UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2006
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 1-9601
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K-V PHARMACEUTICAL COMPANY
(Exact name of registrant as specified in its charter)
DELAWARE 43-0618919
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2503 SOUTH HANLEY ROAD, ST. LOUIS, MISSOURI 63144
(Address of principal executive offices, including ZIP code)
Registrant's telephone number, including area code: (314) 645-6600
Securities Registered Pursuant to Section 12(b) of the Act:
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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 [ ] No [ X ]
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
Act).
Large accelerated filer [ X ] Accelerated filer [ ] Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Act). Yes [ ] No [ X ]
As of January 15, 2008, the registrant had outstanding 37,708,248 and
12,233,802 shares of Class A and Class B Common Stock, respectively.
EXPLANATORY NOTE REGARDING RESTATEMENT OF OUR CONSOLIDATED FINANCIAL STATEMENTS
This Form 10-Q reflects the restatement of our consolidated balance sheets as
of March 31, 2006 and December 31, 2005, the related consolidated statements
of income for the three and nine months ended December 31, 2005, and the
related consolidated statements of cash flows for the nine months ended
December 31, 2005. In our Form 10-K for the fiscal year ended March 31, 2007
to be filed with the Securities and Exchange Commission (the "2007 Form
10-K"), we are restating our consolidated balance sheet as of March 31, 2006,
and the related consolidated statements of income, comprehensive income,
shareholders' equity, and cash flows for the fiscal years ended March 31, 2006
and 2005. We have not amended, and we do not intend to amend, our previously
filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for each
of the fiscal years and fiscal quarters of 1996 through 2006. Our 2007 Form
10-K also reflects the restatement of Selected Financial Data in Item 6 as of
March 31, 2005 and as of and for the fiscal years ended March 31, 2004 and
2003.
On October 31, 2006, we announced that we had been served with a derivative
lawsuit filed in St. Louis City Circuit Court alleging that certain stock
option grants to current or former officers and directors between 1995 and
2002 were dated improperly. In accordance with our established corporate
governance procedures, the Board of Directors referred this matter to the
independent members of its Audit Committee (the "Special Committee" or
"Committee").
Shortly thereafter, the Special Committee, assisted by independent legal
counsel and forensic accounting experts engaged by the Committee, commenced an
investigation of our stock option grant practices, with the objective of
evaluating our accounting for stock options for compliance with U.S. Generally
Accepted Accounting Principles ("GAAP") and with the terms of our related
stock option plans over the period January 1, 1995 through October 31, 2006
(the "relevant period").
The investigation has now been completed and our Board of Directors received a
final report on October 2, 2007 from the Special Committee based on facts
disclosed in the course of the investigation and the advice of its independent
legal counsel and forensic accounting experts. The Special Committee found
that our previous accounting for stock-based compensation was not in
accordance with GAAP and that corrections to our previous consolidated
financial statements were required. We agreed with the Committee's findings
and, as a result, our consolidated retained earnings as of March 31, 2006,
incorporate an additional $16.3 million of stock-based compensation expense,
including related payroll taxes, interest and penalties, net of $2.6 million
in income tax benefits. In the course of the Special Committee's
investigation, we were notified by the SEC staff that it had commenced an
investigation with respect to the Company's stock option program. We have
cooperated with the SEC staff and, among other things, provided them with
copies of the Special Committee's report and all documents collected by the
Committee in the course of its review. Recently, the SEC staff, pursuant to a
formal order of investigation, has issued subpoenas for documents, most of
which have already been produced to the SEC staff, and for testimony by
certain employees. The Company expects that the production of any additional
documents called for by the subpoena and the testimony of the employees will
be completed by April 2008.
In addition and as a separate matter, our consolidated retained earnings as of
March 31, 2006, incorporate an additional $5.4 million of income tax expense
to record additional liabilities associated with tax positions claimed on
filed tax returns for fiscal years 2004, 2005 and 2006 that should have been
recorded in accordance with GAAP, partially offset by certain expected tax
refunds. This adjustment is not related to the accounting for stock-based
compensation expense discussed above.
In addition, our consolidated retained earnings as of March 31, 2006,
incorporates a $0.4 million reduction of net income related primarily to
misstatements of net revenues and cost of sales resulting from improperly
recognizing revenue prior to when title and risk of ownership of the product
transferred to the customer.
Please see "Review of Stock Option Grant Practices," "Review of Tax Positions
(Unrelated to stock options)" and "Other Adjustments (Unrelated to stock
options)" in "Management's Discussion and Analysis of Financial Condition and
Results of Operations " and Note 2 "Restatement of Consolidated Financial
Statements" in our consolidated financial statements for a more detailed
discussion related to the investigation of our former stock option grant
practices, review of tax positions and other adjustments.
2
The effect of these restatements are reflected in our Consolidated Financial
Statements and other supplemental data herein and the unaudited quarterly data
and selected financial data included in the 2007 Form 10-K. Financial
information included in reports previously filed or furnished by K-V
Pharmaceutical Company for the fiscal periods 1996 through 2006 and our
assessment of internal control over financial reporting as of March 31, 2006
should not be relied upon and are superseded by the information in this Form
10-Q and the 2007 Form 10-K.
PART I. - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited; dollars in thousands, except per share data)
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
--------------------------- ---------------------------
2006 2005 2006 2005
--------- --------- --------- ---------
(AS RESTATED) (AS RESTATED)
Net revenues............................................. $ 117,949 $ 101,752 $ 323,132 $ 279,117
Cost of sales............................................ 38,439 34,989 110,764 93,665
--------- --------- --------- ---------
Gross profit............................................. 79,510 66,763 212,368 185,452
--------- --------- --------- ---------
Operating expenses:
Research and development............................. 8,319 6,817 22,605 20,869
Purchased in-process research and
development and transaction costs................ -- -- -- 30,441
Selling and administrative........................... 41,965 36,292 124,974 111,891
Amortization of intangibles.......................... 1,204 1,198 3,602 3,589
--------- --------- --------- ---------
Total operating expenses................................. 51,488 44,307 151,181 166,790
--------- --------- --------- ---------
Operating income......................................... 28,022 22,456 61,187 18,662
--------- --------- --------- ---------
Other expense (income):
Interest expense..................................... 2,214 1,538 6,755 4,382
Interest and other income............................ (2,240) (1,272) (6,606) (3,402)
--------- --------- --------- ---------
Total other expense (income), net........................ (26) 266 149 980
--------- --------- --------- ---------
Income before income taxes and cumulative effect
of change in accounting principle.................... 28,048 22,190 61,038 17,682
Provision for income taxes............................... 9,586 7,484 22,369 17,274
--------- --------- --------- ---------
Income before cumulative effect of change
in accounting principle.............................. 18,462 14,706 38,669 408
Cumulative effect of change in accounting
principle (net of $670 in taxes)..................... -- -- 1,976 --
--------- --------- --------- ---------
Net income............................................... $ 18,462 $ 14,706 $ 40,645 $ 408
========= ========= ========= =========
(CONTINUED)
3
K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME - (CONTINUED)
(Unaudited; dollars in thousands, except per share data)
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------------- ----------------------------------
2006 2005 2006 2005
---------------- ---------------- ---------------- ----------------
(AS RESTATED) (AS RESTATED)
Earnings per share before effect of change in
accounting principle:
Basic - Class A common............................. $ 0.39 $ 0.31 $ 0.82 $ 0.01
Basic - Class B common............................. 0.33 0.26 0.68 0.01
Diluted - Class A common........................... 0.33 0.27 0.71 0.01
Diluted - Class B common........................... 0.29 0.23 0.61 0.01
Per share effect of cumulative effect of change
in accounting principle:
Basic - Class A common............................. $ - $ - $ 0.04 $ -
Basic - Class B common............................. - - 0.04 -
Diluted - Class A common........................... - - 0.03 -
Diluted - Class B common........................... - - 0.03 -
Earnings per share:
Basic - Class A common............................. $ 0.39 $ 0.31 $ 0.86 $ 0.01
Basic - Class B common............................. 0.33 0.26 0.72 0.01
Diluted - Class A common........................... 0.33 0.27 0.74 0.01
Diluted - Class B common........................... 0.29 0.23 0.64 0.01
Shares used in per share calculation:
Basic - Class A common............................. 36,926 35,930 36,757 35,688
Basic - Class B common............................. 12,336 12,912 12,422 13,000
Diluted - Class A common........................... 59,016 58,713 58,928 49,584
Diluted - Class B common........................... 12,412 13,093 12,529 13,195
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4
K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited; dollars in thousands)
DECEMBER 31, MARCH 31,
2006 2006
---- ----
(AS RESTATED)
ASSETS
------
CURRENT ASSETS:
Cash and cash equivalents............................................................ $ 55,550 $ 100,706
Marketable securities................................................................ 155,126 106,763
Receivables, less allowance for doubtful accounts of $574 and $397
at December 31, 2006 and March 31, 2006, respectively............................. 83,859 53,571
Inventories, net..................................................................... 82,020 71,166
Prepaid and other assets............................................................. 7,791 7,012
Deferred tax asset................................................................... 13,911 10,072
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Total Current Assets.............................................................. 398,257 349,290
Property and equipment, net.......................................................... 187,656 178,042
Intangible assets and goodwill, net.................................................. 70,042 72,955
Other assets......................................................................... 19,828 19,026
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TOTAL ASSETS......................................................................... $ 675,783 $ 619,313
=========== ===========
LIABILITIES
-----------
CURRENT LIABILITIES:
Accounts payable..................................................................... $ 17,408 $ 17,975
Accrued liabilities.................................................................. 29,632 24,676
Current maturities of long-term debt................................................. 1,875 1,681
----------- -----------
Total Current Liabilities......................................................... 48,915 44,332
Long-term debt....................................................................... 239,940 241,319
Other long-term liabilities.......................................................... 6,007 5,442
Deferred tax liability............................................................... 34,964 25,221
----------- -----------
TOTAL LIABILITIES.................................................................... 329,826 316,314
----------- -----------
COMMITMENTS AND CONTINGENCIES........................................................ -- --
SHAREHOLDERS' EQUITY
--------------------
7% cumulative convertible Preferred Stock, $.01 par value; $25.00 stated and
liquidation value; 840,000 shares authorized; issued and outstanding --
40,000 shares at December 31, 2006 and March 31, 2006 (convertible into Class A
shares at a ratio of 8.4375-to-one)............................................... -- --
Class A and Class B Common Stock, $.01 par value;150,000,000 and
75,000,000 shares authorized, respectively;
Class A - issued 40,273,884 and 39,660,637 at December 31, 2006
and March 31, 2006, respectively.............................................. 403 397
Class B - issued 12,400,482 and 12,679,986 at December 31, 2006 and March 31,
2006, respectively (convertible into Class A shares on a one-for-one basis)... 124 127
Additional paid-in capital........................................................... 149,364 145,180
Retained earnings.................................................................... 252,003 211,410
Accumulated other comprehensive loss................................................. -- (211)
Less: Treasury stock, 3,235,263 shares of Class A and 92,902 shares of Class B Common
Stock at December 31, 2006, respectively, and 3,123,975 shares of Class A and
92,902 shares of Class B Common Stock at March 31, 2006, respectively, at cost.... (55,937) (53,904)
----------- -----------
TOTAL SHAREHOLDERS' EQUITY........................................................... 345,957 302,999
----------- -----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........................................... $ 675,783 $ 619,313
=========== ===========
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5
K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited; dollars in thousands)
NINE MONTHS ENDED
DECEMBER 31,
----------------------------
2006 2005
------------ ----------
(AS RESTATED)
OPERATING ACTIVITIES:
Net income............................................................. $ 40,645 $ 408
Adjustments to reconcile net income to net cash provided by
operating activities:
Acquired in-process research and development........................ -- 29,570
Cumulative effect of change in accounting principle................. (1,976) --
Depreciation and amortization....................................... 16,662 13,065
Deferred income tax provision....................................... 5,126 1,293
Deferred compensation............................................... 565 839
Stock-based compensation............................................ 2,948 686
Excess tax benefit associated with stock options.................... (565) --
Other............................................................... 270 --
Changes in operating assets and liabilities:
Increase in receivables, net........................................ (30,288) (5,727)
Increase in inventories, net........................................ (10,854) (3,896)
(Increase) decrease in prepaid and other assets..................... (2,910) 2,771
Increase in accounts payable and accrued liabilities................ 4,607 3,296
------------- ------------
Net cash provided by operating activities.............................. 24,230 42,305
------------- ------------
INVESTING ACTIVITIES:
Purchase of property and equipment, net............................. (21,634) (47,317)
Purchase of marketable securities................................... (48,314) (50,735)
Purchase of preferred stock......................................... (400) (11,300)
Product acquisition................................................. -- (25,643)
------------- ------------
Net cash used in investing activities.................................. (70,348) (134,995)
------------- ------------
FINANCING ACTIVITIES:
Principal payments on long-term debt................................ (1,185) (698)
Dividends paid on preferred stock................................... (52) (52)
Excess tax benefit associated with stock options.................... 565 --
Purchase of common stock for treasury............................... (2,033) (140)
Cash deposits received for stock options............................ 3,667 594
------------- ------------
Net cash provided by (used in) financing activities.................... 962 (296)
------------- ------------
Decrease in cash and cash equivalents.................................. (45,156) (92,986)
Cash and cash equivalents:
Beginning of year................................................... 100,706 159,825
------------- ------------
End of period....................................................... $ 55,550 $ 66,839
============= ============
SUPPLEMENTAL INFORMATION:
Interest paid, net of portion capitalized........................... $ 6,700 $ 4,640
Income taxes paid................................................... 13,629 9,132
Stock options exercised (at expiration of two-year
forfeiture period)............................................... 3,317 2,489
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share data)
1. BASIS OF PRESENTATION
K-V Pharmaceutical Company and its subsidiaries ("KV" or the "Company") are
primarily engaged in the development, manufacture, acquisition, marketing and
sale of technologically distinguished branded and generic/non-branded
prescription pharmaceutical products. The Company was incorporated in 1971 and
has become a leader in the development of advanced drug delivery and
formulation technologies that are designed to enhance therapeutic benefits of
existing drug forms. Through internal product development and synergistic
acquisitions of products, KV has grown into a fully integrated specialty
pharmaceutical company. The Company also develops, manufactures and markets
technologically advanced, value-added raw material products for the
pharmaceutical, nutritional, food and personal care industries.
The accompanying unaudited consolidated financial statements of the Company
have been prepared in accordance with U.S. Generally Accepted Accounting
Principles ("GAAP") for interim financial information and with the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they
do not include all of the information and footnotes required by GAAP for
complete financial statements. However, in the opinion of management, all
adjustments (consisting of only normal recurring accruals) considered
necessary for a fair presentation have been included. The balance sheet
information as of March 31, 2006 has been derived from the Company's
consolidated balance sheet as of that date, as restated (see Note 2). These
Consolidated Financial Statements and accompanying notes should be read in
conjunction with the Company's consolidated financial statements and notes
thereto for the fiscal year ended March 31, 2007, which are included in the
Company's Annual Report on Form 10-K for the fiscal year ended March 31, 2007
to be filed with the Securities and Exchange Commission (the "2007 Form
10-K").
2. RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS
REVIEW OF STOCK OPTION GRANT PRACTICES
BACKGROUND AND CONCLUSIONS
This Form 10-Q reflects the restatement of the Company's consolidated balance
sheets as of March 31, 2006 and December 31, 2005, the related consolidated
statements of income for the three and nine months ended December 31, 2005 and
the related consolidated statements of cash flows for the nine months ended
December 31, 2005. In the Company's 2007 Form 10-K, the Company is restating
its consolidated balance sheet as of March 31, 2006, and the related
consolidated statements of income, comprehensive income, shareholders' equity,
and cash flows for the fiscal years ended March 31, 2006 and 2005. The Company
has not amended, and does not intend to amend, its previously filed Annual
Reports on Form 10-K or Quarterly Reports on Form 10-Q for each of the fiscal
years and fiscal quarters of 1996 through 2006.
On October 31, 2006, the Company announced that it had been served with a
derivative lawsuit filed in St. Louis City Circuit Court alleging that certain
stock option grants to current or former officers and directors between 1995
and 2002 were dated improperly. In accordance with the Company's established
corporate governance procedures, the Board of Directors referred this matter
to the independent members of its Audit Committee (the "Special Committee" or
"Committee").
Shortly thereafter, the Special Committee commenced an investigation of the
Company's stock option grant practices, assisted by independent legal counsel
and forensic accounting experts engaged by the Committee, with the objectives
of evaluating the Company's accounting for stock options for compliance with
GAAP and for compliance with the terms of its related stock option plans over
the period January 1, 1995 through October 31, 2006 (the "relevant period").
On October 11, 2007, the Company filed a Current Report on Form 8-K announcing
the Special Committee had completed its investigation. The investigation
concluded that there was not evidence that any employee, officer or director
of the Company engaged in any intentional wrongdoing or was aware the
Company's policies and procedures for granting and accounting for stock
options were materially non-compliant with GAAP. The investigation also found
no intentional violation of law or accounting rules with respect to the
Company's historical stock option grant practices.
7
However, the Special Committee concluded that stock-based compensation expense
resulting from the stock option granting practices followed by the Company was
not recorded in accordance with GAAP because the expense computed for most of
the grants reflected incorrect measurement dates for financial accounting
purposes. The "measurement date" under applicable accounting principles,
namely APB 25 and related interpretations, is the first date on which all of
the following are known and not subject to change: (a) the individual who is
entitled to receive the option grant, (b) the number of options that an
individual is entitled to receive, and (c) the option's exercise price.
FINDINGS AND ACCOUNTING CONSIDERATIONS
In general, stock options were granted to employees, executives and
non-employee members of the Board of Directors over the relevant period under
the terms of the Company's 1991 and 2001 Incentive Stock Option Plans (the
"option plans"). In addition to options granted to the CEO under those plans,
options were awarded to him under the terms of his employment agreement in
lieu of, and in consideration for a reduction of, the cash bonus provided for
in that agreement.
The option plans required grants to be approved by the Compensation Committee
of the Board of Directors. Under the option plans, options were to be granted
with exercise prices set at no less than the fair market value of the
underlying common stock at the date of grant. The 1991 plan provided for the
exclusive grant of Incentive Stock Options ("ISOs") as defined by Internal
Revenue Code Section 422, while the 2001 plan provided for the grant of ISOs
and non-qualified stock options ("NSOs"). Under the plans, options granted to
employees other than the CEO or directors are subject to a ten-year ratable
vesting period. Options granted to the CEO and directors generally vest
ratably over five years.
Both option plans require that shares received upon exercise of an option
cannot be sold for two years. If the employee terminates employment
voluntarily or involuntarily (other than by retirement, death or disability)
during the two-year forfeiture period, the option plans provide that the
Company may elect to repurchase the shares at the lower of the exercise price
of the option or the fair market value of the stock on the date of
termination. The Company has changed its accounting for stock-based
compensation to consider this provision of the option plans as a forfeiture
provision to be accounted for in accordance with the guidance provided in EITF
No. 00-23, "Issues Related to Accounting for Stock Based Compensation under
APB 25 and FIN 44", specifically Paragraph 78 and Issue 33 (a), "Accounting
for Early Exercise". In accordance with EITF No. 00-23, cash paid by an
employee for the exercise price is considered a deposit or a prepayment of the
exercise price that is recognized as a current liability when received by the
Company at the beginning of the two-year forfeiture period. The receipt of the
exercise price is recognized as a current liability because the options are
deemed not exercised and the option shares are not considered issued until an
employee bears the risk and rewards of ownership. The options are accounted
for as exercised when the two-year forfeiture period lapses. In addition,
because the options are not considered exercised for accounting purposes, the
shares in the two-year forfeiture period are not considered outstanding for
purposes of computing basic EPS.
The Company had accounted for all option grants as fixed in accordance with
the provisions of APB 25 using the date of grant as the measurement date.
Because the exercise price of the option was equal to or greater than the
market price of the stock at the measurement date fixed by the terms of the
awards, under prior procedures the Company did not recognize any compensation
expense since the option had no intrinsic value, with intrinsic value being
the difference between the exercise price and the market price of the
underlying stock at the measurement date.
