The following Management's Discussion and Analysis (MD&A) is intended to help the reader understand our results of operations and financial condition. MD&A is provided as a supplement to, and should be read in conjunction with, our audited Consolidated Financial Statements and the accompanying notes to the Consolidated Financial Statements and other disclosures included in this Annual Report on Form 10-K (including the disclosures under "Item 1A. Risk Factors"). Our Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles and are presented in U.S. dollars.

Management Overview

We are a biopharmaceutical company that discovers, develops and commercializes innovative therapeutics in areas of unmet medical need. Our mission is to advance the care of patients suffering from life threatening diseases worldwide. Headquartered in Foster City, California, we have operations in North America, Europe and Australia. We market Truvada® (emtricitabine and tenofovir disoproxil fumarate), Atripla® (efavirenz 600 mg/emtricitabine 200 mg/tenofovir disoproxil fumarate 300 mg), Viread® (tenofovir disoproxil fumarate) and Emtriva®
(emtricitabine) for the treatment of human immunodeficiency virus (HIV)
infection; Hepsera® (adefovir dipivoxil) and Viread for the treatment of chronic hepatitis B virus (HBV); AmBisome ® (amphotericin B) liposome for injection for the treatment of severe fungal infections; Letairis® (ambrisentan) for the treatment of pulmonary arterial hypertension (PAH); Vistide® (cidofovir injection) for the treatment of cytomegalovirus infection; and Flolan® (epoprostenol sodium) for the treatment of pulmonary hypertension. F. Hoffmann-La Roche Ltd (together with Hoffmann-La Roche Inc., Roche) markets Tamiflu® (oseltamivir phosphate) for the treatment of influenza under a royalty-paying collaborative agreement with us. OSI Pharmaceuticals, Inc. markets Macugen® (pegaptanib sodium injection) in the United States and Europe for the treatment of neovascular age-related macular degeneration under a royalty-paying collaborative agreement with us. GlaxoSmithKline Inc. (GSK) markets Volibris® (ambrisentan) outside of the United States for the treatment of PAH under a royalty-paying collaborative agreement with us.

Business Highlights

During 2008, we made significant progress in various areas of our business. We grew our product sales significantly, executed on product approvals and product launches in multiple territories, made progress on moving our product candidates forward and continued to strengthen our worldwide organization and infrastructure to support our expanded international footprint and business activities.

Our commercial achievements for the year included the continued rollout of Atripla in the European Union (EU), driving growth of Atripla and Truvada in the United States and Canada, launching Viread for hepatitis B in the EU and the United States, making gains in the PAH market with Letairis, as well as continuing the expansion of our sales and marketing infrastructure, including the establishment of new international marketing subsidiaries.

During the year, we received marketing authorization for Viread for the treatment of chronic hepatitis B in adults in all 27 member states of the European Union, Turkey, New Zealand, Australia, the United States and Canada.

Along with the marketing approvals we received in 2008, we made significant advances on the compounds and product candidates in our research and development (R&D) pipeline, including:

• In the HIV area, we received positive feedback from the U.S. Food and Drug Administration (FDA) during the latter part of the year, regarding our development plans for elvitegravir, our novel integrase inhibitor for HIV which we licensed from Japan Tobacco Inc. in 2005; GS 9350, our pharmacoenhancer that is in development as a boosting agent for certain HIV medicines; and our single

• In hepatitis C, we completed dosing of patients in the continuation of the Phase 1b study of GS 9190, a non-nucleoside polymerase inhibitor, and began enrolling the Phase 2 study in patients infected with the hepatitis C virus. During the year, we completed our Phase 2a study of GS 9450, the caspase inhibitor we licensed from LG Life Sciences in 2007, and expect to initiate the Phase 2b study in the second quarter of 2009 to evaluate the longer term safety and efficacy of GS 9450. We are enrolling patients with nonalcoholic steadohepatitis in a Phase 2a study of GS 9450 to evaluate its safety and effect on liver enzymes and anticipate having data from this study before the end of 2009.

