, we have estimated reserves for Medicaid rebates to all states for products dispensed to patients covered by Medicaid; government chargebacks for sales of our products by wholesalers and our specialty distributor to certain Federal government organizations including such organizations as the Veterans Administration; and reserves for rebates related to a health coverage program called Tricare. For the three and nine month periods ended September 30, 2008, we estimated reserves for product returns from our specialty distributor, wholesalers, hospitals and pharmacies. Gross sales are also reduced for payments made under our Acthar patient co-payment assistance programs. We estimate our reserves by utilizing historical information for our existing products and data obtained from external sources.
Significant judgment is inherent in the selection of assumptions and the interpretation of historical experience as well as the identification of external and internal factors affecting the estimates of our reserves for Medicaid rebates and other government program rebates and chargebacks. We believe that the assumptions used to estimate these sales reserves are reasonable considering known facts and circumstances. However, our actual Medicaid rebates and other government program rebates and chargebacks could differ significantly from our estimates because of unanticipated changes in prescription trends or patterns in the states' submissions of

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Medicaid claims, adjustments to the amount of product in the distribution channel, and new interpretations of the Medicaid statutes and regulations. If actual Medicaid rebates, or other government program rebates and chargebacks are significantly different from our estimates, such differences would be accounted for in the period in which they become known. Historically, actual amounts have been generally consistent with our estimates. However, during the three month period ended September 30, 2009, we received higher than anticipated amounts of Medicaid rebates related to prior period Acthar usage. In connection with the receipt of these rebates, we increased our rebate reserve which reduced net sales in the third quarter of 2009 by approximately $4.6 million. During the three month period ended September 30, 2009, we recorded an additional rebate reserve which reduced net sales by $1.4 million as a result of a final rule issued by the Department of Defense for potential rebates due for drugs sold by retail pharmacies to Tricare beneficiaries. Of the $1.4 million recorded during the three month period ended September 30, 2009, $0.4 million related to sales that were recorded in the quarter ended June 30, 2009.
Medicaid Rebates
We provide a rebate related to product dispensed to Medicaid eligible patients in instances where regulations provide for such a rebate. Our a) estimated rebate percentage, adjusted for b) recent and expected future utilization rates for these programs, is used to estimate the rebate units associated with product shipped during a period as follows:
a) The estimated liability included in sales-related reserves as of the end of a period is comprised of the estimated rebate units associated with end user demand data during the period, the estimated rebate units associated with estimated inventory in the distribution channel as of the end of the period, and the estimated rebate units associated with prior rebate periods.

b) In order to assess current and future rates of Medicaid utilization, we analyze inventory levels received from a third party, CuraScript SD, patient prescription and shipment data received from a third party, CuraScript SP, and claims-level detail received from state Medicaid agencies.

The rebate amount per unit is determined based on a formula established by statute and is subject to review and modification by the administrators of the Medicaid program. The rebate per unit formula is comprised of a basic rebate of 15.1% applied to the average per unit amount of payments we receive on our product sales and an additional per unit rebate that is based on our current sales price compared to our sales price on an inflation adjusted basis from a designated base period. We multiply the rebate amount per unit by the estimated rebate units to arrive at the reserve for the period. This reserve is deducted from gross sales in the determination of net sales. Effective January 1, 2008, the amount we rebate for each Acthar vial dispensed to a Medicaid eligible patient is approximately $2,500 higher than our price to CuraScript SD. Management believes that the information received from CuraScript SD related to inventory levels and CuraScript SP related to prescription and shipment data is reliable, but we are unable to independently verify the accuracy of such data. The Medicaid rebates associated with end user demand for a period are mostly paid to the states by the end of the quarter following the quarter in which the rebate reserve is established.
Government Chargebacks
Certain other government-supported entities such as the Veterans Administration and Department of Defense are permitted to purchase Acthar from CuraScript SD for a nominal amount. CuraScript SD charges the significant discount back to us and reduces subsequent payment to us by the amount of the approved chargeback. The chargeback approximates our sales price to our customers. As a result, we recognize nominal, if any, net sales on shipments to these entities that qualify for the government chargeback. The reduction to gross sales for a period related to chargebacks is comprised of actual approved chargebacks originating during the period and an estimate of chargebacks in the ending inventory of our customers. In estimating the government chargeback reserve as of the end of a period, we estimate the amount of chargebacks in our customers' ending inventory using actual average monthly chargeback amounts and ending inventory balances provided by our largest customers. Chargebacks are generally applied by customers against their payments to us approximately 30 to 45 days after they have provided appropriate documentation to confirm their sale to a qualified government-supported entity.
We routinely assess our experience with Medicaid rebates and government chargebacks and adjust the reserves accordingly. Revisions in the Medicaid rebate and chargeback estimates are charged to income in the period in which the information that gives rise to the revision becomes known.