As noted above, the Special Committee determined that the Company's accounting
for most of the stock option grants was not in accordance with GAAP because
the date of grant, as defined by the Company, was not a proper measurement
date. To correct the errors, and consistent with the accounting literature and
guidance from the Securities and Exchange Commission ("SEC"), the Company
organized the grants into categories based on grant type and process by which
the grant was finalized. Based on the relevant facts and circumstances, the
Company applied the authoritative accounting standard (APB 25 and related
interpretations) to determine, for every grant within each category, the
proper measurement date. If the measurement date was not the originally
assigned grant date, accounting adjustments were made as required, resulting
in stock-based compensation expense and related tax effects. The grants were
classified as follows: (1) promotion/retention grants to executives and
employees and new hire grants ("employee options"); (2) grants to persons
elected or appointed to the Board of Directors ("director options"); and (3)
bonus option grants to the CEO in lieu of cash bonus payments under the terms
of his employment agreement ("bonus options").
8
Employee Options. The evidence obtained through the investigation indicated
- ----------------
that employee options were granted based on the lowest market price in the
quarter of grant determined from an effective date (as defined below) to the
end of the quarter. The exercise price and grant date of the options were
determined by looking back from the end of the quarter to the effective date
and choosing the lowest market price during that period. The date on which the
market price was lowest became the grant date. This procedure to "look back"
to the lowest market price in the preceding quarter to set the exercise price
was widely known and understood within the Company. The effective date was
either the date on which the option recipients and the number of shares to be
granted were determined and approved by the CEO, the date of a promotion or
the date of hire. For new hires and promotions of existing employees, which
represents substantially all of the award recipients, the terms of the award,
except for the exercise price, were communicated to the recipients prior to
the end of the quarter. At the end of the quarter, when the exercise price was
determined, board consents were prepared and dated as of the date on which the
stock price was lowest during the quarter, to be approved by the members of
the Compensation Committee. The evidence obtained through the investigation
indicated the Compensation Committee never changed or denied approval of any
grants submitted to them and, as such, their approval was considered a routine
matter. Based on the evidence and findings of the Special Committee, the
results of management's analysis, the criteria specified in APB 25 for
determining measurement dates and guidance from the staff of the SEC, the
Company has concluded that the measurement dates for the employee options
should not have been the originally assigned grant dates, but instead, should
have been the end of the quarter in which awards were granted when the
exercise price and number of shares granted were fixed. Changing the
measurement dates from the originally assigned grant date to the end of the
quarter resulted in recognition of additional stock-based compensation expense
of $153 and $446, net of tax, on 1,461 stock option grants for the three and
nine months ended December 31, 2005, respectively.
Director Options. Director options were issued, prior to the effective date of
- ----------------
the Sarbanes-Oxley Act ("Sarbanes-Oxley") in August 2002, using the same "look
back" process as described above for employee options. This process was
changed when the time for filing Form 4's was shortened under the provisions
of Sarbanes-Oxley, to award options with exercise prices equal to the fair
market value of the stock on the date of grant. Prior to this change in grant
practice, the Company concluded that the measurement date for the director
options should be the end of the quarter. Changing the measurement date from
the originally assigned grant date to the end of the quarter resulted in
recognition of additional stock-based compensation expense of $9 and $25, net
of tax, on 19 stock option grants for the three and nine months ended December
31, 2005, respectively.
Bonus Options. Under the terms of the CEO's employment agreement, he is
- -------------
permitted the alternative of electing incentive stock options, restricted
stock or discounted stock options in lieu of the payment of part or all of the
incentive bonus due to him in cash. In the event of an election to receive
options in lieu of cash incentive, those options were to be valued using the
Black-Scholes option pricing model, applying the same assumptions as those
used in the Company's most recent proxy statement. The employment agreement
provides that the CEO's annual bonus is based on fiscal year net income.
Prior to fiscal 2005, the CEO received ten bonus option grants, consisting of
337,500 shares of Class A Common Stock and 1,743,750 shares of Class B Common
Stock under this arrangement. The CEO and the Board's designated
representative (the Company's Chief Financial Officer) negotiated the terms of
the bonus options, including the number of shares covered, the exercise price
and the grant date (the latter being selected using a "look back" process
similar to that followed in granting employee and director options). The
Company typically granted bonus options prior to fiscal year-end, shortly
after such agreement was reached. These bonus options were fully vested at
grant, had three to five year terms, were granted with a 10% or 25% premium to
the market price of the stock on the selected grant date and were subject to
the approval of the Compensation Committee. The CEO's cash bonus payable at
the end of the fiscal year in which the options were granted was reduced by
the Black-Scholes value of the options according to their terms.
Based on the facts and circumstances relative to the process for granting the
bonus options, the Special Committee determined, and the Company has agreed,
that the measurement dates for these options should be the end of the fiscal
year in which they were granted. The end of the fiscal year was used as the
measurement date because that is the date on which the amount of the annual
bonus could be determined and therefore the terms of the option could be fixed
under APB 25. This conclusion is predicated on the assumption that the terms
of the option were linked to the amount of the bonus earned. While it was
permissible to agree upon the number of shares that were to be issued prior to
the end of the year and would not be forfeitable, under GAAP the exercise
price is considered variable until the amount of the
9
bonus could be determined with finality. The variability in the exercise price
results from the premise that the CEO would have been required to repay any
shortfall in the bonus earned from the value assigned to the option by the
Black-Scholes model. Any amount repaid to cure the bonus shortfall would in
substance be an increase in the exercise price of the option. Since the
exercise price could not be determined with certainty until the amount of the
bonus was known, the Company has applied variable accounting to the bonus
options from the date of grant to the final fiscal year-end measurement date.
Variable accounting requires that compensation expense is to be determined by
comparing the quoted market value of the shares covered by the option grant to
the exercise price at each intervening balance sheet date until the terms of
the option become fixed.
The compensation expense associated with the CEO's estimated bonus was accrued
throughout the fiscal year. When the value of a bonus option was determined
using the Black-Scholes model, previously recorded compensation expense
associated with the accrual of the estimated bonus was reversed in the amount
of the value assigned to the bonus option. The previously recorded
compensation expense should not have been reversed. The Company developed a
methodology in the restatement process that considers both the intrinsic value
of the option under APB 25 and the Black-Scholes value assigned to the bonus
option in determining the amount of compensation expense to recognize once the
exercise price of the option becomes fixed and variable accounting ends. Under
this methodology, the intrinsic value of the option is determined at the
fiscal year-end measurement date under the principles of APB 25. The intrinsic
value is then compared to the Black Scholes value assigned to the option for
compensation purposes (the bonus value). The bonus value is the amount that
would have been accrued during the fiscal year through the grant date as part
of the total liability for the CEO's bonus. The greater of the intrinsic value
or bonus value is recorded as compensation expense. Using this methodology and
fiscal year-end for the measurement dates resulted in an increase in
stock-based compensation expense of $6,944 over the period from fiscal 1996
through fiscal 2004. There was no tax benefit associated with this expense due
to the tax years being closed.
OTHER MODIFICATIONS OF OPTION TERMS
As described above, under the terms of the option plans, shares received on
exercise of an option are to be held for the employee for two years during
which time the shares cannot be sold. If the employee terminated employment
voluntarily or involuntarily (other than by retirement, death or disability)
during the two-year forfeiture period the option plans provided the Company
with the option of repurchasing the shares at the lower of the exercise price
or the fair market value of the stock on the date of termination. In some
circumstances the Company elected not to repurchase the shares upon
termination of employment while the shares were in the two-year forfeiture
period, essentially waiving the remaining forfeiture period requirement. The
Company did not previously recognize this waiver as requiring a new
measurement date.
Based on management's analysis, the Company has concluded that a new
measurement date should have been recognized in two situations: (1) the
employee terminated and the Company did not exercise its right under the
option plans to buy back the shares in the two-year forfeiture period, and (2)
the forfeiture provision was waived and the employee subsequently terminated
within two years of the exercise date. The Company now considers both of these
waivers to be an acceleration of the vesting period because the forfeiture
provision was waived. The employee is no longer subject to a service condition
to earn the right to the shares and will benefit from the modification. As
such, a new measurement date is required. In this case the new measurement
date is the date the forfeiture provision was waived with additional
stock-based compensation expense being recognized at the date of termination.
Since the shares were fully vested, the intrinsic value of the option at the
new measurement date in excess of the intrinsic value at the original
measurement date should be expensed immediately. The new measurement dates
resulted in an increase in stock-based compensation expense of $4, net of tax,
on two stock option grants for the nine months ended December 31, 2005.
STOCK OPTION ADJUSTMENTS
A discussion of the stock option restatement adjustments follows and a table
reflecting the impact of these adjustments is presented below on page 12.
Stock-based Compensation Expense. Although the period for the Special
- --------------------------------
Committee's investigation was January 1, 1995 to October 31, 2006, the Company
extended the period of review back to 1986 in its analysis of the aggregate
impact of the measurement date changes because the incorrect accounting for
stock options extended that far back in time. The Company has concluded that
the measurement date changes identified by the Special Committee's
investigation and management's analysis resulted in an understatement of
stock-based compensation expense arising
10
from stock option grants since 1986, affecting the Company's consolidated
financial statements for each year beginning with the fiscal year ended March
31, 1986. The impact of the misstatements on the consolidated financial
statements for the fiscal years from 1986 to 1995 was not considered material,
individually or in the aggregate.
As previously discussed, the Company now considers the two-year repurchase
option specified in the option plans to be a forfeiture provision that goes
into effect when stock options are exercised. Therefore, the service period
necessary for an employee to earn an award varies based on the timing of stock
option exercises. The Company initially expenses each award (i.e., all
tranches of an option award) on a straight-line basis over ten years, which is
the period that stock options become exercisable. The Company also ensures the
cumulative compensation expense for an award as of any date is at least equal
to the measurement-date intrinsic value of those options that have vested
(i.e., when the two-year forfeiture period has ended). If stock options expire
unexercised or an employee terminates employment after options become
exercisable, no compensation expense associated with the exercisable, but
unexercised options, is reversed. In those instances where an employee
terminates employment before options become exercisable or the Company
repurchased the shares during the two-year forfeiture period, all compensation
expense for those options is reversed as a forfeiture.
Payroll Taxes, Interest and Penalties. In connection with the stock-based
- -------------------------------------
compensation adjustments, the Company determined that certain options
previously classified as ISO grants were determined to have been granted with
an exercise price below the fair market value of the Company's stock on the
revised measurement dates. Under Internal Revenue Code Section 422, ISOs may
not be granted with an exercise price less than the fair market value on the
date of grant, and therefore these grants would not likely qualify for ISO tax
treatment. The disqualification of ISO classification exposes the Company and
the affected employees to payroll related withholding taxes once the
underlying shares are released from the post exercise two-year forfeiture
period and the substantial risk of forfeiture has lapsed (the "taxable
event"). The Company and the affected employees may also be subject to
interest and penalties for failing to properly withhold taxes and report this
taxable event on their respective tax returns. The Company is currently
reviewing the potential disqualification of ISO grants and the related
withholding tax implications with the Internal Revenue Service ("IRS") for
calendar years 2004, 2005 and 2006 in an effort to reach agreement on the
resulting tax liability. In the meantime, the Company has recorded expenses
related to the withholding taxes, interest and penalties associated with
options which would have created a taxable event in calendar years 2004, 2005
and 2006. The estimated payroll tax liability at March 31, 2006 for the
disqualification of tax treatment associated with ISO awards totaled $3,278.
In addition, the Company recorded an income tax benefit of $909 related to
this liability.
Income Tax Benefit. The Company reviewed the income tax effect of the
- ------------------
stock-based compensation charges, and it believes that the proper income tax
accounting for stock options under GAAP depends, in part, on the tax
distinction of the stock options as either ISOs or NSOs. Because of the
potential impact of the measurement date changes on the qualified status of
the options, the Company has determined that substantially all of the options
originally intended to be ISOs might not be qualified under the tax
regulations, and therefore should be accounted for as if they were NSOs for
financial accounting purposes. An income tax benefit has resulted from the
determination that certain NSOs for which stock-based compensation expense was
recorded will create an income tax deduction. The income tax benefit has
resulted in an increase to the Company's deferred tax assets for stock options
prior to the occurrence of a taxable event or the forfeiture of the related
options. Upon the occurrence of a taxable event or forfeiture of the
underlying options, the corresponding deferred tax asset is reversed and the
excess or deficiency in the deferred tax assets is recorded to paid-in capital
in the period in which the taxable event or forfeiture occurs. The Company has
recorded a deferred tax asset of $1,320 as of March 31, 2006 related to stock
options.
REVIEW OF TAX POSITIONS (UNRELATED TO STOCK OPTIONS)
In addition, the Company's restated consolidated financial statements include
an adjustment to increase the provision for income taxes and taxes payable to
reflect additional liabilities associated with tax positions claimed on filed
tax returns for fiscal years 2004, 2005 and 2006 that should have been
recorded in accordance with GAAP, partially offset by certain expected tax
refunds. As of March 31, 2006, the Company's liability for taxes payable
increased $5,407 as a result of these adjustments.
11
OTHER ADJUSTMENTS (UNRELATED TO STOCK OPTIONS)
In addition to the restatement adjustments associated with stock options and
income taxes discussed above, the Company's restated consolidated financial
statements include an adjustment for fiscal years 2002 through 2006 to reflect
the correction of errors related to the recognition of revenue associated with
shipments to customers under FOB destination terms and an adjustment to reduce
the estimated liability for employee medical claims incurred but not reported
at March 31, 2006. The Company improperly recognized revenue for certain
customers prior to when title and risk of ownership transferred to the
customer. The aggregate impact of these adjustments over the periods affected
was a decrease in net revenue of $1,175 and a decrease in net income of $385.
The aggregate impact on net income reflects a $498 decrease associated with
the net revenue errors and a $113 increase related to the adjustment of the
liability for medical claims.
The table below reflects the impacts of the restatement adjustments discussed
above on the Company's consolidated statements of income for the periods
presented below (in thousands):
CUMULATIVE
APRIL 1, 1995
THREE MONTHS ENDED NINE MONTHS ENDED THROUGH
CATEGORY OF ADJUSTMENTS: DECEMBER 31, 2005 DECEMBER 31, 2005 MARCH 31, 2004
- ------------------------ ------------------------ ------------------------ -----------------------
(a)
Pretax income impact:
Stock-based compensation expense
related to measurement date changes (b) $ 234 $ 686 $ 13,626
Payroll tax expense and penalties (b) 611 1,459 439
Other adjustments (2,112) 748 1,666
------------------------ ------------------------ -----------------------
(Increase) decrease in pretax income (1,267) 2,893 15,731
------------------------ ------------------------ -----------------------
Income tax impact:
Measurement date changes (72) (211) (1,050)
Payroll taxes (170) (404) (123)
Other income tax adjustments (c) 560 1,600 1,689
Other adjustments 657 (301) (584)
------------------------ ------------------------ -----------------------
Increase (decrease) in income tax expense 975 684 (68)
------------------------ ------------------------ -----------------------
(Increase) decrease in net income $ (292) $ 3,577 $ 15,663
======================== ======================== =======================
<FN>
- -------------------------------
(a) The cumulative effect of the restatement adjustments from fiscal 1996
through fiscal 2004 is summarized below:
STOCK OPTION ADJUSTMENTS OTHER ADJUSTMENTS DECREASE
YEARS ENDED ----------------------------- OTHER INCOME ------------------------ (INCREASE) TO
MARCH 31, PRETAX INCOME TAX TAX ADJUSTMENTS PRETAX INCOME TAX NET INCOME
- ----------- ------------- ------------- ---------------- ---------- ------------- --------------
1996 $ 829 (d) $ - $ - $ - $ - $ 829
1997 657 (1) - - - 656
1998 2,391 (19) - - - 2,372
1999 535 (27) - - - 508
2000 1,998 (62) - - - 1,936
2001 1,722 (141) - - - 1,581
2002 2,317 (219) - 2,534 (918) 3,714
2003 1,187 (248) - (1,610) 590 (81)
2004 2,429 (456) 1,689 742 (256) 4,148
------------- ------------- ---------------- ---------- ------------- --------------
Cumulative effect $ 14,065 $ (1,173) $ 1,689 $ 1,666 $ (584) $ 15,663
============= ============= ================ ========== ============= ==============
<FN>
(b) Stock-based compensation expenses, including related payroll taxes,
interest and penalties, have been recorded as adjustments to the selling
and administrative expenses line item in the Company's consolidated
statements of income for each period.
(c) This represents liabilities associated with tax positions taken in these
periods, partially offset by certain expected tax refunds and is not
related to accounting for stock options.
(d) Includes additional expense totaling $636, the affect of which on the
consolidated financial statements for 1996 and for each year 1986 to 1995
was not material.
12
Consolidated Statements of Income Impact
The following table reconciles the Company's previously reported results to
the restated consolidated statements of income for the three and nine months
ended December 31, 2005:
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, 2005 DECEMBER 31, 2005
------------------------------------------- -------------------------------------------
AS AS
PREVIOUSLY AS PREVIOUSLY AS
REPORTED ADJUSTMENTS RESTATED REPORTED ADJUSTMENTS RESTATED
---------- ----------- -------- ---------- ----------- --------
Net revenues $ 98,392 $ 3,360 $101,752 $ 280,188 $ (1,071) $279,117
Cost of sales 33,741 1,248 34,989 93,988 (323) 93,665
------------------------------------------- -------------------------------------------
Gross profit 64,651 2,112 66,763 186,200 (748) 185,452
------------------------------------------- -------------------------------------------
Operating expenses:
Research and development 6,817 - 6,817 20,869 - 20,869
Purchased in-process research and
development and transaction costs - - - 30,441 - 30,441
Selling and administrative 35,447 845 36,292 109,746 2,145 111,891
Amortization of intangibles 1,198 - 1,198 3,589 - 3,589
------------------------------------------- -------------------------------------------
Total operating expenses 43,462 845 44,307 164,645 2,145 166,790
------------------------------------------- -------------------------------------------
Operating income 21,189 1,267 22,456 21,555 (2,893) 18,662
------------------------------------------- -------------------------------------------
Other expense (income):
Interest expense 1,538 - 1,538 4,382 - 4,382
Interest and other income (1,272) - (1,272) (3,402) - (3,402)
------------------------------------------- -------------------------------------------
Total other expense 266 - 266 980 - 980
------------------------------------------- -------------------------------------------
Income before income taxes 20,923 1,267 22,190 20,575 (2,893) 17,682
Provision for income taxes 6,509 975 7,484 16,590 684 17,274
------------------------------------------- -------------------------------------------
Net income $ 14,414 $ 292 $ 14,706 $ 3,985 $ (3,577) $ 408
=========================================== ===========================================
Earnings per share:
Basic - Class A common $ 0.31 $ - $ 0.31 $ 0.08 $ (0.07) $ 0.01
Basic - Class B common 0.25 0.01 0.26 0.07 (0.06) 0.01
Diluted - Class A common (a) 0.26 0.01 0.27 0.08 (0.07) 0.01
Diluted - Class B common (a) 0.23 0.01
Shares used in per share calculation:
Basic - Class A common 36,314 (384) (b) 35,930 36,156 (468) (b) 35,688
Basic - Class B common 13,039 (127) (b) 12,912 13,160 (160) (b) 13,000
Diluted - Class A common (a) 59,407 (694) (b) 58,713 50,301 (717) (b) 49,584
Diluted - Class B common (a) 13,093 13,195
<FN>
- ----------
(a) In fiscal 2007, the Company began reporting diluted earnings per share
for Class B Common Stock under the two-class method which does not assume
the conversion of Class B Common Stock into Class A Common Stock.
Previously, the Company did not present diluted earnings per share for
Class B Common Stock.
(b) Adjustment to reflect impact of unrecognized stock-based compensation and
excess tax benefits in applying the treasury stock method and unvested
stock options in the two-year forfeiture period.