• In the cardiovascular area, we completed enrollment of one of our two Phase 3 studies for darusentan for the treatment of resistant hypertension and we anticipate having data from this study in the second quarter of 2009. We continued to enroll patients in our second Phase 3 study for darusentan, and we anticipate completing the enrollment before the end of 2009 with data available in early 2010. We are developing cicletanine for PAH and expect to initiate a Phase 2 clinical trial examining both once daily and twice daily dosing in early 2009. We are also preparing to initiate a Phase 3 study of ambrisentan in patients with pulmonary hypertension in idiopathic pulmonary fibrosis in the second quarter of 2009.

• In the respiratory area, we submitted an NDA for aztreonam for inhalation solution for the treatment of cystic fibrosis (CF) to the FDA in November 2007. In September 2008, we received a complete response letter from the FDA informing us that the FDA will not approve our NDA for aztreonam for inhalation for the treatment of CF and requesting an additional Phase 3 clinical study. In November 2008, we filed a request for a formal dispute resolution with the FDA. In February 2009, in response to our appeal, the FDA notified us that it is reiterating its position that we will need to conduct another clinical study of aztreonam for inhalation solution before we can resubmit our NDA. We have also submitted a marketing authorization application (MAA) in the EU and received notice of acceptance and priority review by Health Canada for approval in Canada. We are still awaiting responses from the respective regulatory bodies. Also in the respiratory area, we began enrolling patients with non-CF bronchietasis in a Phase 2 study evaluating aztreonam for inhalation solution for this indication; we initiated a Phase 1 study in the fourth quarter of 2008 to evaluate the safety and tolerability of GS 9411, a novel epithelial sodium channel blocker designed to increase airway hydration for the treatment of pulmonary disease; and in the fourth quarter of 2008, we also initiated a Phase 2 study evaluating the safety and efficacy of GS 9310/11, an inhaled co-formulation of fosfomycin and tobramycin, for bacterial infections associated with CF.

Financial Highlights

Our operating results for the year were led by total product sales of $5.08 billion. Antiviral product sales (Truvada, Atripla, Viread, Hepsera and Emtriva) increased 36% to $4.67 billion in 2008 from $3.44 billion in 2007, and were the key drivers for total product sales growth of 36% for 2008 as compared to 2007. With the continued uptake of Atripla in the United States and product launches in Europe, Atripla contributed $1.57 billion, or 34%, to our total 2008 antiviral product sales. The growth of Atripla product sales and its increased proportion to overall product sales caused total product gross margin to decrease as expected to 78% in 2008 from 79% in 2007, due primarily to the efavirenz component of Atripla sales at zero gross margin. Truvada product sales for 2008 comprised $2.11 billion, or 45% of our total 2008 antiviral product sales. Truvada product sales for 2008 increased 33% from 2007 primarily due to continued sales volume growth as well as a favorable foreign currency exchange impact. Foreign currency fluctuations in 2008 had a favorable impact of approximately $148.2 million on total revenues and $92.6 million on pre-tax income when compared to 2007.

Royalty revenues that we recognized from our collaborations with corporate partners were $218.2 million in 2008, a decrease of 53% from royalty revenues of $468.2 million in 2007. The decrease in royalty revenues was due primarily to decreased Tamiflu sales by Roche related to pandemic planning initiatives worldwide.

Operating expenses which include R&D, selling, general and administrative (SG&A) and purchased in-process research and development (IPR&D) expenses increased $233.2 million in 2008, or 18%, compared to 2007, reflecting the increased research and clinical study activity in our development pipeline, our expanded commercial activities worldwide, as well as the higher headcount, infrastructure and technology-related costs required to support the continued growth of our business. In 2008, we continued to be very focused on cost control and operating margins and will continue to do so in 2009. Our operating margin is impacted by the efavirenz component of a growing Atripla revenue stream and a declining trend for Tamiflu royalties.