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Tricare Rebates
We have established a reserve for rebates related to a health coverage program called Tricare. On March 17, 2009, the Department of Defense issued final regulations under the Fiscal Year 2008 National Defense Authorization Act which interpreted such Act to expand Tricare to include prescription drugs dispensed by Tricare retail network pharmacies. Our Tricare rebate reserve reflects this program expansion and is based on estimated Department of Defense eligible sales multiplied by the Tricare rebate formula. In estimating our rebate eligible sales, we did not include sales prior to the effective date of the Department of Defense regulations, based on our interpretation of the regulations and a pending dispute between an industry coalition and the Department of Defense. We did not record reserves for retroactive rebates in the amount of $100,000 for 2008 and $1.2 million for the January-May 2009 timeframe. Depending on the outcome of this dispute, it is possible that we will need to increase our rebate reserve relating to Tricare for these amounts.
Co-Pay Assistance Programs
We sponsor co-pay assistance programs for Acthar patients which are administered by the National Organization for Rare Disorders ("NORD"). The payments made under our co-pay assistance programs are accounted for as a reduction of gross sales.
Product Returns
We supply replacement product to CuraScript SD on product returned between one month prior to expiration to three months post expiration. Returns from product lots are exchanged for replacement product, and estimated costs for such exchanges, which include actual product material costs and related shipping charges are included in cost of sales. Product returns have been insignificant since we began utilizing the services of CuraScript SD to distribute Acthar.
Shelf-Stock Adjustment Credit
Under our distribution agreement with CuraScript SD, if the price of Acthar is reduced, CuraScript SD will receive a shelf-stock adjustment credit based upon the amount of product in their inventory at the time of the price reduction. Any reduction in the selling price of Acthar is at our discretion. To date, there have been no such price reductions.
At September 30, 2009 and December 31, 2008, sales-related reserves included in the accompanying Consolidated Balance Sheets were as follows (in thousands):

                                       September 30,       December 31,
                                           2009                2008
             Medicaid rebates         $        12,492     $       11,406
             Tricare rebates                    1,400                  -
             Government chargebacks                73                164
             Product returns                        -                255

                                      $        13,965     $       11,825

Inventories
As of September 30, 2009, our net raw material, work-in-process and finished goods inventories totaled $3.4 million. We maintain inventory reserves primarily for excess and obsolete inventory (due to the expiration of shelf life of a product). In estimating inventory excess and obsolescence reserves, we analyze
(i) the expiration date, (ii) our sales forecasts and (iii) historical demand. Judgment is required in determining whether the forecasted sales information is sufficiently reliable to enable us to reasonably estimate excess and obsolete inventory. If actual future usage and demand for our products is less favorable than projected, additional inventory write-offs may be required in the future which would increase our cost of sales in the period of any write-offs. In the quarter ended September 30, 2009, we reserved $500,000 for a manufactured lot of Acthar that did not meet specifications. We intend to control inventory levels of our products purchased by our customers. Customer inventories may be compared to both internal and external databases to determine adequate inventory levels. We may monitor our product shipments to customers and compare these shipments against prescription demand for our individual products. Intangible and Long-Lived Assets
As of September 30, 2009, our intangible and long-lived assets consisted of goodwill of $299,000 generated from a merger in 1999, net purchased technology of $3.4 million related to our acquisition of Doral and $414,000 of net property and equipment. The costs related to our acquisition of Doral are being amortized over an estimated life of 15 years. The determination of whether or not