13
Consolidated Balance Sheets Impact
The following table reconciles the consolidated balance sheets previously
reported as of March 31, 2006 and December 31, 2005 to the restated amounts:
MARCH 31, 2006
--------------------------------------------------------------
AS
PREVIOUSLY AS
REPORTED ADJUSTMENTS RESTATED
-------- ----------- --------
Current assets:
Cash and cash equivalents $ 100,706 $ - $ 100,706
Marketable securities 106,763 - 106,763
Receivables, net 54,746 (1,175) (f) 53,571
Inventories, net 70,778 388 (f) 71,166
Prepaid and other assets 6,963 49 (a) 7,012
Deferred tax asset 8,034 2,038 (b)(c)(f)(g) 10,072
--------------------------------------------------------------
Total current assets 347,990 1,300 349,290
Property and equipment, net 178,042 - 178,042
Intangible assets and goodwill, net 72,955 - 72,955
Other assets 19,026 - 19,026
--------------------------------------------------------------
Total assets $ 618,013 $ 1,300 $ 619,313
==============================================================
Current liabilities:
Accounts payable $ 17,975 $ - $ 17,975
Accrued liabilities 17,100 7,576 (b)(c)(d)(e)(f)(g) 24,676
Current maturities of long-term debt 1,681 - 1,681
--------------------------------------------------------------
Total current liabilities 36,756 7,576 44,332
Long-term debt 241,319 - 241,319
Other long-term liabilities 5,442 - 5,442
Deferred tax liability 25,221 - 25,221
--------------------------------------------------------------
Total liabilities 308,738 7,576 316,314
--------------------------------------------------------------
Commitments and contingencies - - -
Shareholders' equity:
Preferred stock - - -
Class A Common Stock 400 (3) (d) 397
Class B Common Stock 127 - 127
Additional paid-in capital 129,367 15,813 (b)(d) 145,180
Retained earnings 233,496 (22,086) (a)(b)(c)(e)(f)(g) 211,410
Accumulated other comprehensive income (211) - (211)
Less: Treasury stock (53,904) - (53,904)
--------------------------------------------------------------
Total shareholders' equity 309,275 (6,276) 302,999
--------------------------------------------------------------
Total liabilities and shareholders' equity $ 618,013 $ 1,300 $ 619,313
==============================================================
DECEMBER 31, 2005
--------------------------------------------------------------
AS
PREVIOUSLY AS
REPORTED ADJUSTMENTS RESTATED
-------- ----------- --------
Current assets:
Cash and cash equivalents $ 66,839 $ - $ 66,839
Marketable securities 96,370 - 96,370
Receivables, net 69,159 (2,268) (f) 66,891
Inventories, net 57,519 751 (f) 58,270
Prepaid and other assets 6,621 44 (a) 6,665
Deferred tax asset 9,222 1,768 (b)(c)(f) 10,990
--------------------------------------------------------------
Total current assets 305,730 295 306,025
Property and equipment, net 170,398 - 170,398
Intangible assets and goodwill, net 73,980 - 73,980
Other assets 18,731 - 18,731
--------------------------------------------------------------
Total assets $ 568,839 $ 295 $ 569,134
==============================================================
Current liabilities:
Accounts payable $ 13,656 $ - $ 13,656
Accrued liabilities 20,833 6,631 (b)(c)(d)(e)(f)(g) 27,464
Current maturities of long-term debt 973 - 973
--------------------------------------------------------------
Total current liabilities 35,462 6,631 42,093
Long-term debt 209,069 - 209,069
Other long-term liabilities 5,316 - 5,316
Deferred tax liability 21,942 - 21,942
--------------------------------------------------------------
Total liabilities 271,789 6,631 278,420
--------------------------------------------------------------
Commitments and contingencies - - -
Shareholders' equity:
Preferred stock - - -
Class A Common Stock 396 (3) (d) 393
Class B Common Stock 130 - 130
Additional paid-in capital 128,775 14,959 (b)(d) 143,734
Retained earnings 221,712 (21,292) (a)(b)(c)(e)(f)(g) 200,420
Accumulated other comprehensive income (172) - (172)
Less: Treasury stock (53,791) - (53,791)
--------------------------------------------------------------
Total shareholders' equity 297,050 (6,336) 290,714
--------------------------------------------------------------
Total liabilities and shareholders' equity $ 568,839 $ 295 $ 569,134
==============================================================
<FN>
(a) Adjustment for accrued interest associated with certain expected tax
refunds.
(b) Adjustment for stock-based compensation expense pursuant to APB 25
($15,632 at March 31, 2006 and $15,391 at December 31, 2005) and related
income tax impact ($1,658 at March 31, 2006 and $1,584 at December 31,
2005), partially offset by the net effect of tax benefits realized in
accrued taxes ($2,432 at March 31, 2006 and $1,790 at December 31, 2005)
and excess tax benefits reflected in paid-in capital ($2,094 at March 31,
2006 and $1,538 at December 31, 2005).
(c) Adjustment for payroll taxes, interest and penalties associated with
stock-based compensation expense ($3,278 at March 31, 2006 and $2,443 at
December 31, 2005) and the related income tax impact ($909 at March 31,
2006 and $677 at December 31, 2005).
(d) Adjustment for exercise deposits received by the Company for stock
options in the two-year forfeiture period ($1,916 at March 31, 2006 and
$1,973 at December 31, 2005).
(e) Adjustment for additional liabilities associated with tax positions
taken, partially offset by certain expected tax refunds ($5,407 at March
31, 2006 and $4,831 at December 31, 2005).
(f) Adjustment to record net revenue and cost of sales when product is
received by the customer instead of shipping date for certain customers
(decrease in receivables of $1,175 at March 31, 2006 and $2,268 at
December 31, 2005; increase in inventories of $388 at March 31, 2006 and
$751 at December 31, 2005; decrease in deferred tax assets of $125 at
March 31, 2006 and $241 at December 31, 2005; decrease in accrued
liabilities of $414 at March 31, 2006 and $826 at December 31, 2005; and
decrease in retained earnings of $498 at March 31, 2006 and $932 at
December 31, 2005).
(g) Adjustment for reduction in estimated liability associated with employee
medical claims incurred but not reported (decrease in deferred tax assets
of $66; decrease in accrued liabilities of $179; and increase in retained
earnings of $113).
14
Consolidated Statements of Cash Flows Impact
The following table reconciles the consolidated statement of cash flows
previously reported for the nine months ended December 31, 2005 to the
restated amounts:
NINE MONTHS ENDED DECEMBER 31, 2005
----------------------------------------------------------------------
AS
PREVIOUSLY AS
REPORTED ADJUSTMENTS RESTATED
-------- ----------- --------
Operating Activities:
Net income $ 3,985 $ (3,577) (a)(b)(c)(d)(e) $ 408
Adjustments to reconcile net income to
net cash provided by operating activities:
Acquired in-process research
and development 29,570 - 29,570
Depreciation, amortization and
other non-cash charges 13,065 - 13,065
Deferred income tax provision 1,668 (375) (a)(b)(d)(e) 1,293
Deferred compensation 839 - 839
Stock-based compensation - 686 (a) 686
Changes in operating assets and liabilities:
Decrease (increase) in receivables, net (6,798) 1,071 (d) (5,727)
Increase in inventories (3,574) (322) (d) (3,896)
Decrease (increase) in prepaid
and other assets 2,805 (34) (c) 2,771
Increase (decrease) in accounts payable
and accrued liabilities 745 2,551 (b)(c)(d)(e) 3,296
------------ ------------- ------------
Net cash provided by operating activities 42,305 - 42,305
------------ ------------- ------------
Investing Activities:
Purchase of property and equipment (47,317) - (47,317)
Purchase of marketable securities (50,735) - (50,735)
Purchase of preferred stock (11,300) - (11,300)
Product acquisition (25,643) - (25,643)
------------ ------------- ------------
Net cash used in investing activities (134,995) - (134,995)
------------ ------------- ------------
Financing Activities:
Principal payments on long-term debt (698) - (698)
Dividends paid on preferred stock (52) - (52)
Purchase of common stock for treasury (140) - (140)
Cash deposits received for stock options 594 - 594
------------ ------------- ------------
Net cash used in financing activities (296) - (296)
------------ ------------- ------------
Decrease in cash and cash equivalents (92,986) - (92,986)
Cash and cash equivalents:
Beginning of year 159,825 - 159,825
------------ ------------- ------------
End of period $ 66,839 $ - $ 66,839
============ ============= ============
<FN>
- ---------------------
(a) Adjustment for stock-based compensation expense pursuant to APB 25 and
the related income tax impact.
(b) Adjustment for payroll taxes, interest and penalties associated with
stock-based compensation expense and the related income tax impact.
(c) Adjustment for additional liabilities associated with tax positions
taken, partially offset by certain expected tax refunds.
(d) Adjustment for revenue recognition errors related to shipments made to
certain customers.
(e) Adjustment for reduction in estimated liability associated with employee
medical claims incurred but not reported.
15
3. ACQUISITION AND LICENSE AGREEMENTS
In May 2005, the Company and FemmePharma, Inc. ("FemmePharma") mutually agreed
to terminate the license agreement between them entered into in April 2002. As
part of this transaction, the Company acquired all of the common stock of
FemmePharma for $25,000 after certain assets of the entity had been
distributed to FemmePharma's other shareholders. Under a separate agreement,
the Company had previously invested $5,000 in FemmePharma's convertible
preferred stock. Included in the Company's acquisition of FemmePharma are the
worldwide marketing rights to an endometriosis product that has successfully
completed Phase II clinical trials. This product was originally part of the
licensing arrangement with FemmePharma that provided the Company, among other
things, marketing rights for the product principally in the United States. In
accordance with the new agreement, the Company acquired worldwide licensing
rights of the endometriosis product, no longer is responsible for milestone
payments and royalties specified in the original licensing agreement, and
secured exclusive worldwide rights for use of the FemmePharma technology for
vaginal anti-infective products. During the nine months ended December 31,
2005, the Company recorded expense of $30,441 in connection with the
FemmePharma acquisition that consisted of $29,570 for acquired in-process
research and development and $871 in direct expenses related to the
transaction. The acquired in-process research and development charge
represented the estimated fair value of the endometriosis product being
developed that, at the time of the acquisition, had no alternative future use
and for which technological feasibility had not been established. The
FemmePharma acquisition expense was determined by the Company to not be
deductible for tax purposes. The Company also allocated $375 of the purchase
price for a non-compete agreement and $300 of the purchase price for the
royalty-free worldwide license to use FemmePharma's technology for vaginal
anti-infective products acquired in the transaction.
In May 2005, the Company entered into a long-term product development and
marketing license agreement with Strides Arcolab Limited ("Strides"), an
Indian generic pharmaceutical developer and manufacturer, for exclusive
marketing rights in the United States and Canada for ten new generic drugs.
Under the agreement, Strides will be responsible for developing, submitting
for regulatory approval and manufacturing the ten products and the Company
will be responsible for exclusively marketing the products in the territories
covered by the agreement. Under a separate agreement, the Company invested
$11,300 in Strides redeemable preferred stock. This investment is denominated
in the Indian rupee and is subject to foreign currency transaction gains or
losses resulting from exchange rate changes. As a result of changes in the
exchange rate, the carrying value of this investment was $11,145 at December
31, 2006. This investment has been accounted for using the cost method and is
included in "Other assets" in the accompanying consolidated balance sheet at
December 31, 2006.
4. EARNINGS PER SHARE
The Company has two classes of common stock: Class A Common Stock and Class B
Common Stock that is convertible into Class A Common Stock. With respect to
dividend rights, holders of Class A Common Stock are entitled to receive cash
dividends per share equal to 120% of the dividends per share paid on the Class
B Common Stock. In June 2004, the Company adopted the guidance in Emerging
Issues Task Force ("EITF") Issue No. 03-06, "Participating Securities and the
Two-Class Method under FASB Statement No. 128." The pronouncement required the
use of the two-class method in the calculation and disclosure of basic
earnings per share and provided guidance on the allocation of earnings and
losses for purposes of calculating basic earnings per share. For purposes of
calculating basic earnings per share, undistributed earnings are allocated to
each class of common stock based on the contractual participation rights of
each class of security.
Beginning in fiscal 2007, the Company presented diluted earnings per share for
Class B Common Stock for all periods using the two-class method which does not
assume the conversion of Class B Common Stock into Class A Common Stock.
Previously, diluted earnings per share for Class B Common Stock was not
presented. The Company continues to present diluted earnings per share for
Class A Common Stock using the if-converted method which assumes the
conversion of Class B Common Stock into Class A Common Stock, if dilutive.
Basic earnings per share is computed using the weighted average number of
common shares outstanding during the period except that it does not include
unvested common shares subject to repurchase. Diluted earnings per share is
computed using the weighted average number of common shares and, if dilutive,
potential common shares outstanding during the period. Potential common shares
consist of the incremental common shares issuable upon the exercise of
16
stock options, unvested common shares subject to repurchase, convertible
preferred stock and the Convertible Subordinated Notes. The dilutive effects
of outstanding stock options and unvested common shares subject to repurchase
are reflected in diluted earnings per share by application of the treasury
stock method. Convertible preferred stock and the Convertible Subordinated
Notes are reflected on an if-converted basis. The computation of diluted
earnings per share for Class A Common Stock assumes the conversion of the
Class B Common Stock, while the diluted earnings per share for Class B Common
Stock does not assume the conversion of those shares.
The following table sets forth the computation of basic and diluted earnings
per share for the three months ended December 31, 2006 and 2005:
THREE MONTHS ENDED THREE MONTHS ENDED
DECEMBER 31, 2006 DECEMBER 31, 2005
--------------------------------- ---------------------------------
CLASS A CLASS B CLASS A CLASS B
---------------- ---------------- ---------------- ----------------
(AS RESTATED)
Basic earnings per share:
Numerator:
Allocation of undistributed earnings $ 14,428 $ 4,017 $ 11,304 $ 3,385
---------------- ---------------- ---------------- ----------------
Denominator:
Weighted average shares outstanding 37,288 12,372 36,313 13,039
Less - weighted average unvested
common shares subject to repurchase (362) (36) (383) (127)
---------------- ---------------- ---------------- ----------------
Number of shares used in per
share computations 36,926 12,336 35,930 12,912
================ ================ ================ ================
Basic earnings per share $ 0.39 $ 0.33 $ 0.31 $ 0.26
================ ================ ================ ================
Diluted earnings per share:
Numerator:
Allocation of undistributed earnings
for basic computation $ 14,428 $ 4,017 $ 11,304 $ 3,385
Reallocation of undistributed earnings as a
result of conversion of Class B to
Class A shares 4,017 - 3,385 -
Reallocation of undistributed earnings to
Class B shares - (480) - (350)
Add - preferred stock dividends 17 - 17 -
Add - interest expense convertible notes 1,014 - 1,021 -
---------------- ---------------- ---------------- ----------------
Allocation of undistributed earnings $ 19,476 $ 3,537 $ 15,727 $ 3,035
================ ================ ================ ================
Denominator:
Number of shares used in basic computation 36,926 12,336 35,930 12,912
Weighted average effect of dilutive securities:
Conversion of Class B to Class A shares 12,336 - 12,912 -
Employee stock options (2) 724 76 841 181
Convertible preferred stock 338 - 338 -
Convertible notes 8,692 - 8,692 -
---------------- ---------------- ---------------- ----------------
Number of shares used in per share
computations 59,016 12,412 58,713 13,093
================ ================ ================ ================
Diluted earnings per share (1) $ 0.33 $ 0.29 $ 0.27 $ 0.23
================ ================ ================ ================
<FN>
- ----------
(1) Excluded from the computation of diluted earnings per share were
outstanding stock options whose exercise prices were greater than the
average market price of the common shares for the period reported. For
the three months ended December 31, 2006 and 2005, excluded from the
computation were options to purchase 518 and 690 shares of Class A and
Class B Common Stock, respectively.
(2) Includes adjustment to reflect impact of unrecognized stock-based
compensation and excess tax benefits in applying the treasury stock
method and unvested stock options in the two-year forfeiture period.
17
The following table sets forth the computation of basic and diluted earnings
per share for the nine months ended December 31, 2006 and 2005:
NINE MONTHS ENDED DECEMBER 31,
-------------------------------------------------------------------------
2006 2005
------------------------------------ ------------------------------------
CLASS A CLASS B CLASS A CLASS B
----------------- ----------------- ------------------ -----------------
(AS RESTATED)
Basic earnings per share:
Numerator:
Allocation of undistributed earnings before
cumulative effect of change in accounting
principle $ 30,131 $ 8,486 $ 273 $ 83
Allocation of cumulative effect of
change in accounting principle 1,542 434 - -
----------------- ----------------- ------------------ -----------------
Allocation of undistributed earnings $ 31,673 $ 8,920 $ 273 $ 83
================= ================= ================== =================
Denominator:
Weighted average shares outstanding 37,100 12,475 36,156 13,161
Less - weighted average unvested
common shares subject to repurchase (343) (53) (468) (161)
----------------- ----------------- ------------------ -----------------
Number of shares used in per
share computations 36,757 12,422 35,688 13,000
================= ================= ================== =================
Basic earnings per share before cumulative
effect of change in accounting principle $ 0.82 $ 0.68 $ 0.01 $ 0.01
Per share effect of cumulative effect of
change in accounting principle 0.04 0.04 - -
----------------- ----------------- ------------------ -----------------
Basic earnings per share $ 0.86 $ 0.72 $ 0.01 $ 0.01
================= ================= ================== =================
Diluted earnings per share:
Numerator:
Allocation of undistributed earnings
for basic computation before cumulative
effect of change in accounting principle $ 30,131 $ 8,486 $ 273 $ 83
Reallocation of undistributed earnings as a
result of conversion of Class B to
Class A shares 8,486 - 83 -
Reallocation of undistributed earnings to
Class B shares - (845) - -
Add - preferred stock dividends 52 - - -
Add - interest expense convertible notes 2,929 - - -
----------------- ----------------- ------------------ -----------------
Allocation of undistributed earnings
for diluted computation before cumulative
effect of change in accounting principle 41,598 7,641 356 83
Allocation of cumulative effect of
change in accounting principle 1,976 363 - -
----------------- ----------------- ------------------ -----------------
Allocation of undistributed earnings $ 43,574 $ 8,004 $ 356 $ 83
================= ================= ================== =================
(CONTINUED)
18
NINE MONTHS ENDED DECEMBER 31,
--------------------------------------------------------------------------
2006 2005
------------------------------------ ------------------------------------
CLASS A CLASS B CLASS A CLASS B
----------------- ----------------- ----------------- -----------------
(AS RESTATED)
Diluted earnings per share (continued):
Denominator:
Number of shares used in basic computation 36,757 12,422 35,688 13,000
Weighted average effect of dilutive securities:
Conversion of Class B to Class A shares 12,422 - 13,000 -
Employee stock options (2) 719 107 896 195
Convertible preferred stock 338 - - -
Convertible notes 8,692 - - -
----------------- ----------------- ----------------- -----------------
Number of shares used in per share
computations 58,928 12,529 49,584 13,195
================= ================= ================= =================
Diluted earnings per share before cumulative
effect of change in accounting principle $ 0.71 $ 0.61 $ 0.01 $ 0.01
Per share effect of cumulative effect of
change in accounting principle 0.03 0.03 - -
----------------- ----------------- ----------------- -----------------
Diluted earnings per share (1) $ 0.74 $ 0.64 $ 0.01 $ 0.01
================= ================= ================= =================
<FN>
- -------------------
(1) Excluded from the computation of diluted earnings per share were
outstanding stock options whose exercise prices were greater than the
average market price of the common shares for the period reported. For
the nine months ended December 31, 2006, excluded from the computation
were options to purchase 778 shares of Class A and Class B Common Stock.
For the nine months ended December 31, 2005, there were stock options to
purchase 916 shares of Class A and Class B Common Stock, preferred shares
convertible into 338 shares of Class A Common Stock and $200,000
principal amount of Convertible Subordinated Notes convertible into 8,692
shares of Class A Common Stock that were excluded from the computation of
diluted loss per share because their effect would have been
anti-dilutive.
(2) Includes adjustment to reflect impact of unrecognized stock-based
compensation and excess tax benefits in applying the treasury stock
method and unvested stock options in the two-year forfeiture period.