Cash, cash equivalents and marketable securities increased by $517.2 million during the year, driven primarily by our operating cash flows of $2.20 billion. Our strong cash position allowed us to complete two accelerated share repurchase transactions as well as make significant common stock repurchases from the open market under the $3.00 billion stock repurchase program authorized by our Board of Directors (Board) in October 2007, which expires in December 2010. During 2008, we repurchased a total of $1.97 billion under our stock repurchase program, or approximately 39.2 million shares. As of December 31, 2008, the remaining authorized amount of stock repurchases that may be made under the Board authorized stock repurchase program was $998.1 million.

In light of the volatility and developments in the financial markets, we continued to review our cash equivalents and marketable securities carefully as well as invest prudently in 2008. Safety and preservation of principal and diversification of risk, as well as liquidity of investments sufficient to meet cash flow requirements, continued to be of primary importance to our investment goals. This approach helped protect us from the significant risks in the credit markets in 2008 while allowing us to meet our operating cash flow requirements and execute on other opportunities such as our share repurchases.

2009 Outlook

We anticipate that the high level of productivity and financial performance experienced in 2008 will continue in 2009. Our operating objectives include the expansion of our commercial markets, both from a franchise perspective as well as leveraging the new international marketing subsidiaries that we have established in the last two years, reaching our significant R&D development timelines, continuing to strengthen our pipeline with internally developed and/or externally in-licensed or purchased opportunities and strengthening our key alliances.

From a commercial standpoint, a number of internal and external initiatives may help promote the continued growth of our franchises. In the HIV area, we should be favorably impacted by the presentation of important data sets at upcoming medical conferences, continued testing and screening initiatives, and recent changes in HIV treatment guidelines. In the area of hepatitis B, a broad platform of educational activities concentrated in Asian American communities, highlighting the need to screen, diagnose and link patients to care, will help support Viread for HBV. In the United States, since the launch of Viread for HBV in August 2008, our hepatitis sales and medical affairs teams have concentrated their efforts solely on promotion of Viread. In the cardiovascular area, we will continue to build our presence within the PAH community and to support the growth of Letairis in 2009.

We are mindful that conditions in our current macroeconomic environment could affect our ability to achieve our goals. Some of the factors that could affect our business include: the volatility in foreign currency exchange rates, government pricing pressures in both the United States and internationally, as well as changes in the financial health and/or practices of our significant business partners and customers. Although we have not yet seen significant changes, we will continue to monitor the credit and foreign currency exchange markets,

developments in health care reform and legislation as well as the practices of our suppliers, manufacturers, corporate partners and customers, and will adjust our business processes as needed to mitigate these risks to our business.

The successes we experienced in 2008 have helped us maintain and build a financially sound business model that we believe will allow us to continue to expand our commercial, collaborative and R&D activities, and maintain the infrastructure to ensure quality and compliance in all areas of our business. As we continue to grow our business and achieve greater operational leverage, we remain focused on profitable revenue growth and prudent expense management that we believe will enable solid execution of our operating objectives for 2009.

Critical Accounting Policies, Estimates and Judgments

The discussion and analysis of our financial condition and results of operations is based on 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 ongoing basis, we evaluate our estimates, including those related to revenue recognition, allowance for doubtful accounts, prepaid royalties, clinical trial accruals, our tax provision and stock-based compensation. We base our estimates on historical experience and on various other market specific assumptions that we believe to be 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, however, may differ significantly from these estimates.

We believe the following critical accounting policies reflect the more significant judgments and estimates used in the preparation of our Consolidated Financial Statements.

Revenue Recognition

Product Sales

We recognize revenues from product sales when there is persuasive evidence that an arrangement exists, delivery to the customer has occurred, the price is fixed or determinable and collectibility is reasonably assured. We record estimated reductions to revenues for government rebates such as Medicaid reimbursements, customer incentives such as cash discounts for prompt payment, distributor fees and expected returns of expired products. These estimates are deducted from gross product sales at the time such revenues are recognized. Of these reductions from gross product sales, government rebates significantly impact our reported net product sales and are based upon certain estimates that require complex and significant judgment by management.