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our intangible and long-lived assets are impaired and the expected useful lives of purchased technology involves significant judgment. Changes in strategy or market conditions could significantly impact these judgments and require a write-down of our recorded asset balances and a reduction in the expected useful life of our purchased technology. Such a write-down of our recorded asset balances or reduction in the expected useful life of our purchased technology would increase our operating expenses. In accordance with ASC 350, Intangibles-Goodwill and Other(formerly SFAS No. 142), we review goodwill for impairment on an annual basis or whenever events occur or circumstances change that could indicate a possible impairment may have occurred. Our fair value is compared to the carrying value of our net assets, including goodwill. If the fair value is greater than the carrying amount, then no impairment is indicated. In accordance with ASC 360, Property Plant and Equipment (formerly SFAS No. 144), we review long-lived assets, consisting of property and equipment and purchased technology, for impairment whenever events or circumstances indicate that the carrying amount may not be fully recoverable. Recoverability of assets is measured by comparison of the carrying amount of the asset to the net undiscounted future cash flows expected to be generated from the use or disposition of the asset. If the future undiscounted cash flows are not sufficient to recover the carrying value of the assets, the assets' carrying value is adjusted to fair value. As of September 30, 2009, no impairment had been indicated.
Share-Based Compensation Expense
Effective January 1, 2006, we adopted the fair value recognition provisions of ASC 718, Compensation-Stock Compensation (formerly SFAS No. 123(R)), using the modified-prospective transition method. Under the fair value recognition provisions of ASC 718, share-based compensation cost is estimated at the grant date based on the fair value of the award and is recognized as expense, net of estimated pre-vesting forfeitures, ratably over the vesting period of the award. We selected the Black-Scholes option pricing model as the most appropriate fair value method for our awards. Calculating share-based compensation expense requires the input of highly subjective assumptions, including the expected term of the share-based awards, stock price volatility, and pre-vesting forfeitures. We estimated the expected term of stock options granted for the three and nine month periods ended September 30, 2009 and 2008 based on the historical term of our stock option awards. We estimated the volatility of our common stock at the date of grant based on the historical volatility of our common stock. The assumptions used in calculating the fair value of share-based awards represent our best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our share-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected pre-vesting forfeiture rate and only recognize expense for those shares expected to vest. We estimate the pre-vesting forfeiture rate based on historical experience. If our actual forfeiture rate is materially different from our estimate, our share-based compensation expense could be significantly different from what we have recorded in the current period.
Our net income for the three and nine month periods ended September 30, 2009 included $669,000 and $2.4 million, respectively, of share-based compensation expense related to employees and non-employee members of our board of directors. Our net income for the three and nine month periods ended September 30, 2008 included $635,000 and $3.7 million, respectively, of share-based compensation expense related to employees and non-employee members of our board of directors. Lease Termination Liability
We entered into an agreement to sublease laboratory and office space, including laboratory equipment, at our Hayward, California facility in July 2000, due to the termination of our then existing drug discovery programs. The sublease on our Hayward facility expired in July 2006. Our obligations under the Hayward master lease extend through November 2012. During the fourth quarter of 2005, the sublessee notified us that they did not intend to extend the sublease beyond the end of July 2006.
We determined that there was no loss associated with the Hayward facility when we initially subleased the space, as we expected cash inflows from the sublease to exceed our rent cost over the term of the master lease. However, we reevaluated this in 2005 when the sublessee notified us that it would not be renewing the sublease beyond July 2006. As a result, we computed a loss and liability on the sublease in the fourth quarter of 2005 in accordance with ASC 840, Leases (which now includes former FIN 27 and FTB 79-15). As of September 30, 2009 and December 31, 2008, the estimated liability related to the Hayward facility totaled $1.0 million and $1.2 million, respectively, and is included in Lease Termination and Deferred Rent Liabilities in the accompanying Consolidated Balance Sheets. The fair value of the liability was determined using a credit-adjusted risk-free rate to discount the estimated future net cash flows, consisting of the minimum lease payments under the master lease, net of estimated sublease rental income that could reasonably be obtained from the property. The most significant assumption in estimating the lease termination liability relates to our estimate of future sublease income. We base our estimate of sublease income, in part, on the opinion of independent real estate experts, current market conditions, and rental rates, among other factors. Adjustments to the lease termination liability will be required if actual sublease income differs from amounts currently expected. We review all assumptions used in determining the estimated

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liability quarterly and revise our estimate of the liability to reflect changes in circumstances. Effective November 1, 2007, we subleased 5,000 square feet of the facility through April 2009 and effective February 1, 2008 we subleased the remaining 25,000 square feet through the remainder of the term of the master lease. The 5,000 square foot sublease is currently leased on a month-to-month basis. These subleases cover a portion of our lease commitment, and all of our insurance, taxes and common area maintenance. As of September 30, 2009, we are obligated to pay rent on the Hayward facility of $2.8 million. Over the remaining term of the master lease, we anticipate that we will receive approximately $1.3 million in sublease income to be used to pay a portion of our Hayward facility obligation.
We are also required to recognize an on-going accretion expense representing the difference between the undiscounted net cash flows and the discounted net cash flows over the remaining term of the Hayward master lease using the interest method. The accretion amount represents an on-going adjustment to the estimated liability. The on-going accretion expense and any revisions to the liability are recorded in Selling, General and Administrative expense in the accompanying Consolidated Statements of Income. Income Taxes
We make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the . . .