5. STOCK-BASED COMPENSATION
Effective April 1, 2006, the Company adopted Statement of Financial Accounting
Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"), which
requires the measurement and recognition of compensation expense, based on
estimated fair values, for all share-based compensation awards made to
employees and directors over the vesting period of the awards. The Company
adopted SFAS 123R using the modified prospective method and, as a result, did
not retroactively adjust results from prior periods. Under the modified
prospective method, stock-based compensation was recognized (1) for the
unvested portion of previously issued awards that were outstanding at the
initial date of adoption based on the grant date fair value estimated in
accordance with the pro forma provisions of SFAS 123, "Accounting for
Stock-Based Compensation," and (2) for any awards granted or modified on or
subsequent to the effective date of SFAS 123R based on the grant date fair
value estimated in accordance with the provisions of this statement. Prior to
the adoption of SFAS 123R, the Company measured compensation expense for its
employee stock-based compensation plans using the intrinsic value method
prescribed by Accounting Principles Board Opinion No. 25 ("APB 25"). The
Company also applied the disclosure provisions of SFAS 123, as amended by SFAS
148, as if the fair-value-based method had been applied in measuring
compensation expense. Under APB 25, compensation cost for stock options was
recognized based on the excess, if any, of the quoted market price of the
stock at the grant date of the award or other measurement date over the amount
an employee must pay to acquire the stock. Determining the fair value of
share-based awards at the grant date requires judgment to identify the
appropriate valuation model and estimate the assumptions, including the
expected term of the stock options and expected stock-price volatility, to be
used in the calculation. Judgment is also required in estimating the
percentage of share-based awards that are expected to be forfeited. The
Company estimated the fair value of stock options granted using the
Black-Scholes option pricing model with assumptions based primarily on
historical data. If actual results differ significantly from these estimates,
stock-based compensation expense and the Company's results of operations could
be materially impacted.
On August 30, 2002, the Company's shareholders approved KV's 2001 Incentive
Stock Option Plan (the "2001 Plan"),
19
which allows for the issuance of up to 4,500 shares of common stock. Under the
Company's stock option plan, options to acquire shares of common stock have
been made available for grant to certain employees. Each option granted has an
exercise price of not less than 100% of the market value of the common stock
on the date of grant. The contractual life of each option is generally ten
years and the options vest at the rate of 10% per year from the date of grant.
The Company estimates the fair value of stock options granted using the
Black-Scholes option pricing model (the "Option Model"). The Option Model
requires the use of subjective and complex assumptions, including the option's
expected term and the estimated future price volatility of the underlying
stock, which determine the fair value of the share-based awards. The Company's
estimate of expected term was determined based on the average period of time
that options granted are expected to be outstanding considering current
vesting schedules and the historical exercise patterns of existing option
plans and the two-year forfeiture period. The expected volatility assumption
used in the Option Model is based on historical volatility over a period
commensurate with the expected term of the related options. The risk-free
interest rate used in the Option Model is based on the yield of U.S.
Treasuries with a maturity closest to the expected term of the Company's stock
options.
The Company's stock option agreements include a post-exercise service
condition which provides that exercised options are to be held by the Company
for a two-year period during which time the shares cannot be sold by the
employee. If the employee terminates employment voluntarily or involuntarily
(other than by retirement, death or disability) during the two-year period the
stock option agreements provide the Company with the option of repurchasing
the shares at the lower of the exercise price or the fair market value of the
stock on the date of termination. This repurchase option is considered a
forfeiture provision and the two-year period is included in determining the
requisite service period over which stock-based compensation expense is
recognized. The requisite service period initially is equal to the expected
term (as discussed above) plus two years and is revised when an option
exercise occurs.
If stock options expire unexercised or an employee terminates employment after
options become exercisable, no compensation expense associated with the
exercisable, but unexercised options, is reversed. In those instances where an
employee terminates employment before options become exercisable or the
Company repurchases the shares during the two-year forfeiture period,
compensation expense for these options is reversed as a forfeiture.
When an employee exercises stock options, the exercise proceeds received by
the Company are recorded as a deposit and classified as a current liability
for the two-year forfeiture period. These options are accounted for as issued
shares when the two-year forfeiture period lapses. Until the two-year
forfeiture requirement is met, the underlying shares are not considered
outstanding and not included in calculating basic earnings per share.
In accordance with the provisions of SFAS 123R, share-based compensation
expense recognized during a period is based on the value of the portion of
share-based awards that are expected to vest with employees. Accordingly, the
recognition of share-based compensation expense beginning April 1, 2006 has
been reduced for estimated future forfeitures. SFAS 123R requires forfeitures
to be estimated at the time of grant with adjustments recorded in subsequent
period compensation expense if actual forfeitures differ from those estimates.
Prior to implementing SFAS 123R, the Company accounted for forfeitures as they
occurred for the disclosure of pro forma information presented in the Notes to
Consolidated Financial Statements for prior periods. Upon adoption of SFAS
123R on April 1, 2006, the Company recognized the cumulative effect of a
change in accounting principle to reflect the effect of estimated forfeitures
related to outstanding awards that are not expected to vest as of the adoption
date. The cumulative adjustment increased net income for the nine months ended
December 31, 2006 by $1,976, net of tax, and increased diluted earnings per
share for Class A and Class B shares by $0.03 and $0.03, respectively.
The Company recognized, in accordance with SFAS 123R, stock-based compensation
of $1,029 and $2,948, respectively, and related tax benefits of $289 and $859,
respectively, for the three and nine months ended December 31, 2006. As a
result of the restatement discussed in Note 2, stock-based compensation
totaling $234 and $686 and related tax benefits of $72 and $211 were
recognized during the three and nine months ended December 31, 2005,
respectively. There was no stock-based employee compensation cost capitalized
as of December 31, 2006. Cash received from stock option deposits was $1,247
and $144 for the three months ended December 31, 2006 and 2005, respectively,
and $3,667 and $594 for the nine months ended December 31, 2006 and 2005,
respectively. The actual tax benefit realized from tax deductions associated
with stock option exercises (at expiration of two-year forfeiture period) was
$339 and $458 for the three months ended December 31, 2006 and 2005,
respectively, and $762 and $1,067 for the nine months ended December 31, 2006
and 2005, respectively.
20
The following weighted average assumptions were used for stock options granted
during the three and nine months ended December 31, 2006 and 2005:
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
-------------------- -------------------
2006 2005 2006 2005
---- ---- ---- ----
(AS RESTATED) (AS RESTATED)
Dividend yield............................... None None None None
Expected volatility.......................... 45% 48% 45% 48%
Risk-free interest rate...................... 4.93% 4.92% 4.93% 4.93%
Expected term ............................... 8.9 years 8.9 years 8.9 years 8.9 years
Weighted average fair value per share
at grant date.............................. $ 14.14 $ 13.41 $ 12.98 $ 12.16
A summary of the changes in the Company's stock option plan during the nine
months ended December 31, 2006 is presented below (in thousands, except per
share amounts):
WEIGHTED
WEIGHTED AVERAGE
AVERAGE REMAINING AGGREGATE
EXERCISE CONTRACTUAL INTRINSIC
SHARES PRICE TERM VALUE
------ ----- ---- -----
Balance, March 31, 2006 (as restated)...... 3,926 $ 14.71
Options granted............................ 555 18.66
Options exercised.......................... (331) 9.33 $ 4,947
Options canceled........................... (256) 16.00
-----------
Balance, December 31, 2006................. 3,894 16.10 5.5 $ 30,172
===========
Expected to vest at
December 31, 2006..................... 3,018 $ 16.10 5.5 $ 23,383
Options exercisable at
December 31, 2006 (excluding shares
in the two-year forfeiture period).... 1,374 $ 15.53 4.2 $ 13,165
As of December 31, 2006, the Company had $36,994 of total unrecognized
compensation expense, net of estimated forfeitures, related to stock option
grants, which will be recognized over the remaining weighted average period of
5.0 years.
21
Prior to April 1, 2006, the Company determined stock-based compensation
expense using the intrinsic value method of APB 25 and provided the
disclosures required by SFAS 123, as amended by SFAS 148. The following table
illustrates the effect of the restatement adjustments on the Company's pro
forma net income and pro forma earnings per share as if the Company had
applied the fair value recognition provisions of SFAS 123 to options granted
under the Company's stock option plans:
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, 2005 DECEMBER 31, 2005
--------------------------------------- ---------------------------------------
AS AS
PREVIOUSLY AS PREVIOUSLY AS
REPORTED ADJUSTMENTS RESTATED REPORTED ADJUSTMENTS RESTATED
-------- ----------- -------- -------- ----------- --------
Net income $ 14,414 $ 292 $ 14,706 $ 3,985 $ (3,577) $ 408
Add: Stock-based compensation
expense included in reported
net income, net of tax - 162 162 - 475 475
Deduct: Stock-based compensation
using the fair value based
method for all awards (206) (596) (802) (606) (1,471) (2,077)
-------------------------------------- --------------------------------------
Pro forma net income $ 14,208 $ (142) $ 14,066 $ 3,379 $ (4,573) $ (1,194)
====================================== ======================================
Earnings per share:
Basic - Class A common $ 0.31 $ - $ 0.31 $ 0.08 $ (0.07) $ 0.01
Basic - Class B common 0.25 0.01 0.26 0.07 (0.06) 0.01
Diluted - Class A common 0.26 0.01 0.27 0.08 (0.07) 0.01
Diluted - Class B common 0.23 0.01
Earnings per share - pro forma:
Basic - Class A common $ 0.30 $ - $ 0.30 $ 0.07 $ (0.10) $ (0.03)
Basic - Class B common 0.25 - 0.25 0.06 (0.09) (0.03)
Diluted - Class A common 0.26 - 0.26 0.07 (0.10) (0.03)
Diluted - Class B common 0.22 (0.03)
6. REVENUE RECOGNITION
Revenue is generally realized or realizable and earned when persuasive
evidence of an arrangement exists, delivery has occurred or services have been
rendered, the seller's price to the buyer is fixed or determinable, and the
customer's payment ability has been reasonably assured. Accordingly, the
Company records revenue from product sales when title and risk of ownership
have been transferred to the customer. The Company also enters into long-term
agreements under which it assigns marketing rights for the products it has
developed to pharmaceutical marketers. Royalties under these arrangements are
earned based on the sale of products.
Concurrently with the recognition of revenue, the Company records estimated
sales provisions for product returns, sales rebates, payment discounts,
chargebacks, and other sales allowances. Sales provisions are established
based upon consideration of a variety of factors, including but not limited
to, historical relationship to revenues, historical payment and return
experience, estimated customer inventory levels, customer rebate arrangements,
and current contract sales terms with wholesale and indirect customers.
Actual product returns, chargebacks and other sales allowances incurred are,
however, dependent upon future events and may be different than the Company's
estimates. The Company continually monitors the factors that influence sales
allowance estimates and makes adjustments to these provisions when management
believes that actual product returns, chargebacks and other sales allowances
may differ from established allowances.
22
Accruals for sales provisions are presented in the consolidated financial
statements as reductions to net revenues and accounts receivable. Sales
provisions totaled $42,617 and $41,700 (as restated) for the three months
ended December 31, 2006 and 2005, respectively, and $114,811 and $118,930 (as
restated) for the nine months ended December 31, 2006 and 2005, respectively.
The reserve balances related to the sales provisions totaled $38,352 and
$28,697 (as restated) at December 31, 2006 and March 31, 2006, respectively,
and are included in "Receivables, less allowance for doubtful accounts" in the
accompanying consolidated balance sheets.
7. INVENTORIES
Inventories consist of the following:
DECEMBER 31, 2006 MARCH 31, 2006
----------------- --------------
(AS RESTATED)
Finished goods..................... $ 29,722 $ 29,365
Work-in-process.................... 12,547 7,969
Raw materials...................... 39,751 33,832
----------- -----------
$ 82,020 $ 71,166
=========== ===========
Management establishes reserves for potentially obsolete or slow-moving
inventory based on an evaluation of inventory levels, forecasted demand and
market conditions.
8. INTANGIBLE ASSETS AND GOODWILL
Intangible assets and goodwill consist of the following:
DECEMBER 31, 2006 MARCH 31, 2006
---------------------------- ----------------------------
GROSS GROSS
CARRYING ACCUMULATED CARRYING ACCUMULATED
AMOUNT AMORTIZATION AMOUNT AMORTIZATION
------ ------------ ------ ------------
Product rights - Micro-K(R)................ $36,140 $(14,062) $36,140 $(12,708)
Product rights - PreCare(R)................ 8,433 (3,127) 8,433 (2,811)
Trademarks acquired:
Niferex(R)............................ 14,834 (2,781) 14,834 (2,225)
Chromagen(R)/StrongStart(R)........... 27,642 (5,183) 27,642 (4,147)
License agreements......................... 4,400 (435) 4,400 (300)
Covenant not to compete.................... 375 (62) 375 (34)
Trademarks and patents..................... 4,044 (733) 3,403 (604)
------- --------- ------- ---------
Total intangible assets.................. 95,868 (26,383) 95,227 (22,829)
Goodwill................................... 557 - 557 -
------- --------- ------- ---------
$96,425 $(26,383) $95,784 $(22,829)
======= ========= ======= =========
As of December 31, 2006, the Company's intangible assets have a weighted
average useful life of approximately 19 years. Amortization expense for
intangible assets was $1,204 and $1,198 for the three months ended December
31, 2006 and 2005, respectively, and $3,602 and $3,589 for the nine months
ended December 31, 2006 and 2005, respectively.
Assuming no additions, disposals or adjustments are made to the carrying
values and/or useful lives of the intangible assets, annual amortization
expense on product rights, trademarks acquired and other intangible assets is
estimated to be approximately $1,207 for the remainder of fiscal 2007 and
approximately $4,828 in each of the four succeeding fiscal years.
9. REVOLVING CREDIT AGREEMENT
On June 9, 2006, the Company replaced its $140,000 credit line by entering
into a new syndicated credit agreement with ten banks that provides for a
revolving line of credit for borrowing up to $320,000. The new credit
agreement also includes a provision for increasing the revolving commitment,
at the lenders' sole discretion, by up to an
23
additional $50,000. The new credit facility is unsecured unless the Company,
under certain specified circumstances, utilizes the facility to redeem part or
all of its outstanding Convertible Subordinated Notes. Interest is charged
under the facility at the lower of the prime rate or LIBOR plus 62.5 to 150
basis points depending on the ratio of senior debt to EBITDA. The new credit
agreement contains financial covenants that impose limits on dividend
payments, require minimum equity, a maximum senior leverage ratio and minimum
fixed charge coverage ratio. The new credit facility has a five-year term
expiring in June 2011. As of December 31, 2006, there were no borrowings
outstanding under the new credit facility.
10. LONG-TERM DEBT
Long-term debt consists of the following:
DECEMBER 31, 2006 MARCH 31, 2006
----------------- --------------
Building mortgages.......................... $ 41,815 $ 43,000
Convertible notes........................... 200,000 200,000
----------- ----------
241,815 243,000
Less current portion........................ (1,875) (1,681)
----------- ----------
$ 239,940 $ 241,319
=========== ==========
In March 2006, the Company entered into a $43,000 mortgage loan agreement with
one of its primary lenders, in part, to refinance $9,859 of existing
mortgages. The $32,764 of net proceeds the Company received from this mortgage
loan was used for working capital and general corporate purposes. The mortgage
loan, which is secured by three of the Company's buildings, bears interest at
a rate of 5.91% and matures on April 1, 2021.
On May 16, 2003, the Company issued $200,000 principal amount of Convertible
Subordinated Notes (the "Notes") that are convertible, under certain
circumstances, into shares of Class A common stock at an initial conversion
price of $23.01 per share. The Notes, which are due May 16, 2033, bear
interest that is payable on May 16 and November 16 of each year at a rate of
2.50% per annum. The Company also is obligated to pay contingent interest at a
rate equal to 0.5% per annum during any six-month period from May 16 to
November 15 and from November 16 to May 15, with the initial six-month period
commencing May 16, 2006, if the average trading price of the Notes per $1,000
principal amount for the five trading day period ending on the third trading
day immediately preceding the first day of the applicable six-month period
equals $1,200 or more. As of May 15, 2006, the average trading price of the
Notes had not reached the price that would result in the payment of contingent
interest.
The Company may redeem some or all of the Notes at any time on or after May
21, 2006, at a redemption price, payable in cash, of 100% of the principal
amount of the Notes, plus accrued and unpaid interest, including contingent
interest, if any. Holders may require the Company to repurchase all or a
portion of their Notes on May 16, 2008, 2013, 2018, 2023 and 2028 or upon a
change in control, as defined in the indenture governing the Notes, at a
purchase price, payable in cash, of 100% of the principal amount of the Notes,
plus accrued and unpaid interest, including contingent interest, if any. The
Notes are subordinate to all of our existing and future senior obligations.
The Notes are convertible, at the holders' option, into shares of the
Company's Class A Common Stock prior to the maturity date under the following
circumstances:
* during any quarter commencing after June 30, 2003, if the
closing sale price of the Company's Class A Common Stock
over a specified number of trading days during the previous
quarter is more than 120% of the conversion price of the
Notes on the last trading day of the previous quarter. The
Notes are initially convertible at a conversion price of
$23.01 per share, which is equal to a conversion rate of
approximately 43.4594 shares per $1,000 principal amount of
Notes;
* if the Company has called the Notes for redemption;
24
* during the five trading day period immediately following any
nine consecutive day trading period in which the trading
price of the Notes per $1,000 principal amount for each day
of such period was less than 95% of the product of the
closing sale price of our Class A Common Stock on that day
multiplied by the number of shares of our Class A Common
Stock issuable upon conversion of $1,000 principal amount of
the Notes; or
* upon the occurrence of specified corporate transactions.
The Company has reserved 8,692 shares of Class A Common Stock for issuance in
the event the Notes are converted into the Company's common shares.
Certain conversion features of the Notes and the contingent interest feature
meet the criteria of and qualify as embedded derivatives. Although these
features represent embedded derivative financial instruments, based on the de
minimis value of them at the time of issuance and at December 31, 2006, no
value has been assigned to these embedded derivatives.
The Notes, which are unsecured, do not contain any restrictions on the payment
of dividends, the incurrence of additional indebtedness or the repurchase of
the Company's securities, and do not contain any financial covenants.
11. TAXABLE INDUSTRIAL REVENUE BONDS
In December 2005, the Company entered into a financing arrangement with St.
Louis County, Missouri related to expansion of its operations in St. Louis
County. Up to $135,500 of industrial revenue bonds may be issued to the
Company by St. Louis County relative to capital improvements made through
December 31, 2009. This agreement provides that 50% of the real and personal
property taxes on up to $135,500 of capital improvements will be abated for a
period of ten years subsequent to the property being placed in service.
Industrial revenue bonds totaling $109,397 were outstanding at December 31,
2006. The industrial revenue bonds are issued by St. Louis County to the
Company upon its payment of qualifying costs of capital improvements, which
are then leased by the Company for a period ending December 1, 2019, unless
earlier terminated. The Company has the option at any time to discontinue the
arrangement and regain full title to the abated property. The industrial
revenue bonds bear interest at 4.25% per annum and are payable as to principal
and interest concurrently with payments due under the terms of the lease. The
Company has classified the leased assets as property and equipment and has
established a capital lease obligation equal to the outstanding principal
balance of the industrial revenue bonds. Lease payments may be made by
tendering an equivalent portion of the industrial revenue bonds. As the
capital lease payments to St. Louis County may be satisfied by tendering
industrial revenue bonds (which is the Company's intention), the capital lease
obligation, industrial revenue bonds and related interest expense and interest
income, respectively, have been offset for presentation purposes in the
Consolidated Financial Statements.
12. COMPREHENSIVE INCOME
Comprehensive income includes all changes in equity during a period except
those that resulted from investments by or distributions to the Company's
shareholders. Other comprehensive income refers to revenues, expenses, gains
and losses that, under generally accepted accounting principles, are included
in comprehensive income, but excluded from net income as these amounts are
recorded directly as an adjustment to shareholders' equity. For the Company,
comprehensive income is comprised of net income and the net changes in
unrealized gains and losses on available for sale marketable securities, net
of applicable income taxes. Total comprehensive income totaled $18,632 and
$14,681 (as restated) for the three months ended December 31, 2006 and 2005,
respectively, and $40,856 and $369 (as restated) for the nine months ended
December 31, 2006 and 2005, respectively.
13. SEGMENT REPORTING
The reportable operating segments of the Company are branded products,
specialty generics and specialty materials. The branded products segment
includes patent-protected products and certain trademarked off-patent products
that the Company sells and markets as branded pharmaceutical products. The
specialty generics segment includes off-patent pharmaceutical products that
are therapeutically equivalent to proprietary products. The Company sells its
branded and generic products primarily to pharmaceutical wholesalers, drug
distributors and chain drug stores. The specialty materials segment is
distinguished as a single segment because of differences in products,
marketing and regulatory approval when compared to the other segments.