Government Rebates

We estimate amounts payable by us to government managed Medicaid programs as well as to certain other qualifying federal, state and foreign government programs for the reimbursement of portions of the retail price of prescriptions filled that are covered by these programs. Government rebates that are invoiced directly to us are recorded in other accrued liabilities on our Consolidated Balance Sheets. For qualified programs that can purchase our products through wholesalers at a lower contractual government price, the wholesalers charge back to us the difference between their acquisition cost and the lower price, which we record as allowances against accounts receivable. Although we may pay rebates in countries outside of the United States, to date, payments made to foreign governments have not represented a significant portion of our total government rebates. For government programs in the United States, we estimate these sales allowances based on contractual terms, historical utilization rates, new information regarding changes in these programs' regulations and guidelines that would impact the amount of the actual rebates, our expectations regarding future utilization rates for these programs and, for U.S. product sales, channel inventory data obtained from our major U.S. wholesalers in accordance with our inventory management agreements. During 2008, 2007 and 2006, U.S government rebates

of $625.0 million, $423.3 million and $232.5 million, respectively, representing 10%, 10% and 8% of total gross product sales, respectively, were deducted from gross product sales. Based on the current information available to us, actual government rebates claimed for these periods have varied by less than 3% from our estimates recorded in those periods. As of December 31, 2008 and 2007, we had accrued U.S. government rebates of $173.4 million and $114.1 million, respectively, in other accrued liabilities and an allowance of $32.8 million and $25.3 million, respectively, recorded against accounts receivable.

The following table summarizes the aggregate activity in our U.S. government rebates allowance and accrued liabilities accounts:

                                                 Balance at                     Deducted     Balance at
                                                 Beginning       Charged          from         End of
                                                  of Year       to Expense      Accruals        Year
Year ended December 31, 2008:
Government rebates allowances and accrued
liabilities
Activity related to 2008 sales                  $         -    $    627,935     $ 424,298   $    203,637
Activity related to sales prior to 2008              139,370         (2,965 )     133,769          2,636

Total                                           $    139,370   $    624,970     $ 558,067   $    206,273

Year ended December 31, 2007:
Government rebates allowances and accrued
liabilities
Activity related to 2007 sales                  $         -    $    426,084     $ 298,189   $    127,895
Activity related to sales prior to 2007               75,663         (2,753 )      61,435         11,475

Total                                           $     75,663   $    423,331     $ 359,624   $    139,370

Allowance for Doubtful Accounts

We also maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. This allowance is based on our analysis of several factors including, but not limited to, contractual payment terms, historical payment patterns of our customers and individual customer circumstances, an analysis of days sales outstanding by customer and geographic region and a review of the local economic environment and its potential impact on government funding and reimbursement practices. If the financial condition of our customers or the economic environment in which they operate were to deteriorate, resulting in an inability to make payments, additional allowances may be required. Our allowance for doubtful accounts balance as a percentage of total accounts receivable did not materially change from December 31, 2007 to December 31, 2008. We believe that the allowance for doubtful accounts is adequate to cover anticipated losses under current conditions; however, significant deterioration in any of the above factors, especially with respect to the government funding and reimbursement practices in the European market could materially change these expectations and may result in an increase to our allowance for doubtful accounts.

Prepaid Royalties

We capitalize royalties that we have prepaid at cost, specifically those related to the emtricitabine royalties we paid to Emory University (Emory) for the HIV indication, based on the present value of the future royalty obligation that we would expect to pay to Emory assuming certain expected future levels of our product sales incorporating emtricitabine. The present value of our future royalty obligation was derived using our weighted-average cost of capital. We review quarterly the expected future sales levels of our products and any indicators that might require a write-down in the net recoverable value of our asset or a change in the estimated life of the prepaid royalty. Some potential indicators of impairment include the launch of a significant product by a competitor, significant deviations in recognized product sales compared to forecast and product safety issues and recalls.