25
Accounting policies of the segments are the same as the Company's consolidated
accounting policies. Segment profits are measured based on income before taxes
and are determined based on each segment's direct revenues and expenses. The
majority of research and development expense, corporate general and
administrative expenses, amortization and interest expense, as well as
interest and other income, are not allocated to segments, but included in the
"all other" classification. Identifiable assets for the three reportable
operating segments primarily include receivables, inventory, and property and
equipment. For the "all other" classification, identifiable assets consist of
cash and cash equivalents, corporate facilities including manufacturing and
distribution property and equipment, intangible and other assets and all
income tax related assets.
The following presents information for the Company's reportable operating
segments for the three and nine months ended December 31, 2006 and 2005.
THREE MONTHS
ENDED BRANDED SPECIALTY SPECIALTY ALL
DECEMBER 31, PRODUCTS GENERICS MATERIALS OTHER ELIMINATIONS CONSOLIDATED
------------ -------- -------- --------- ----- ------------ ------------
Net revenues 2006 $48,311 $64,745 $4,545 $ 348 $ - $ 117,949
(as restated) 2005 42,910 55,056 3,433 353 - 101,752
Segment profit (loss) 2006 22,102 35,956 725 (30,735) - 28,048
(as restated) 2005 18,232 27,171 (657) (22,556) - 22,190
Identifiable assets
(at period end) 2006 28,858 87,736 7,967 552,380 (1,158) 675,783
(as restated) 2005 28,833 71,184 8,273 462,002 (1,158) 569,134
Property and 2006 3 - - 3,292 - 3,295
equipment additions 2005 - 1,005 117 9,339 - 10,461
Depreciation and 2006 178 84 40 5,312 - 5,614
amortization 2005 146 82 43 4,405 - 4,676
NINE MONTHS
ENDED BRANDED SPECIALTY SPECIALTY ALL
DECEMBER 31, PRODUCTS GENERICS MATERIALS OTHER ELIMINATIONS CONSOLIDATED
------------ -------- -------- --------- ----- ------------ ------------
Net revenues 2006 $138,453 $170,072 $13,206 $ 1,401 $ - $ 323,132
(as restated) 2005 107,664 157,825 12,386 1,242 - 279,117
Segment profit (loss) 2006 62,317 88,341 2,047 (91,667) - 61,038
(as restated) 2005 39,488 78,853 1,327 (101,986) - 17,682
Property and 2006 96 - - 21,538 - 21,634
equipment additions 2005 124 1,048 333 45,812 - 47,317
Depreciation and 2006 533 253 121 15,755 - 16,662
amortization 2005 432 233 125 12,275 - 13,065
Consolidated revenues are principally derived from customers in North America
and substantially all property and equipment is located in the St. Louis,
Missouri metropolitan area.
14. CONTINGENCIES - LITIGATION
The Company is named as a defendant a patent infringement case filed in the
U.S. District Court for the District of New Jersey by Janssen, L.P., Janssen
Pharmaceutica N.V. and Ortho-McNeil Neurologics, Inc. (collectively,
"Janssen") on December 14, 2007 and styled Janssen, L.P. et al. v. KV
Pharmaceutical Company. After the Company
26
filed an ANDA with the FDA seeking permission to market a generic version of
the 8 mg and 16 mg strengths of Razadyne(R) ER (formerly Reminyl(R))
galantamine hydrobromide extended-release capsules, Janssen filed these
lawsuits for patent infringement under a patent owned by Janssen. In the
Company's Paragraph IV certification, KV contended that its proposed generic
versions do not infringe Janssen's patent. Pursuant to the Hatch-Waxman Act,
the filing date of the suit against the Company instituted an automatic stay
of FDA approval of the Company's ANDA until the earlier of a judgment, or 30
months from the date of the suit. The Company has filed an answer and
counterclaim for declaratory judgment of non-infringement and patent
invalidity. The case is just commencing and no trial date has yet been set.
The Company intends to vigorously defend its interests; however, it cannot
give any assurance that it will prevail.
The Company is named as a defendant in a patent infringement case filed in the
U.S. District Court for the District of New Jersey by Celgene Corporation
("Celgene") and Novartis Pharmaceuticals Corporation and Novartis Pharma AG
(collectively, "Novartis") on October 4, 2007 and styled Celgene Corporation
et al. v. KV Pharmaceutical Company. After the Company filed an ANDA with the
FDA seeking permission to market a generic version of the 10 mg, 20 mg, 30 mg,
and 40 mg strengths of Ritalin LA(R) methylphenidate hydrochloride
extended-release capsules, Celgene and Novartis filed this lawsuit for patent
infringement under the provisions of the Hatch-Waxman Act with respect to two
patents owned by Celgene and licensed to Novartis. In the Company's Paragraph
IV certification, KV contended that its proposed generic versions do not
infringe Celgene's patents. Pursuant to the Hatch-Waxman Act, the filing date
of the suit against the Company instituted an automatic stay of FDA approval
of the Company's ANDA until the earlier of a judgment, or 30 months from the
date of the suit. The Company has been served with this complaint and has
filed its answer and a counterclaim in the case, seeking a declaratory
judgment of non-infringement, patent invalidity, and inequitable conduct in
obtaining the patents. The case is just commencing and no trial date has yet
been set. The Company intends to vigorously defend its interests; however, it
cannot give any assurance that it will prevail.
The Company is named as a defendant in a patent infringement case brought by
Purdue Pharma L.P., The P.F. Laboratories, Inc., and Purdue Pharmaceuticals
L.P. ("Purdue") on January 17, 2007 against it and an unrelated third party
and styled Purdue Pharma L.P. et al. v. KV Pharmaceutical Company et al. filed
in the U.S. District Court for the District of Delaware. After the Company
filed an ANDA with the FDA seeking permission to market a generic version of
the 10 mg, 20 mg, 40 mg, and 80 mg strengths of OxyContin(R) in
extended-release tablet form, Purdue filed a lawsuit against KV for patent
infringement under the provisions of the Hatch-Waxman Act with respect to
three Purdue patents. In the Company's Paragraph IV certification, KV
contended that its proposed generic versions do not infringe Purdue's patents.
On February 12, 2007, a second patent infringement lawsuit was filed in the
same court against the Company by Purdue, asserting patent infringement under
the same three patents with respect to the Company's filing of an amendment to
its ANDA with FDA to sell a generic equivalent of Purdue's OxyContin(R), 30 mg
and 60 mg strengths, products. On June 6, 2007, a third patent infringement
lawsuit was filed against the Company by Purdue in the U.S. District Court for
the Southern District of New York, asserting patent infringement under the
same three patents with respect to the Company's filing of an amendment to its
ANDA with FDA to sell a generic equivalent of Purdue's OxyContin(R), 15 mg
strength, product. The two lawsuits filed in federal court in Delaware have
been transferred to the federal court in New York for multi-district
litigation purposes together with an additional lawsuit by Purdue against
another unrelated company, also in federal court in New York. Purdue currently
has a similar lawsuit pending against an additional unrelated company in
federal court in Delaware.
The Company filed answers and counterclaims against Purdue in all three
lawsuits, asserting various defenses to Purdue's claims; seeking declaratory
relief of the invalidity, unenforceability and non-infringement of the Purdue
patents; and asserting counterclaims against Purdue for violations of federal
antitrust law, including Sherman Act Section 1 and Section 2 for
monopolization, attempt to monopolize, and conspiracy to monopolize with
respect to the U.S. market for controlled-release oxycodone, and agreements in
unreasonable restraint of competition, and for intentional interference with
valid business expectancy. Purdue has filed replies to the Company's
counterclaims.
Pursuant to the Hatch-Waxman Act, the filing date of the suit against the
Company instituted an automatic stay of FDA approval of the Company's ANDA
until the earlier of a judgment, or 30 months from the date of the suit. The
court initially stayed all proceedings pending determining whether Purdue
committed inequitable conduct in its dealings with the U.S. Patent and
Trademark Office with respect to the issuance of its patents, which would
render such patents unenforceable, and the court's subsequent decision on the
issue. On January 7, 2008, the court issued its decision finding that Purdue
had not committed inequitable conduct with respect to the patents in suit.
Discovery in the suit has not yet commenced but is expected to commence
shortly. No trial date has yet been set. The Company intends to
27
vigorously defend its interests; however, it cannot give any assurance that it
will prevail.
The Company and ETHEX are named as defendants in a case brought by CIMA LABS,
Inc. and Schwarz Pharma, Inc. and styled CIMA LABS, Inc. et. al. v. KV
Pharmaceutical Company et. al. filed in U.S. District Court for the District
of Minnesota. CIMA alleged that the Company and ETHEX infringed on a CIMA
patent in connection with the manufacture and sale of Hyoscyamine Sulfate
Orally Dissolvable Tablets, 0.125 mg. The court has entered a stay pending the
outcome of the U.S. Patent and Trademark Office's reexamination of a patent at
issue in the suit. The Patent and Trademark Office has, to date, issued a
final office action rejecting all existing and proposed new claims by CIMA
with respect to this patent. CIMA has certain rights of appeal of this
rejection of its claims and has exercised those rights. ETHEX will continue to
market the product during the stay. The Company intends to vigorously defend
its interests if and when the stay is lifted; however, it cannot give any
assurance it will prevail.
The Company and ETHEX were named as defendants in a case brought by Solvay
Pharmaceuticals, Inc. and styled Solvay Pharmaceuticals, Inc. v. ETHEX
Corporation, filed in U.S. District Court in Minnesota. In general, Solvay
alleged that ETHEX's comparative promotion of its Pangestyme(TM) CN 10 and
Pangestyme(TM) CN 20 products to Solvay's Creon(R) 10 and Creon(R) 20 products
resulted in false advertising and misleading statements under various federal
and state laws, and constituted unfair and deceptive trade practices. The
court has previously entered an order granting in part, and denying in part,
the Company's motion for partial summary judgment on certain of plaintiff's
allegations of violations of the Lanham Act, and an order denying a second
motion by the Company for partial summary judgment on plaintiff's remaining
allegations under the Lanham Act and state law. Settlement discussions
required by federal court processes were not fruitful. Trial took place in
federal court in Minneapolis and on March 6, 2007, the jury held for the
Company and ETHEX on all counts and the complaint has been dismissed. The time
for appeal by Solvay has now passed.
The Company and ETHEX are named as defendants in a case brought by Axcan
ScandiPharm Inc. and styled Axcan ScandiPharm Inc. v. ETHEX Corporation et.
al., filed in U.S. District Court in Minnesota on June 1, 2007. In general,
Axcan alleges that ETHEX's comparative promotion of its Pangestyme(TM) UL12
and Pangestyme(TM) UL18 products to Axcan's Ultrase(R) MT12 and Ultrase(R)
MT18 products resulted in false advertising and misleading statements under
various federal and state laws, and constituted unfair and deceptive trade
practices. The Company filed a motion for judgment on the pleadings in its
favor on several grounds. The motion has been granted in part and denied in
part by the court on October 19, 2007, with the court applying the statute of
limitations to cut off Axcan's claims concerning conduct prior to June 2001,
determining that it was too early to determine whether laches or res judicata
barred the suit, and rejecting the remaining bases for dismissal. Discovery
has since commenced and a trial date has been set for January 2010. The
Company intends to vigorously defend its interests; however, it cannot give
any assurance that it will prevail.
The Company has been advised that one of its former distributor customers is
being sued in Florida state court in a case captioned Darrian Kelly v. K-Mart
et. al. for personal injury allegedly caused by ingestion of K-Mart diet
caplets that are alleged to have been manufactured by the Company and to
contain phenylpropanolamine, or PPA. The distributor has tendered defense of
the case to the Company and has asserted a right to indemnification for any
financial judgment it must pay. The Company previously notified its product
liability insurer of this claim in 1999 and again in 2004, and the Company has
demanded that the insurer assume the Company's defense. The insurer has stated
that it has retained counsel to secure additional factual information and will
defer its coverage decision until that information is received. The Company
intends to vigorously defend its interests; however, it cannot give any
assurance that it will not be impleaded into the action, or that, if it is
impleaded, that it would prevail.
KV's product liability coverage for PPA claims expired for claims made after
June 15, 2002. Although the Company renewed its product liability coverage for
coverage after June 15, 2002, that policy excludes future PPA claims in
accordance with the standard industry exclusion. Consequently, as of June 15,
2002, the Company will provide for legal defense costs and indemnity payments
involving PPA claims on a going forward basis as incurred. Moreover, the
Company may not be able to obtain product liability insurance in the future
for PPA claims with adequate coverage limits at commercially reasonable prices
for subsequent periods. From time to time in the future, KV may be subject to
further litigation resulting from products containing PPA that it formerly
distributed. The Company intends to vigorously defend its interests in the
event of such future litigation; however, it cannot give any assurance it will
prevail.
After the Company filed ANDAs with the FDA seeking permission to market a
generic version of the 25 mg, 50 mg,
28
100 mg, and 200 mg strengths of Toprol-XL(R) in extended-release capsule
form, AstraZeneca filed lawsuits against KV for patent infringement
under the provisions of the Hatch-Waxman Act. In the Company's
Paragraph IV certification, KV contended that its proposed generic
versions do not infringe AstraZeneca's patents. Pursuant to the Hatch-
Waxman Act, the filing date of the suit against the Company instituted
an automatic stay of FDA approval of the Company's ANDA until the
earlier of a judgment, or 30 months from the date of the suit. The
Company filed motions for summary judgment with the United States District
Court in Missouri alleging, among other things, that AstraZeneca's patent is
invalid and unenforceable. These motions were granted and AstraZeneca
appealed. On July 23, 2007, the Court of Appeals for the Federal Circuit
affirmed the decision of the District Court below with respect to the
invalidity of AstraZeneca's patent but reversed and remanded with respect to
inequitable conduct by AstraZeneca. AstraZeneca filed for rehearing by the
Federal Circuit, which was denied and the time has now run with respect to any
petition for certiorari to the United States Supreme Court. As a result, the
Company no longer faces the prospect of any liability to AstraZeneca in
connection with this lawsuit. KV is, however, proceeding with its counterclaim
against AstraZeneca for inequitable conduct in obtaining the patents that have
been ruled invalid, in order to recover the Company's defense costs, including
legal fees; however, it cannot give any assurance it will prevail.
The Company and/or ETHEX have been named as defendants in certain multi-
defendant cases alleging that the defendants reported improper or
fraudulent pharmaceutical pricing information, i.e., Average Wholesale
Price, or AWP, and/or Wholesale Acquisition Cost, or WAC, information,
which caused the governmental plaintiffs to incur excessive costs for
pharmaceutical products under the Medicaid program. Cases of this type
have been filed against the Company and/or ETHEX and other
pharmaceutical manufacturer defendants by the States of Massachusetts,
Alabama, Mississippi, Utah and Iowa, New York City, and approximately 45
counties in New York State. The State of Mississippi effectively
voluntarily dismissed the Company and ETHEX without prejudice on October
5, 2006 by virtue of the State's filing an Amended Complaint on such
date that does not name either the Company or ETHEX as a defendant. In
the remaining cases, only ETHEX is a named defendant. On August 13,
2007, ETHEX settled the Massachusetts lawsuit for $575 in cash and $150
in free pharmaceuticals over the next two years and received a general
release; no admission of liability was made. The New York City case and
all New York county cases (other than the Erie, Oswego and Schenectady
County cases) have been transferred to the U.S. District Court for the
District of Massachusetts for coordinated or consolidated pretrial
proceedings under the Average Wholesale Price Multidistrict Litigation
(MDL No. 1456). The cases pertaining to the State of Alabama, Erie
County, Oswego County, and Schenectady County were removed to federal
court by a co-defendant in October 2006, but all of these cases have
since been remanded to the state courts in which they originally were
filed. A motion is pending in New York state courts to coordinate the
Oswego, Erie and Schenectady Counties cases. Each of these actions is
in the early stages, with fact discovery commencing or ongoing in the
Alabama case and the federal cases involving New York City and 42 New
York counties. On October 24, 2007, ETHEX was served with a complaint
filed in Utah state court by the State of Utah naming it and nine other
pharmaceutical companies as defendants in a pricing suit. On November
19, 2007, the State of Utah filed an amended complaint. The Utah suit
has been removed to federal court and a motion has been filed to
transfer the case to the MDL litigation for pretrial coordination. The
State is seeking to remand the case to state court, and the decision is
pending before the court. The time for ETHEX to answer or respond to
the Utah complaint has not yet run. On October 9, 2007, the State of
Iowa filed a complaint in federal court in Iowa naming ETHEX and 77
other pharmaceutical companies as defendants in a pricing suit. ETHEX
and the other defendants have filed a motion to dismiss the Iowa
complaint. The Company intends to vigorously defend its interests in
the actions described above; however, it cannot give any assurance it
will prevail.
The Company believes that various other governmental entities have
commenced investigations into the generic and branded pharmaceutical
industry at large regarding pricing and price reporting practices.
Although the Company believes its pricing and reporting practices have
complied in all material respects with its legal obligations, it cannot
give any assurance that it would prevail if legal actions are instituted
by these governmental entities.
The Company and ETHEX were named as co-defendants in a suit in the U.S.
District Court for the Southern District of Florida filed by the
personal representative of the estate of Joyce Hoyle and her children in
connection with Ms. Hoyle's death in 2003, allegedly from oxycodone
toxicity styled Thomas Hoyle v. Purdue Pharma et al. The suit alleged
that between June 2001 and May 2003 Ms. Hoyle was prescribed and took
three different opiate pain medications manufactured and sold by the
defendants, including one product, oxycodone, that was manufactured by
the Company and marketed by ETHEX, and that such medications were
promoted without sufficient warnings about the side effect of addiction.
The causes of action were strict liability for an inherently dangerous
product, negligence, breach of express and implied warranty and breach
of implied warranty of fitness for a particular purpose. The
29
discovery process had not yet begun, and the court had set the trial to
commence in July 2007. The plaintiff and the Company agreed, however,
to a tolling agreement, under which the plaintiff dismissed the case
without prejudice in return for the Company's agreement to toll the
statute of limitations in the event the plaintiff refiled its case in
the future. The case was dismissed without prejudice. On January 18,
2008, the Company and ETHEX were served with a new complaint,
substantially similar to the earlier law suit. KV and ETHEX have filed
an answer to the new complaint. The Company intends to vigorously
defend its interests; however, it cannot give any assurance that it will
prevail.
On September 15, 2006, a shareholder derivative suit, captioned Fuhrman
v. Hermelin et al., was filed in state court in St. Louis, Missouri
against the Company, as nominal defendant, and seven present or former
officers and directors, alleging that defendants had breached their
fiduciary duties and engaged in unjust enrichment in connection with the
granting, dating, expensing and accounting treatment of past grants of
stock options between 1995 and 2002 to six current or former directors
or officers. Relief sought included damages, disgorgement of backdated
stock options and their proceeds, attorneys' fees, and equitable relief.
On February 26, 2007, the Fuhrman lawsuit was dismissed without
prejudice by the plaintiff in state court, and a lawsuit, captioned
Krasick v. Hermelin et al., was filed in the U.S. District Court for the
Eastern District of Missouri by the same law firms as in the Fuhrman
lawsuit, with a different plaintiff. The Krasick lawsuit was also a
shareholder derivative suit filed against the Company, as nominal
defendant, and 19 present or former officers and directors. The
complaint asserted within its fiduciary duties claims allegations that
the officers and/or directors of KV improperly (including through
collusion and aiding and abetting) backdated stock option grants in
violation of shareholder-approved plans, improperly recorded and
accounted for the allegedly backdated options in violation of GAAP,
improperly took tax deductions under the Internal Revenue Code,
disseminated and filed false financials and false SEC filings in
violation of federal securities laws and rules thereunder, and engaged
in insider trading and misappropriation of information. Relief sought
included damages, a demand for accounting and recovery of the benefits
allegedly improperly received, rescission of the allegedly backdated
stock options and disgorgement of their proceeds, and reasonable
attorney's fees, in addition to equitable relief, including an
injunction to require the Company to change certain of its corporate
governance and internal control procedures. On May 11, 2007, the
Company learned of the filing of another lawsuit, captioned Gradwell v.
Hermelin et al., also in the U.S. District Court for the Eastern
District of Missouri. The complaint was brought by the same law firms
that brought the Krasick litigation and was substantively the same as in
the Krasick litigation, other than being brought on behalf of a
different plaintiff and eliminating one individual defendant from the
suit. On July 18, 2007, the Krasick and Gradwell suits were refiled as
a consolidated action in U.S. District Court for the Eastern District of
Missouri, styled In re K-V Pharmaceutical Company Derivative Litigation,
which was substantively the same as the Krasick and Gradwell suits. The
Company has moved to terminate the litigation based on a determination
by members of a Special Committee of the Board of Directors, as
described more fully in Note 2, that continuation of the litigation was
not in the best interest of KV and its shareholders. All individual
officer and director defendants have joined in that motion. Plantiffs
filed a motion for rule to show cause why the defendants' motion to
terminate the lawsuit should not be stricken and dismissed. The Company
has filed an opposition and the matter is pending before the court. On
February 15, 2008, the court stayed proceedings in the case until April
9, 2008, to permit mediation pursuant to the parties' stipulation.
Mediation is scheduled to occur April 2, 2008. No formal discovery
has yet commenced, and no trial date has been set.
In the course of the Special Committee's investigation, by letter dated
December 18, 2006, the Company was notified by the SEC staff that it had
commenced an investigation with respect to the Company's stock option
plans, grants, exercises, and accounting treatment. The Company has
cooperated with the SEC staff in its investigation and, among other
things, has provided them with copies of the Special Committee's report
and all documents collected by the Special Committee in the course of
its review. Recently, the SEC staff, pursuant to a formal order of
investigation, has issued subpoenas for testimony of certain employees
and for documents, most of which have already been produced to the SEC
staff. The Company expects that the production of any additional
documents called for by the subpoena and the testimony of the employees
will be completed by April 2008.
Resolution of any of the matters discussed above could have a material
adverse effect on the Company's results of operations or financial
condition.
From time to time, the Company is involved in various other legal
proceedings in the ordinary course of its business. While it is not
feasible to predict the ultimate outcome of such other proceedings, the
Company believes that the ultimate outcome of such other proceedings
will not have a material adverse effect on its results of operations or
financial condition.
30
There are uncertainties and risks associated with all litigation and
there can be no assurance that the Company will prevail in any
particular litigation.
15. RECENTLY ISSUED ACCOUNTING STANDARDS
In June 2006, the FASB issued FASB Interpretation No. 48, "Accounting
for Uncertainty in Income Taxes - an interpretation of FASB Statement
No. 109" ("FIN 48"), which prescribes accounting for and disclosure of
uncertainty in tax positions. This interpretation addresses the
determination of whether tax benefits claimed or expected to be claimed
on a tax return should be recorded in the financial statements. Under
FIN 48, the Company may recognize the tax benefit from an uncertain tax
position only if it is more likely than not that the tax position will
be sustained on examination by the taxing authorities, based on the
technical merits of the position. The tax benefits recognized in the
financial statements from such a position should be measured based on
the largest benefit that has a greater than fifty percent likelihood of
being realized upon ultimate settlement. FIN 48 also provides guidance
on derecognition of tax positions, financial statement classification,
recognition of interest and penalties, accounting in interim periods,
and disclosure and transition requirements. FIN 48 is effective for
fiscal years beginning after December 15, 2006. The Company adopted FIN
48 on April 1, 2007.
In September 2006, FASB issued SFAS 157, "Fair Value Measurements"
("SFAS 157") which provides enhanced guidance for using fair value to
measure assets and liabilities. SFAS 157 clarifies the principle that
fair value should be based on the assumptions that market participants
would use when pricing an asset or liability, provides a framework for
measuring fair value under GAAP and expands disclosures requirements
about fair value measurements. SFAS 157 is effective for financial
statements issued in fiscal years beginning after November 15, 2007, and
interim periods within those fiscal years. The Company plans to adopt
SFAS 157 at the beginning of fiscal 2009 and is evaluating the impact,
if any, the adoption of SFAS 157 will have on its financial condition
and results of operations.
In March 2007, the FASB ratified the consensus reached by the Emerging
Issues Task Force ("EIFT") in Issue No. 06-10, "Accounting for
Collateral Assignment Split-Dollar Life Insurance Arrangements" ("Issue
06-10"). Issue 06-10 requires companies with collateral assignment
split-dollar life insurance policies that provide a benefit to an
employee that extends to postretirement periods to recognize a liability
for future benefits based on the substantive agreement with the
employee. Recognition should be in accordance with FASB Statement
No. 106, "Employers' Accounting for Postretirement Benefits Other Than
Pensions," or APB Opinion No. 12, "Omnibus Opinion - 1967," depending on
whether a substantive plan is deemed to exist. Companies are permitted
to recognize the effects of applying the consensus through either (1) a
change in accounting principle through a cumulative-effect adjustment to
retained earnings or to other components of equity or net assets as of
the beginning of the year of adoption or (2) a change in accounting
principle through retrospective application to all prior periods. Issue
06-10 is effective for fiscal years beginning after December 15, 2007,
with early adoption permitted. The Company plans to adopt Issue 06-10 at
the beginning of fiscal 2009 and is evaluating the impact of the
adoption of Issue 06-10 on its financial condition and results of
operations.
In June 2007, the FASB ratified the consensus reached by the EITF on
Issue No. 07-3, Accounting for Advance Payments for Goods or Services
Received for Use in Future Research and Development Activities ("Issue
07-3"), which is effective December 15, 2007 and is applied
prospectively for new contracts entered into on or after the effective
date. Issue 07-3 addresses nonrefundable advance payments for goods or
services for use in future research and development activities. Issue
07-3 will require that these payments that will be used or rendered for
future research and development activities be deferred and capitalized
and recognized as an expense as the related goods are delivered or the
related services are performed. If an entity does not expect the goods
to be delivered or the services to be rendered the capitalized advance
payments should be expensed. The Company is assessing the effects of
adoption of Issue 07-3 on its financial condition and results of
operations.
In September 2007, the EITF reached a consensus on Issue No. 07-1
("Issue 07-1"), "Accounting for Collaborative Arrangements." The scope
of Issue 07-1 is limited to collaborative arrangements where no separate
legal entity exists and in which the parties are active participants and
are exposed to significant risks and rewards that depend on the success
of the activity. The EITF concluded that revenue transactions with third
parties and associated costs incurred should be reported in the
appropriate line item in each company's financial statements pursuant to
the guidance in Issue 99-19, "Reporting Revenue Gross as a Principal
versus Net as an Agent." The EITF also concluded that the equity method
of accounting under Accounting Principles Board Opinion 18, "The Equity
Method of Accounting for
31
Investments in Common Stock," should not be applied to arrangements that
are not conducted through a separate legal entity. The EITF also
concluded that the income statement classification of payments made
between the parties in an arrangement should be based on a consideration
of the following factors: the nature and terms of the arrangement; the
nature of the entities' operations; and whether the partners' payments
are within the scope of existing GAAP. To the extent such costs are not
within the scope of other authoritative accounting literature, the
income statement characterization for the payments should be based on an
analogy to authoritative accounting literature or a reasonable,
rational, and consistently applied accounting policy election. The
provisions of Issue 07-1 are effective for fiscal years beginning on or
after December 15, 2007, and companies will be required to apply the
provisions through retrospective application. The Company plans to adopt
Issue 07-1 at the beginning of fiscal 2009 and is evaluating the impact
of the adoption of Issue 07-1 on its financial condition and results of
operations.
In December 2007, the FASB issued SFAS 141 (revised 2007), "Business
Combinations" ("SFAS 141(R)"), which replaces SFAS 141 but retains the
fundamental concept of purchase method of accounting in a business
combination and improves reporting by creating greater consistency in
the accounting and financial reporting of business combinations,
resulting in more complete, comparable, and relevant information for
investors and other users of financial statements. To achieve this goal,
the new standard requires the acquiring entity in a business combination
to recognize all the assets acquired and liabilities assumed in the
transaction and any non-controlling interest at the acquisition date
measured at their fair value as of that date. This statement requires
measuring a non-controlling interest in the acquiree at fair value which
will result in recognizing the goodwill attributable to the non-
controlling interest in addition to that attributable to the acquirer.
This statement also requires the recognition of assets acquired and
liabilities assumed arising from contractual contingencies as of the
acquisition date, measured at their acquisition fair values. SFAS 141(R)
is effective for fiscal years beginning after December 15, 2008. The
Company plans to adopt SFAS 141(R) at the beginning of fiscal 2010 and
is evaluating the impact of SFAS 141(R) on its financial condition and
results of operations.
In December 2007, the FASB issued SFAS. 160, "Non-controlling Interests
in Consolidated Financial Statements" ("SFAS 160") an amendment of ARB.
51, which will affect only those entities that have an outstanding non-
controlling interest in one or more subsidiaries or that deconsolidate a
subsidiary by requiring all entities to report non-controlling
(minority) interests in subsidiaries in the same way as equity in the
consolidated financial statements. In addition, SFAS 160 eliminates the
diversity that currently exists in accounting for transactions between
an entity and non-controlling interests by requiring they be treated as
equity transactions. SFAS 160 is effective for fiscal years beginning
after December 15, 2008. The Company plans to adopt SFAS 160 at the
beginning of fiscal 2010 and is evaluating the impact of SFAS 160 on
its financial condition and results of operations.
16. SUBSEQUENT EVENTS
In May 2007, the Company acquired the U.S. marketing rights to
EvaMist(TM), a new low-dose estrogen replacement therapy product
delivered with a patented metered-dose transdermal spray system, from
VIVUS, Inc. Under terms of the Asset Purchase Agreement, the Company
paid $10,000 in cash at closing and agreed to make an additional cash
payment of $140,000 upon final approval of the product by the U.S. Food
and Drug Administration ("FDA"). The agreement also provides for two
future payments upon achievement of certain net sales milestones. If
EvaMist(TM) achieves at least $100,000 of net sales in a fiscal year, a
one-time payment of $10,000 will be made, and if net sales levels reach
$200,000 in a fiscal year, a one-time payment of up to $20,000 will be
made. In July 2007, FDA approval for EvaMist(TM) was received and a
payment of $140,000 was subsequently made to VIVUS, Inc. The Company is
in the process of determining the appropriate allocation of the $140,000
payment. Since the product had not yet obtained FDA approval when the
initial payment was made at closing, the Company recorded $10,000 of in-
process research and development expense during the three months ended
June 30, 2007.
In May 2007, the Company received FDA approval to market the 100 mg and
200 mg strengths of metoprolol succinate extended-release tablets, the
generic version of Toprol-XL(R) (marketed by AstraZeneca). In fiscal
2006, the Company received a favorable court ruling in a Paragraph IV
patent infringement action filed against the Company by AstraZeneca
based on our ANDA submissions to market these generic formulations.
Since KV was the first company to file with the FDA for generic approval
of the 100 mg and 200 mg dosage strengths, the Company was accorded the
opportunity for a 180-day exclusivity period for marketing these two
dosage strengths.
32
In January 2008, the Company entered into a definitive asset purchase
agreement with CYTYC Prenatal Products and Hologic, Inc. ("CYTYC") to
acquire the U.S. and worldwide rights to Gestiva(TM) (17-alpha
hydroxyprogesterone caproate). Gestiva(TM) is used in the prevention of
preterm birth in certain categories of pregnant women. The proposed
indication is for women with a history of at least one spontaneous
preterm delivery (i.e., less than 37 weeks), who are pregnant with a
single fetus. Under the terms of the asset purchase agreement, the
Company agreed to pay a total of $82,000 for Gestiva(TM), $7,500 of
which was paid at closing. The remainder is payable on the completion
of two milestones: (1) $2,000 on CYTYC's receipt of acknowledgement from
the FDA that their response to the FDA's October 20, 2006 Approval
letter is sufficient for the FDA to proceed with their review of the NDA
and (2) $72,500 on FDA approval of a Gestiva(TM) NDA and receipt by the
Company of 15,000 units of finished Gestiva(TM) suitable for commercial
sale. Because the product is not expected to have received FDA approval
by the closing of the transaction, the Company expects to record $7,500
when the initial payment is made and $2,000 when the subsequent
milestone payment is made of in-process research and development
expenses.
On January 9, 2008 the Company has received a subpoena from the Office
of Inspector General of HHS, seeking documents with respect to two of
ETHEX's nitroglycerin products. The subpoena states that it is in
connection with an investigation into potential false claims under Title
42 of the U.S. Code, and the inquiry appears to pertain to whether these
nitroglycerin products are eligible for reimbursement under federal
health care programs, such as Medicaid and VA programs. The Company is
in the process of gathering the relevant documents in response to the
subpoena.
On January 23, 2008, the 133 employees represented by the Teamsters
Union voted to decertify union representation effective February 7,
2008. As a result of the decertification, the Company incurred a
withdrawal liability for the portion of the unfunded benefit obligation
associated with the multi-employer pension plan administered by the
union applicable to its employees covered by the plan. The withdrawal
liability of $923 will be paid and recorded as an expense in fiscal year
2008.
As of February 24, 2008, the Company held auction rate debt securities
in the aggregate principal amount of $83,900. The auction rate
securities are AAA rated, long-term debt obligations secured by student
loans, which are guaranteed by the U.S. Government. Liquidity for these
securities has been provided by an auction process that resets the
applicable interest rate at pre-determined intervals, up to 35 days. In
the past, the auction process has allowed investors to obtain immediate
liquidity by selling the securities at their face amounts. The value of
these securities was not impaired as of March 31, 2007. Disruptions in
credit markets, subsequent to March 31, 2007, however, have adversely
affected the auction market for these types of securities. During the
period from February 11, 2008 to March 6, 2008 auctions for all of the
auction rate securities held by the Company failed to produce sufficient
bidders to allow for successful auctions. The Company cannot predict how
long the current imbalance in the auction market will continue. As a
result, for a period of time, the Company may or may not be able to
liquidate any of its auction-rate securities prior to their maturities
at prices approximating their face amounts. The Company is currently
evaluating the market for these securities to determine if impairment of
the carrying value of the securities has occurred due to the loss of
liquidity. If such impairment has occurred and is not temporary, the
Company would recognize an impairment loss in the statement of income
for fiscal year 2008.
33
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
This Form 10-Q, including the documents that we incorporate herein by
reference, contains various forward-looking statements within the
meaning of the United States Private Securities Litigation Reform Act of
1995, and which may be based on or include assumptions concerning our
operations, future results and prospects. Such statements may be
identified by the use of words like "plans," "expect," "aim," "believe,"
"projects," "anticipates," "commit," "intend," "estimate," "will,"
"should," "could," and other expressions that indicate future events and
trends.
All statements that address expectations or projections about the
future, including without limitation, statements about our continued
satisfaction of the continued listing requirements on the New York Stock
Exchange and our strategy for growth, product development, regulatory
approvals, market position, acquisitions, revenues, expenditures and
other financial results, are forward-looking statements.
All forward-looking statements are based on current expectations and are
subject to risk and uncertainties. In connection with the "safe harbor"
provisions, we provide the following cautionary statements identifying
important economic, political and technology factors which, among
others, could cause actual results or events to differ materially from
those set forth or implied by the forward-looking statements and related
assumptions.
Such factors include (but are not limited to) the following: (1)
changes in the current and future business environment, including
interest rates and capital and consumer spending; (2) the difficulty of
predicting FDA approvals, including the timing, and that any period of
exclusivity may not be realized; (3) acceptance and demand for new
pharmaceutical products; (4) the impact of competitive products and
pricing, including as a result of so-called authorized-generic drugs;
(5) new product development and launch, including the possibility that
any product launch may be delayed or that product acceptance may be less
than anticipated; (6) reliance on key strategic alliances; (7) the
availability of raw materials and/or products manufactured for the
Company under contract manufacturing arrangements with third parties;
(8) the regulatory environment, including regulatory agency and judicial
actions and changes in applicable law or regulations; (9) fluctuations
in revenues and operating results; (10) the difficulty of predicting
international regulatory approval, including the timing; (11) the
difficulty of predicting the pattern of inventory movements by our
customers; (12) the impact of competitive response to our sales,
marketing and strategic efforts; (13) risks that we may not ultimately
prevail in our litigation; (14) the restatement of our financial
statements for fiscal periods 1996 through 2006 and for the quarter
ended June 30, 2006, as well as completion of the Company's financial
statements for the second and third quarters of fiscal 2007 and for the
full fiscal year ended March 31, 2007, and for the first, second and
third quarters of fiscal 2008; (15) actions by the Securities and
Exchange Commission and the Internal Revenue Service with respect to the
Company's stock option grants and accounting practices; (16) the risks
detailed from time to time in our filings with the Securities and
Exchange Commission; (17) actions by the NYSE Regulation, Inc. with
respect to the continued listing of the Company's stock on the New York
Stock Exchange; and (18) the impact of credit market disruptions on the
fair value of auction rate securities that the Company has acquired as
short-term investments.
This discussion is by no means exhaustive, but is designed to highlight
important factors that may impact the Company's outlook. We are under
no obligation to update any of the forward-looking statements after the
date of this report.
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 are subject to known
and unknown risks, uncertainties, and other factors that may cause our
actual results to differ materially from those expressed or implied by
such forward-looking statements. These risks, uncertainties and other
factors are discussed throughout this report and specifically under the
captions "Cautionary Statement Regarding Forward-Looking Information"
and "Risk Factors." In addition, the following discussion and analysis
of financial condition and results of operations, which gives effect to
the restatement discussed in Note 2 to the Consolidated Financial
Statements, should be read in conjunction with the consolidated
financial statements, the related notes to consolidated financial
statements and "Management's Discussion and Analysis of Results of
Operations and Financial Condition" included in our Annual Report on
Form 10-K for the fiscal year ended March 31, 2007 to be filed with the
Securities and Exchange Commission (the "2007 Form 10-K"), and the
unaudited interim consolidated financial statements and related notes to
unaudited interim consolidated financial statements included in Item 1
of this Quarterly Report on Form 10-Q.
34
REVIEW OF STOCK OPTION GRANT PRACTICES
BACKGROUND AND CONCLUSIONS
On October 31, 2006, we announced that we had been served with a
derivative lawsuit filed in St. Louis City Circuit Court alleging that
certain stock option grants to current or former officers and directors
between 1995 and 2002 were dated improperly. In accordance with our
established corporate governance procedures, the Board of Directors
referred this matter to the independent members of its Audit Committee
(the "Special Committee" or "Committee").
Shortly thereafter, the Special Committee commenced an investigation of
our stock option grant practices, assisted by independent legal counsel
and forensic accounting experts engaged by the Committee, with the
objectives of evaluating our accounting for stock options for compliance
with GAAP and for compliance with the terms of our related stock option
plans over the period January 1, 1995 through October 31, 2006 (the
"relevant period"). Over an approximately twelve-month period, the
Committee and its advisors interviewed all available persons (45 in all)
believed to be relevant to the issues being investigated, including
current and former employees, current and former outside directors and
our current auditors and outside legal counsel. They reviewed nearly
300,000 electronic and hard copy documents relating to our stock option
grant practices. During the relevant period we awarded 2,639 option
grants covering 10.6 million shares of our Class A and Class B Common
Stock, which were reviewed by the Committee.
On October 11, 2007, we filed a Current Report on Form 8-K announcing
the Special Committee had completed its investigation. The investigation
concluded that there was no evidence that any employee, officer or
director of the Company engaged in any intentional wrongdoing or was
aware that the Company's policies and procedures for granting and
accounting for stock options were materially non-compliant with GAAP.
The investigation also found no intentional violation of law or
accounting rules with respect to our historical stock option grant
practices.
However, the Special Committee concluded that stock-based compensation
expense resulting from the stock option grant practices followed by the
Company prior to April 2, 2006 were not recorded in accordance with GAAP
because the expense computed for most of the grants reflected incorrect
measurement dates for financial accounting purposes. The "measurement
date" means the date on which the option expense is fixed under
applicable accounting principles, namely Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees," ("APB 25")
and related interpretations, is the first date on which all of the
following are known and not subject to change: (a) the individual who is
entitled to receive the option grant, (b) the number of options that an
individual is entitled to receive, and (c) the option's exercise price.
FINDINGS AND ACCOUNTING CONSIDERATIONS
In general, stock options were granted to employees, executives and non-
employee members of the Board of Directors over the relevant period
under the terms of our 1991 and 2001 Incentive Stock Option Plans (the
"option plans"). The majority of our employees participate in our stock
option program. Approximately 78% of our employees have been awarded
grants under our option plans. In addition to options granted to the
CEO under those plans, "bonus options" were awarded to him under the
terms of his employment agreement in lieu of, and in consideration for a
reduction of, the cash bonus provided for in that agreement.