We amortize our prepaid royalties based on an effective royalty rate that we derive from forecasted HIV product sales incorporating emtricitabine. Our product sales forecasts are prepared annually and determined using our best estimates of future activity upon considering such factors as historical and expected future patient usage or uptake of our products, the introduction of complimentary or combination therapies or products and future product launch plans. If a previously unanticipated and significant change occurs to our sales forecasts, including the introduction of a competing product by us or one of our competitors in the same HIV market as emtricitabine, we will prospectively update the royalty rate used to amortize our prepaid royalties which may increase future royalty expense. As of December 31, 2008, we had a prepaid royalty asset relating to the emtricitabine royalties we paid to Emory of $275.0 million. Amortization expense relating to this prepaid royalty asset was $31.8 million, $14.3 million and $15.1 million, for the years ended December 31, 2008, 2007 and 2006, respectively.

Clinical Trial Accruals

We record accruals for estimated clinical study costs. Most of our clinical studies are performed by third party contract research organizations (CROs). These costs are a significant component of R&D expenses. During 2008, 2007 and 2006, we incurred CRO costs of $111.8 million, $65.6 million and $30.2 million, respectively. We accrue costs for clinical studies performed by CROs on a straight-line basis over the service periods specified in the contracts and adjust our estimates, if required, based upon our ongoing review of the level of effort and costs actually incurred by the CROs. We validate our accruals quarterly with our vendors and perform detailed reviews of the activities related to our significant contracts. Based upon the results of these validation processes, we assess the appropriateness of our accruals and make any adjustments we deem necessary to ensure that our expenses reflect the actual effort incurred by the CROs.

Generally, a significant portion of the total clinical trial costs is associated with start up activities for the trial and patient enrollment. We extensively outsource our clinical trial activities and usually perform only a small portion of the start-up activities in-house. As a result, CROs typically perform most of the total start-up activities for our trials, including document preparation, site identification, screening and preparation, pre-study visits, training and program management. Start-up costs usually occur within a few months after the contract has been executed and are milestone or event driven in nature.

The remaining clinical activities and related costs, such as patient monitoring and administration, generally occur ratably throughout the life of the individual contract or study. Most contracts are negotiated as fixed per unit prices and can vary in length between three months for a single dose Phase 1 clinical study and up to two years or more for a more complex Phase 3 clinical study. The average length of contracts in 2008, 2007 and 2006 has been at the upper end of this range in order to provide long-term safety and efficacy data to support the commercial launches of Truvada, Atripla, Viread, Hepsera, Emtriva and Letairis. All of our material CRO contracts are terminable by us upon written notice and we are generally only liable for actual effort expended by the CRO and certain non-cancelable expenses incurred at any point of termination. Amounts paid in advance relating to uncompleted services will be refunded to us if a contract is terminated. Some contracts may include additional termination payments that become due and payable if we terminate the contract. Such additional termination payments are only recorded if it becomes probable that a contract will be terminated. Through December 31, 2008, differences between actual and estimated activity levels for any particular study have not been material. However, if management does not receive complete and accurate information from our vendors or underestimates activity levels associated with a study at a given point in time, we may have to record additional and potentially significant R&D expenses in future periods.

Tax Provision

We estimate our income tax provision, including deferred tax assets and liabilities, based on significant management judgment. We evaluate the realization of all or a portion of our deferred tax assets on a quarterly basis. We record a valuation allowance to reduce our deferred tax assets to the amounts that are more likely than not to be realized. We consider future taxable income, ongoing tax planning strategies and our historical financial performance in assessing the need for a valuation allowance.

If we expect to realize deferred tax assets for which we have previously recorded a valuation allowance, we will reduce the valuation allowance in the period in which such determination is first made. Such an adjustment was made in 2008 and 2007 when we determined that it was more likely than not that certain of our deferred tax assets would be realized, and therefore, we released the related valuation allowance. This resulted in a credit to goodwill of approximately $8.0 million for 2008 and an income tax benefit of approximately $15.5 million and $1.5 million for 2008 and 2007, respectively.

Our future effective income tax rate may be affected by such factors as changes in tax laws, regulations or rates, changing interpretation of existing laws or regulations, the impact of accounting for stock-based compensation, changes in our international organization and changes in overall levels of income before tax.

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes(FIN 48), an interpretation of Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes (SFAS 109). FIN 48 clarifies the accounting for . . .