The option plans required grants to be approved by the Compensation
Committee of the Board of Directors. Under the option plans, options
were to be granted with exercise prices set at no less than the fair
market value of the underlying common stock at the date of grant. The
1991 plan provided for the exclusive grant of Incentive Stock Options
("ISOs") as defined by Internal Revenue Code Section 422, while the 2001
plan provided for the grant of both ISOs and non-qualified stock options
("NSOs"). Under the plans, options granted to employees other than the
CEO or directors are subject to a ten year ratable vesting period.
Options granted to the CEO and directors generally vest ratably over
five years.
Both option plans require that shares received upon exercise of an
option cannot be sold for two years. If the employee terminates
employment voluntarily or involuntarily (other than by retirement, death
or disability) during the two-year forfeiture period, the option plans
provide the Company with the option of repurchasing the shares at the
lower of the exercise price of the option or the fair market value of
the stock on the date of termination. We have changed our accounting for
stock-based compensation to consider this provision of the option plans
as a forfeiture provision to be accounted for in accordance with the
guidance provided in EITF No. 00-23, "Issues Related to Accounting for
Stock
35
Based Compensation under APB 25 and FIN 44," specifically Paragraph 78
and Issue 33 (a), "Accounting for Early Exercise". In accordance with
EITF No. 00-23, cash paid by an employee for the exercise price is
considered a deposit or a prepayment of the exercise price that is
recognized as a current liability when received by the Company at the
beginning of the two-year forfeiture period. The receipt of the exercise
price is recognized as a current liability because the options are
deemed not exercised and the option shares are not considered issued
until an employee bears the risk and rewards of ownership. The options
are accounted for as exercised when the two-year forfeiture period
lapses. In addition, because the options are not considered exercised
for accounting purposes, the shares in the two-year forfeiture period
are not considered outstanding for purposes of computing basic EPS.
Prior to fiscal 2007, we had accounted for all option grants as fixed in
accordance with the provisions of APB 25 using the date of grant as the
measurement date. Because the exercise price of the option was equal to
or greater than the market price of the stock at the measurement date,
under our prior procedures we did not recognize any compensation expense
since the option had no intrinsic value (intrinsic value being the
difference between the exercise price and the market price of the
underlying stock at the measurement date).
As noted above, the Special Committee determined that our accounting for
most of the stock option grants was not in accordance with GAAP because
the date of grant, as defined by the Company, was not a proper
measurement date. To correct those errors, and consistent with the
accounting literature and guidance from the Securities and Exchange
Commission ("SEC"), we organized the grants into categories based on
grant type and process by which the grant was finalized. Based on the
relevant facts and circumstances, we applied the authoritative
accounting standard (APB 25 and related interpretations) to determine,
for every grant within each category, the proper measurement date. If
the measurement date was not the originally assigned grant date,
accounting adjustments were made as required, resulting in stock-based
compensation expense and related tax effects. The grants were classified
as follows: (1) promotion/retention grants to executives and employees
and new hire grants ("employee options"); (2) grants to persons elected
or appointed to the Board of Directors ("director options"); and (3)
bonus option grants to the CEO in lieu of cash bonus payments under the
terms of his employment agreement ("bonus options").
Employee Options. The evidence obtained through the Committee's
- ----------------
investigation indicates that employee options were granted based on the
lowest market price in the quarter of grant determined from an effective
date (as defined below) to the end of the quarter. The exercise price
and grant date of the options were determined by looking back from the
end of the quarter to the effective date and choosing the lowest market
price during that period. The date on which the market price was lowest
became the grant date. This procedure to "look back" to the lowest
market price in the preceding quarter to set the exercise price was
widely known and understood within the Company. The effective date was
either the date on which the option recipients and the number of shares
to be granted were determined and approved by the CEO, the date of a
promotion or the date of hire. For new hires and promotions of existing
employees, which represents substantially all of the award recipients,
the terms of the award, except for the exercise price, were communicated
to the recipients prior to the end of the quarter. At the end of the
quarter, when the exercise price was determined, written consents were
prepared, dated as of the date on which the stock price was lowest
during the quarter, to be approved by the members of the Compensation
Committee. The evidence obtained through the investigation indicates the
Compensation Committee never changed or denied approval of any grants
submitted to them and, as such, their approval was considered a routine
matter. Based on the evidence and findings of the Special Committee, the
results of management's analysis, the criteria specified in APB 25 for
determining measurement dates and guidance from the staff of the SEC,
we have concluded that the measurement dates for the employee options
should not have been the originally assigned grant dates, but instead,
should have been the end of the quarter in which awards were granted
when the exercise price and number of shares granted were fixed.
Changing the measurement date from the originally assigned grant date to
the end of the quarter resulted in recognition of additional stock-based
compensation expense of $6.0 million, net of tax, on 2,830 stock option
grants over the period from fiscal 1996 through fiscal 2006.
Director Options. Director options were issued, prior to the effective
- ----------------
date of the Sarbanes-Oxley Act ("Sarbanes-Oxley"), in August 2002, using
the same "look back" process as described above for employee options.
This process was changed when the time for Form 4's was shortened under
the provisions of Sarbanes-Oxley, to award options with exercise prices
equal to the fair market value of the stock on the date of grant. We
concluded that the measurement date for the director options granted
prior to this change in grant practice should be the end of the quarter.
Changing the measurement date from the originally assigned grant date to
the end of the quarter resulted in recognition of additional stock-based
compensation expense of $0.7 million, net of tax, on 24 stock option
grants over the period from fiscal
36
1996 through fiscal 2006.
Bonus Options. The terms of the CEO's employment agreement permitted him
- -------------
the alternative of electing incentive stock options, restricted stock or
discounted stock options in lieu of the cash payment of part or all of
the annual incentive bonus due to him. In the event of an election to
receive options in lieu of the cash incentive due, those options were to
be valued using the Black-Scholes option pricing model, applying the
same assumptions as those used in the Company's most recent proxy
statement. The employment agreement provides that the CEO's annual
bonus, based on the fiscal year net income, is payable after the end of
the year. However, based on advice provided to us by legal counsel, and
longstanding interpretation, the Company believed that it was
permissible to make advance payments in the form of bonus options during
the year based on the anticipated annual bonus, and did so.
Prior to fiscal 2005, the CEO received ten bonus option grants,
consisting of options to purchase 337,500 shares of Class A Common Stock
and 1,743,750 shares of Class B Common Stock under this arrangement. The
CEO and the Board's designated representative (our Chief Financial
Officer) agreed on the terms of the bonus options, including the number
of shares covered, the exercise price and the grant date (the latter
being selected using a "look back" process similar to that followed in
granting employee and director options). We typically granted bonus
options prior to fiscal year-end, shortly after such agreement was
reached. These bonus options were fully vested at grant, had three-to-
five year terms, were granted with a 10% or 25% premium to the market
price of the stock on the selected grant date and were subject to the
approval of the Compensation Committee. The CEO's cash bonus payable at
the end of the fiscal year in which the options were granted, was reduced
by the Black-Scholes value of the options according to their terms.
Based on the facts and circumstances relative to the process for
granting the bonus options, the Special Committee determined, and
management has agreed that the measurement dates for these options
should be the end of the fiscal year in which they were granted. The end
of the fiscal year was used as the measurement date because that is the
date on which the amount of the annual bonus could be determined and
therefore the terms of the option could be fixed under APB 25. This
conclusion is predicated on the assumption that the terms of the option
were linked to the amount of the bonus earned. While it was permissible
to agree upon the number of shares that were to be issued prior to the
end of the year and would not be forfeitable, under GAAP the exercise
price is considered variable until the amount of the bonus could be
determined with finality. The variability in the exercise price results
from the premise that the CEO would have been required to repay any
shortfall in the bonus earned from the value assigned to the option by
the Black-Scholes model. Although there was never an instance when the
CEO's bonus did not exceed substantially the value of the options as
calculated, if that were to have occurred, the amount repaid to cure the
bonus shortfall would in substance be an increase in the exercise price
of the option. Since the exercise price could not be determined with
certainty until the amount of the bonus was known, we have applied
variable accounting to the bonus options from the date of grant to the
final fiscal year-end measurement date. Variable accounting requires
that compensation expense is to be determined by comparing the quoted
market value of the shares covered by the option grant to the exercise
price at each intervening balance sheet date until the terms of the
option become fixed.
The compensation expense associated with the CEO's estimated bonus was
accrued throughout the fiscal year. When the value of a bonus option was
determined using the Black-Scholes model, previously recorded
compensation expense associated with the accrual of the estimated bonus
was reversed in the amount of the value assigned to the bonus option.
The previously recorded compensation expense should not have been
reversed. We developed a methodology in the restatement process that
considers both the intrinsic value of the option under APB 25 and the
Black-Scholes value assigned to the bonus option in determining the
amount of compensation expense to recognize once the exercise price of
the option becomes fixed and variable accounting ends. Under this
methodology, the intrinsic value of the option is determined at the
fiscal year-end measurement date under the principles of APB 25. The
intrinsic value is then compared to the Black-Scholes value assigned to
the option for compensation purposes (the bonus value). The bonus value
is the amount that would have been accrued during the fiscal year
through the grant date as part of the total liability for the CEO's
bonus. The greater of the intrinsic value or bonus value is recorded as
compensation expense. Using this methodology and fiscal year-end for the
measurement dates resulted in an increase in stock-based compensation
expense of $6.9 million over the period from fiscal 1996 through fiscal
2004. There was no tax benefit associated with this expense due to the
tax years being closed.
OTHER MODIFICATIONS OF OPTION TERMS
As described above, under the terms of our stock option plans shares
received on exercise of an option are to be held for the employee for
two years during which time the shares cannot be sold. If the employee
terminates employment
37
voluntarily or involuntarily (other than by retirement, death or
disability) during the two-year forfeiture period the plans provide the
Company with the option of repurchasing the shares at the lower of the
exercise price or the fair market value of the stock on the date of
termination. In some circumstances we elected not to repurchase the
shares upon termination of employment while the shares were in the two-
year forfeiture period essentially waiving the remaining forfeiture
period requirement. We did not recognize this waiver as requiring a new
measurement date.
Based on management's analysis we have concluded that a new measurement
date should have been recognized in two situations: (1) where the
employee terminated and the Company did not exercise its right under the
option plans to buy back the shares in the two-year forfeiture period;
and (2) where the forfeiture provision was waived and the employee
subsequently terminated within two years of the exercise date. We now
consider both of these waivers to be an acceleration of the vesting
period because the forfeiture provision was waived (i.e., the employee
is no longer subject to a service condition to earn the right to the
shares and will benefit from the modification). As such, a new
measurement date is required. In this case the new measurement date is
the date the forfeiture provision was waived with additional stock-based
compensation expense being recognized at the date of termination. Since
the shares were fully vested, the intrinsic value of the option at the
new measurement date in excess of the intrinsic value at the original
measurement date should be expensed immediately. The new measurement
dates resulted in an increase in stock-based compensation expense of
$0.4 million, net of tax, on 27 stock option grants over the period from
fiscal 1996 through fiscal 2006.
STOCK OPTION ADJUSTMENTS
Stock-based Compensation Expense. Although the period for the Special
- --------------------------------
Committee's investigation was January 1, 1995 to October 31, 2006,
management extended the period of review back to 1986 for purposes of
analyzing the aggregate impact of the measurement date changes because
the incorrect accounting for stock options extended that far back in
time. We have concluded that the measurement date changes identified by
the Special Committee's investigation and management's analysis resulted
in an understatement of stock-based compensation expense arising from
stock option grants since fiscal 1986, effecting our consolidated
financial statements for each year beginning with fiscal year ended
March 31, 1986. The affect on the consolidated financial statements for
the fiscal years from 1986 to 1995 was not considered material,
individually or in the aggregate. Therefore, it was included as a
cumulative adjustment to the stock-based compensation expense for fiscal
1996. We have determined the aggregate understatement of stock-based
compensation expense for the 11-year restatement period from 1996
through 2006 was $14.0 million, net of tax, on 2,891 stock option
grants.
As previously discussed, we now consider the two-year repurchase option
specified in the option plans to be a forfeiture provision that goes
into effect when stock options are exercised. Therefore, the service
period necessary for an employee to earn an award varies based on the
timing of stock option exercises. We initially expense each award
(i.e., all tranches of an option award) on a straight-line basis over
ten years, which is the period that stock options become exercisable.
We ensure the cumulative compensation expense for an award as of any
date is at least equal to the measurement-date intrinsic value of those
options that have vested (i.e., when the two-year forfeiture period has
ended). If stock options expire unexercised or an employee terminates
employment after options become exercisable, no compensation expense
associated with the exercisable, but unexercised options, is reversed.
In those instances where an employee terminates employment before
options become exercisable or we repurchased the shares during the two-
year forfeiture period, all compensation expense for those options is
reversed as a forfeiture.
Payroll Taxes, Interest and Penalties. In connection with the stock-
- -------------------------------------
based compensation adjustments, we determined that certain options
previously classified as ISO grants were determined to have been granted
with an exercise price below the fair market value of our stock on the
revised measurement date. Under the Internal Revenue Code Section 422,
ISOs may not be granted with an exercise price less than the fair market
value on the date of grant and, therefore, these grants would not likely
qualify for ISO tax treatment. The disqualification of ISO
classification exposes the Company and the affected employees to payroll
related withholding taxes once the two-year forfeiture period and the
substantial risk of forfeiture has lapsed (the "taxable event"). The
Company and the affected employees may also be subject to interest and
penalties for failing to properly withhold taxes and report this taxable
event on their respective tax returns. The Company is currently
reviewing the potential disqualification of ISO grants and the related
withholding tax implications with the Internal Revenue Service for
calendar years 2004, 2005 and 2006 in an effort to reach agreement on
the resulting tax liability. In the meantime, the Company has recorded
expenses related to the withholding taxes, interest and penalties
associated with options which would have created a taxable event in
calendar years 2004, 2005 and 2006. The Company estimates that the
payroll tax liability at March 31, 2006 for the
38
disqualification tax treatment associated with ISO awards totaled $3.3
million. In addition, we recorded an income tax benefit of $0.9 million
related to this liability.
Income Tax Benefit. We reviewed the income tax effect of the stock-based
- ------------------
compensation charges, and we believe that the proper income tax
accounting for stock options under GAAP depends, in part, on the tax
designation of the stock options as either ISOs or NSOs. Because of the
potential impact of measurement date changes on the qualified status of
the options, we have determined that substantially all of the options
originally intended to be ISOs might not be qualified under the tax
regulations and, therefore, should be accounted for as if they were NSOs
for financial accounting purposes. An income tax benefit has resulted
from the determination that certain NSOs for which stock-based
compensation expense was recorded will create an income tax deduction.
This tax benefit has resulted in an increase to our deferred tax assets
for stock options prior to the occurrence of a taxable event or the
forfeiture of the related options. Upon the occurrence of a taxable
event or forfeiture of the underlying options, the corresponding
deferred tax asset is reversed and the excess or deficiency in the
deferred tax assets is recorded to paid-in capital in the period in
which the taxable event or forfeiture occurs. We have recorded a
deferred tax asset of $1.3 million as of March 31, 2006 related to stock
options.
The stock option adjustments and related income tax impacts discussed
above reduced net income by $16.3 million in aggregate for the fiscal
years ended March 31, 1996 through 2006. We have restated pro forma net
income and earnings per share under Statement of Financial Accounting
Standards No. 123 ("SFAS 123") in Note 1 of the Notes to Consolidated
Financial Statements of this Form 10-Q to reflect the impact of these
adjustments for the three and nine months ended December 31, 2005.
The Special Committee recommended a remediation plan that included the
repricing of certain stock option grants awarded to officers and
directors and reimbursement by our CEO of $1.4 million. To reprice the
stock option grants awarded to certain senior officers and directors,
the original exercise prices have been increased to the market prices of
the stock on the new measurement date for all options outstanding as of
the beginning of the investigation.
As described above, the Special Committee concluded that the CEO's bonus
options awarded under his employment agreement should have been issued
at the end of the fiscal year rather than during the year as had been
our past practice. The Committee concluded that an adjustment was
appropriate to reflect that the bonus options should not have been
issued before fiscal year end and to remove any benefits to the CEO from
our past practice of looking back to select grant dates and exercise
prices. The Committee determined the adjustment by calculating the
Black-Scholes values of the bonus options as if they had been issued at
the end of the fiscal year and then comparing those values to the
amounts reported in our proxy statements as the values of the bonus
options based on the earlier grant dates. The difference in the
aggregate value of the bonus options based on this methodology was $1.4
million. The Committee considered several other alternative remediation
calculations but concluded, based on consideration of all of the facts
and circumstances, that the recommended amount was the appropriate
remediation. The CEO has made the recommended reimbursement of $1.4
million by delivery to the Company of 45,531 shares of Class A Common
Stock on November 1, 2007.
The Committee also recommended changes to our stock option grant
practices and additional training for employees involved in the
accounting for and administration of our stock option program. These
recommendations were accepted by the Board of Directors by unanimous
consent on October 11, 2007.
REVIEW OF TAX POSITIONS (UNRELATED TO STOCK OPTIONS)
In addition to the restatement adjustments associated with stock options
discussed above, our restated Consolidated Financial Statements include
an adjustment for fiscal years 2004, 2005 and 2006 to reflect additional
liabilities associated with tax positions taken on filed tax returns for
those years that should have been recorded in accordance with GAAP,
partially offset by certain expected tax refunds. The aggregate impact
of this adjustment was a $5.4 million increase in income tax expense
with a corresponding increase in taxes payable. This adjustment is not
related to accounting for stock-based compensation expense discussed
above.
39
OTHER ADJUSTMENTS (UNRELATED TO STOCK OPTIONS)
In addition to the restatement adjustments associated with stock options
and income taxes discussed above, our restated Consolidated Financial
Statements include an adjustment for fiscal years 2002 through 2006 to
reflect the correction of errors related to the recognition of revenue
associated with shipments to customers under FOB destination terms and
an adjustment to reduce the estimated liability for employee medical
claims incurred but not reported at March 31, 2006. We improperly
recognized revenue from certain customers prior to when title and risk
of ownership transferred to the customer. The aggregate impact of these
adjustments over the periods affected was a decrease in net revenue of
$1.2 million and a decrease in net income of $0.4 million. The aggregate
impact on net income reflected a $0.5 million decrease associated with
the net revenue errors and a $0.1 million increase related to the
adjustment of the liability for medical claims.
RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS
This Form 10-Q reflects the restatement of our consolidated balance
sheets as of March 31, 2006 and December 31, 2005, the related
consolidated statements of operations for the three and nine months
ended December 31, 2005, and the related consolidated statement of cash
flows for the nine months ended December 31, 2005. In our Form 10-K for
the year ended March 31, 2007 to be filed with the Securities and
Exchange Commission (the "2007 Form 10-K"), we are restating our
consolidated balance sheet as of March 31, 2006, and the related
consolidated statements of income, comprehensive income, shareholders'
equity, and cash flows for the fiscal years ended March 31, 2006 and
2005. We have not amended, and we do not intend to amend, our
previously filed Annual Reports on Form 10-K or Quarterly Reports on
Form 10-Q for each of the fiscal years and fiscal quarters of 1996
through 2006. Our 2007 Form 10-K also reflects the restatement of
Selected Financial Data in Item 6 as of March 31, 2005 and as of and for
the fiscal years ended March 31, 2004 and 2003.
The table below reflects the impacts of the restatement adjustments
discussed above on the Company's consolidated statements of income for
the periods presented below:
CUMULATIVE
APRIL 1, 1995
THREE MONTHS ENDED NINE MONTHS ENDED THROUGH
CATEGORY OF ADJUSTMENTS: DECEMBER 31, 2005 DECEMBER 31, 2005 MARCH 31, 2004
- ------------------------ ------------------------ ------------------------ -----------------------
(a)
Pretax income impact:
Stock-based compensation expense
related to measurement date changes (b) $ 234 $ 686 $ 13,626
Payroll tax expense and penalties (b) 611 1,459 439
Other adjustments (2,112) 748 1,666
------------------------ ------------------------ -----------------------
(Increase) decrease in pretax income (1,267) 2,893 15,731
------------------------ ------------------------ -----------------------
Income tax impact:
Measurement date changes (72) (211) (1,050)
Payroll taxes (170) (404) (123)
Other income tax adjustments (c) 560 1,600 1,689
Other adjustments 657 (301) (584)
------------------------ ------------------------ -----------------------
Increase (decrease) in income tax expense 975 684 (68)
------------------------ ------------------------ -----------------------
(Increase) decrease in net income $ (292) $ 3,577 $ 15,663
======================== ======================== =======================
<FN>
- -------------------------------
(a) The cumulative effect of the restatement adjustments from fiscal 1996
through fiscal 2004 is summarized below:
40
STOCK OPTION ADJUSTMENTS OTHER ADJUSTMENTS DECREASE
YEARS ENDED ----------------------------- OTHER INCOME ------------------------ (INCREASE) TO
MARCH 31, PRETAX INCOME TAX TAX ADJUSTMENTS PRETAX INCOME TAX NET INCOME
- ----------- ------------- ------------- ---------------- ---------- ------------- --------------
1996 $ 829 (d) $ - $ - $ - $ - $ 829
1997 657 (1) - - - 656
1998 2,391 (19) - - - 2,372
1999 535 (27) - - - 508
2000 1,998 (62) - - - 1,936
2001 1,722 (141) - - - 1,581
2002 2,317 (219) - 2,534 (918) 3,714
2003 1,187 (248) - (1,610) 590 (81)
2004 2,429 (456) 1,689 742 (256) 4,148
------------- ------------- ---------------- ---------- ------------- --------------
Cumulative effect $ 14,065 $ (1,173) $ 1,689 $ 1,666 $ (584) $ 15,663
============= ============= ================ ========== ============= ==============
<FN>
(b) Stock-based compensation expenses, including related payroll
taxes, interest and penalties have been recorded as adjustments
to the selling and administrative expenses line item in the
Company's consolidated statements of income for each period.
(c) This represents liabilities associated with tax positions taken in
previous years, partially offset by certain tax refunds and is not
related to accounting for stock options.
(d) Includes additional expense totaling $0.6 million, from fiscal 1986 to
1995 the affect of which on the consolidated financial statements for
1996 and for each year 1986 to 1995 was not material.
GOVERNMENT REGULATION
In June 2006, May 2007 and September 2007, the FDA issued Notices to the
pharmaceutical industry stating that manufacture of all unapproved drug
products containing carbinoxamine, carbinoxamine labeled for children under
two, timed-released guaifenesin, hydrocodone labeled for children under six
and all other unapproved products containing hydrocodone, respectively, cease
by September 6, 2006, July 9, 2006, August 26, 2007, October 31, 2007, and
December 31, 2007, respectively. These Notices affect the continued
manufacture and sale of ETHEX's Hydro-Tussin(TM) CBX Syrup, Tri-Vent(TM) HC
Liquid, Guaifenex(R) DM ER Tablets, Guaifenex(R) PSE 60 ER Tablets,
PhenaVent(TM) D Capsules, Guaifenex(R) PSE 80 ER Tablets, Pseudovent(TM) DM
Tablets, Histinex(R) PV Syrup, Hydrocodone Bitartrate & Guaifenesin Liquid,
Hydro-Tussin(TM) HC Syrup, Histinex(R) HC Syrup and Hydro-Tussin(TM) Syrup.
On March 13, 2008, representatives of the Missouri Department of Health and
Senior Services, accompanied by representatives of the FDA, notified the
Company of a hold on the Company's inventory of certain unapproved drug
products, restricting the Company's ability to remove or dispose of those
inventories without permission. KV believes that the hold relates to a
potential misunderstanding by KV about the intended scope of recent FDA
notices setting limits on the marketing of unapproved guaifenesin products. In
response to notices issued by FDA in 2002 and 2003 with respect to
single-entity timed-release guaifenesin products, and a further notice issued
in 2007 with respect to combination timed-released guaifenesin products, KV
timely discontinued a number of its guaifenesin products and believed that, by
doing so, it had complied with those notices. The recent action to place a
hold on certain KV products may indicate, however, that additional guaifenesin
products may have to be discontinued. Pursuant to discussions with the
Missouri Department, and with the FDA, seeking to clarify the status of
products that were initially placed on hold, certain categories of those
products were released from the hold later in the day on March 13, 2008. These
discussions are continuing with respect to the status of the remaining
products subject to the hold. In fiscal 2007, ETHEX reported net sales of
$39.2 million from the products remaining subject to the hold. Of this amount,
approximately 84%, or $33.0 million, are cough/cold and allergy products sold
by ETHEX as part of its respiratory product line, 90% of which contain
guaifenesin. We believe this hold will not materially affect our results of
operations for fiscal 2008. If the hold continues for an extended period or if
it becomes permanent, it would substantially eliminate ETHEX's respiratory
product line. The Company believes that the potential loss of these revenues
will be more than offset by increases in revenues expected in our existing
branded and generic product lines and by anticipated new product approvals.
BACKGROUND
We are a fully integrated specialty pharmaceutical company that
develops, acquires, manufactures and markets technologically-
distinguished branded and generic/non-branded prescription
pharmaceutical products. We have a broad range of dosage form
capabilities, including tablets, capsules, creams, liquids and
ointments. We conduct our branded pharmaceutical operations through
Ther-Rx Corporation and our generic/non-branded pharmaceutical
operations through ETHEX Corporation, which focuses principally on
technologically-distinguished generic/non-branded products. Through
Particle Dynamics, Inc., we develop, manufacture and market
technologically advanced, value-added raw material products for the
pharmaceutical, nutritional, personal care, food and other markets.
We have a diverse portfolio of drug delivery technologies which we
leverage to create technologically- distinguished brand name and
specialty generic products. We have developed and patented 15 drug
delivery and formulation technologies primarily in four principal areas:
SITE RELEASE(R) bioadhesives, oral controlled release, tastemasking and
oral quick dissolving tablets. We incorporate these technologies in the
products we market to control and improve the absorption and utilization
of active pharmaceutical compounds. These technologies provide a number
of benefits, including reduced frequency of administration, reduced side
effects, improved drug efficacy, enhanced patient compliance and
improved taste.
Our drug delivery technologies allow us to differentiate our products in
the marketplace, both in the branded and non-branded/generic
pharmaceutical areas. We believe that this differentiation provides
substantial competitive advantages for our products, allowing us to
establish a strong record of growth and profitability and a leadership
position in certain segments of our industry.
RESULTS OF OPERATIONS
Net revenues for the three months ended December 31, 2006 increased
$16.2 million, or 15.9%, as we experienced sales growth in all three of
our operating segments: branded products, specialty generics and
specialty materials. The resultant $12.7 million increase in gross
profit was offset in part by a $7.2 million increase in operating
expenses. The increase in operating expenses was primarily due to an
increase in research and development expense, higher personnel costs,
the impact of stock-based compensation expense recorded in conjunction
with the adoption of SFAS 123R (see Note 5 to the Consolidated Financial
Statements), and additional costs associated with the expansion of our
facilities. As a result, net income for the second quarter increased
$3.8 million, or 25.5%, to $18.5 million.
41
Net revenues for the nine months ended December 31, 2006 increased $44.0
million, or 15.8%, as we experienced sales growth of $30.8 million, or
28.6%, in our branded products segment and $12.2 million, or 7.8%, in
our specialty generics/non-branded segment. The resulting $26.9 million
increase in gross profit was offset in part by a $14.8 million increase
in operating expenses before taking into account the $30.4 million of
expense associated with the prior year acquisition of FemmePharma. The
increase in operating expenses was primarily due to an increase in
research and development expense, higher personnel costs, the impact of
stock-based compensation expense recorded in conjunction with the
adoption of SFAS 123R (see Note 5 to the Consolidated Financial
Statements), and additional costs associated with the expansion of our
facilities.
For the nine months ended December 31, 2006, we reported net income of
$40.6 million compared to net income of $0.4 million for the nine months
ended December 31, 2005. During the prior year nine-month period, we
recorded expense of $30.4 million in connection with the FemmePharma
acquisition (see Note 3 to the Consolidated Financial Statements) that
consisted of $29.6 million for acquired in-process research and
development and $0.9 million in direct expenses related to the
transaction. Excluding the $30.4 million of expense associated with the
prior year acquisition of FemmePharma, net income for the nine months
ended December 31, 2006 would have increased $9.8 million, or 31.8%.
NET REVENUES BY SEGMENT
- -----------------------
($ IN THOUSANDS)
- -----------------------
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------------- ----------------------------------
% %
2006 2005 CHANGE 2006 2005 CHANGE
--------- --------- -------- --------- ---------- ---------
(AS RESTATED) (AS RESTATED)
Branded products $48,311 $42,910 12.6% $138,453 $107,664 28.6%
as % of total net revenues 41.0% 42.2% 42.8% 38.6%
Specialty generics/non-branded 64,745 55,056 17.6% 170,072 157,825 7.8%
as % of total net revenues 54.9% 54.1% 52.6% 56.5%
Specialty materials 4,545 3,433 32.4% 13,206 12,386 6.6%
as % of total net revenues 3.9% 3.4% 4.1% 4.4%
Other 348 353 (1.4)% 1,401 1,242 12.8%
Total net revenues $117,949 $101,752 15.9% $323,132 $279,117 15.8%
The increases in branded product sales of $5.4 million and $30.8 million
for the three- and nine-month periods, respectively, were due primarily
to continued sales growth from our prescription prenatal and hematinic
product lines coupled with increased sales of our anti-infective brand,
Clindesse(TM). Sales from our PreCare(R) product line increased 15.9%
to $22.2 million and 53.1% to $59.2 million during the three- and nine-
month periods, respectively. These increases were primarily due to
sales growth experienced by PrimaCare(R) ONE, the introduction of
PreCare Premier(TM) and product line price increases that have occurred
over the past 12 months. Sales of PrimaCare(R) ONE increased $7.4
million, or 86.6%, for the quarter and $21.8 million, or 147.0%, for the
nine-month period due primarily to continued market share gains.
Specifically, PrimaCare(R) ONE has experienced increases in prescription
volume of 78.6% and 142.0% during the three- and nine-month periods,
respectively. Sales from our hematinic products increased 30.5% to $9.6
million and 23.4% to $30.3 million during the three- and nine-month
periods, respectively. These increases mainly reflected the sales
growth of Repliva 21/7(TM), a new hematinic product introduced in the
second quarter of last year. Clindesse(TM), a single-dose prescription
cream therapy indicated to treat bacterial vaginosis, experienced sales
growth of 41.2% to $4.4 million and 24.9% to $18.8 million as our share
of the prescription intravaginal bacterial vaginosis market increased to
23.0% at the end of the third quarter. For the nine-month period, the
increase in Clindesse(TM) sales also reflected the impact of a price
increase in September 2006. Sales of Gynazole-1(R), our vaginal
antifungal cream product, declined 11.1% to $8.5 million for the quarter
and increased 1.5% to $21.9 million for the nine-month period. The
change in Gynazole-1(R) sales was impacted by price increases that have
occurred over the past 12 months offset by a decline in market share.
The growth in specialty generic net sales of $9.7 million and $12.2
million for the three- and nine-month periods, respectively, resulted
primarily from sales of new products. In September 2006, we expanded
our cardiovascular product line when we received approval to market six
strengths of Diltiazem HCI ER Capsules (AB rated to Tiazac(R)).
Although the six strengths of Diltiazem HCI ER Capsules were launched
late in September 2006, we were able to
42
generate incremental revenues of $6.1 million and $7.4 million for the
three- and nine-month periods, respectively. The remainder of the
increases primarily resulted from the impact of price increases on
certain cardiovascular and pain management products, offset in part by a
decline in sales volume from certain pain management products during the
quarter and certain prenatal vitamin products during the nine-month
period.
The increases in specialty material product sales for the three- and
nine-month periods were primarily due to the impact of price increases
on certain products.
GROSS PROFIT BY SEGMENT
- -----------------------
($ IN THOUSANDS)
- -----------------------
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------------- ----------------------------------
% %
2006 2005 CHANGE 2006 2005 CHANGE
--------- --------- -------- --------- ---------- ---------
(AS RESTATED) (AS RESTATED)
Branded products $42,532 $37,427 13.6% $122,297 $95,160 28.5%
as % of net revenues 88.0% 87.2% 88.3% 88.4%
Specialty generics/non-branded 38,148 29,728 28.3% 97,824 86,961 12.5%
as % of net revenues 58.9% 54.0% 57.5% 55.1%
Specialty materials 1,404 458 206.6% 4,467 4,030 10.8%
as % of net revenues 30.9% 13.3% 33.8% 32.5%
Other (2,574) (850) (202.8)% (12,220) (699) NM
Total gross profit $79,510 $66,763 19.1% $212,368 $185,452 14.5%
as % of total net revenues 67.4% 65.6% 65.7% 66.4%
The increases in gross profit of $12.7 million and $26.9 million for the
three- and nine-month periods, respectively, were primarily attributable
to the sales growth experienced by all three of our segments: branded
products, specialty generics, and specialty materials. For the three-
and nine-month periods, the higher specialty generic gross profit
percentage was primarily attributable to sales of new specialty generic
products coupled with the impact of price increases on certain specialty
generic cardiovascular and pain management products. Impacting the
Other category were contract manufacturing revenues, pricing and
production variances, and changes to inventory reserves associated with
production. Any inventory reserve changes associated with finished
goods are reflected in the applicable segment. The fluctuation in the
Other category for the nine-month period was primarily due to the impact
of higher production costs during the first six months of the fiscal
year that resulted from lower-than-expected production volume, coupled
with an increase in the provision for obsolete inventory on existing
products. Also, during the second and third quarters, we recorded
provisions associated with certain new products where production
occurred prior to receiving FDA approval and the upcoming expiration
dates made them unsalable. The provision for obsolete inventory for the
nine months ended December 31, 2006 and 2005 was $8.2 million and $3.0
million, respectively.
RESEARCH AND DEVELOPMENT
- ------------------------
($ IN THOUSANDS)
- ------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------------- ----------------------------------
% %
2006 2005 CHANGE 2006 2005 CHANGE
--------- --------- -------- --------- ---------- ---------
Research and development $8,319 $6,817 22.0% $ 22,605 $20,869 8.3%
as % of total net revenues 7.1% 6.7% 7.0% 7.5%
The increases in research and development expense of $1.5 million and
$1.7 million for the three- and nine-month periods, respectively, were
due to increased spending on bioequivalency studies as we continue
active development of various brand and generic/non-brand products in
our internal and external pipelines coupled with an increase in research
and development personnel.
43
PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT
- ---------------------------------------------
($ IN THOUSANDS)
- -----------------------
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------------- ----------------------------------
% %
2006 2005 CHANGE 2006 2005 CHANGE
--------- --------- -------- --------- ---------- ---------
Purchased in-process research
and development $ - $ - - % $ - $30,441 NM
as % of total net revenues - % - % - % 10.9%
During the nine months ended December 31, 2005, we recorded expense of
$30.4 million in connection with the FemmePharma acquisition (see Note 3
to the Consolidated Financial Statements) that consisted of $29.6
million for acquired in-process research and development and $0.9
million in direct expenses related to the transaction. The valuation of
acquired in-process research and development represented the estimated
fair value of the worldwide marketing rights to an endometriosis product
we acquired as part of the FemmePharma, Inc. acquisition that, at the
time of the acquisition, had no alternative future use and for which
technological feasibility had not been established.
SELLING AND ADMINISTRATIVE
- --------------------------
($ IN THOUSANDS)
- -----------------------
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------------- ----------------------------------
% %
2006 2005 CHANGE 2006 2005 CHANGE
--------- --------- -------- --------- ---------- ---------
(AS RESTATED) (AS RESTATED)
Selling and administrative $41,965 $36,292 15.6% $124,974 $111,891 11.7%
as % of total net revenues 35.6% 35.7% 38.7% 40.1%
The increases in selling and administrative expense of $5.7 million and
$13.1 million for the three- and nine-month periods were primarily due
to greater personnel costs associated with increases in management and
other personnel, an increase in branded marketing and promotions expense
and increases in expense resulting from facility expansion. The
increases in personnel costs were also impacted by the adoption of SFAS
123R, "Share Based Payment," using the modified prospective method which
resulted in the recognition of incremental stock-based compensation
expense during the three- and nine-month periods of $0.8 million and
$2.3 million, respectively. We adopted SFAS 123R using the modified
prospective method and, as a result, did not retroactively adjust
results from prior periods. Prior to the adoption of SFAS 123R, we
accounted for stock-based compensation using the intrinsic value method
prescribed in APB 25 (see the "Explanatory Note" immediately preceding
Part I, Item 1, "Management's Discussion and Analysis of Financial
Condition and Results of Operation", and Note 2 "Restatement of
Consolidated Financial Statements" of the Notes to Consolidated
Financial Statements in this Form 10-Q). For the nine-month period, the
increase in selling and administrative expense was offset in part by a
$0.8 million reimbursement of legal fees received during the first
quarter.
OPERATING INCOME
- ----------------
($ IN THOUSANDS)
- -----------------------
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------------- ----------------------------------
% %
2006 2005 CHANGE 2006 2005 CHANGE
--------- --------- -------- --------- ---------- ---------
(AS RESTATED) (AS RESTATED)
Operating income $28,022 $22,456 24.8% $61,187 $18,662 227.9%
For the nine-month period, the improvement in operating income was
partially due to the $30.4 million of expense we recorded during the
nine months ended December 31, 2005 in connection with the FemmePharma
acquisition. Excluding the effect of this $30.4 million of expense,
operating income for the nine months ended December 31, 2006 would have
increased $12.1 million, or 24.6%.
44
INTEREST EXPENSE
- ----------------
($ IN THOUSANDS)
- -----------------------
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------------- ----------------------------------
% %
2006 2005 CHANGE 2006 2005 CHANGE
--------- --------- -------- --------- ---------- ---------
Interest expense $2,214 $1,538 44.0% $6,755 $4,382 54.2%
as % of total net revenues 1.9% 1.5% 2.1% 1.6%
The increases in interest expense for the three- and nine-month periods
resulted from interest incurred on the $43.0 million mortgage loan
agreement we entered into in March 2006 coupled with the completion of a
number of sizable capital projects during fiscal 2006 and the reduced
level of capitalized interest thereon.
INTEREST AND OTHER INCOME
- -------------------------
($ IN THOUSANDS)
- -------------------------
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------------- ----------------------------------
% %
2006 2005 CHANGE 2006 2005 CHANGE
--------- --------- -------- --------- ---------- ---------
Interest and other income $2,240 $1,272 76.1% $6,606 $3,402 94.2%
as % of total net revenues 1.9% 1.3% 2.0% 1.2%
The increases in interest and other income for the three- and nine-month
periods were primarily due to an increase in interest income on short-
term investments and dividends earned on the Strides redeemable
preferred stock investment. The increases in interest income on short-
term investments resulted from an increase in the average balance of
invested cash and an increase in short-term interest rates.
PROVISION FOR INCOME TAXES
- --------------------------
($ IN THOUSANDS)
- -----------------------
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------------- ----------------------------------
% %
2006 2005 CHANGE 2006 2005 CHANGE
--------- --------- -------- --------- ---------- ---------
(AS RESTATED) (AS RESTATED)
Provision for income taxes $9,586 $7,484 28.1% $ 22,369 $17,274 29.5%
Effective tax rate 34.2% 33.7% 36.6% 35.9%
The decline in the effective tax rate for the quarter was primarily due
to the retroactive passage in December 2006 of Federal research and
experimentation tax credits that had previously expired on December 31,
2005. The lower than expected effective tax rates for both the current
and prior quarter resulted from the reversal of certain tax liabilities
associated with tax positions from previous years that upon review were
determined to no longer be necessary. The effective tax rates for all
periods were also adversely affected by the non-deductibility of stock-
based compensation on certain of our outstanding stock options that were
issued as incentive stock options (see Note 2 to the Consolidated
Financial Statements). For the nine months ended December 31, 2005, we
recorded a provision for income taxes whereby the $30.4 million of
expense we recognized for the FemmePharma acquisition was determined to
not be deductible for tax purposes. The effective tax rate of 35.9% for
that period was applied to a pre-tax income amount for the nine months
ended December 31, 2005 that excluded the FemmePharma acquisition
expense of $30.4 million.
45
NET INCOME AND DILUTED EARNINGS PER SHARE
- ------------------------------------------
($ IN THOUSANDS)
- -----------------------
THREE MONTHS ENDED NINE MONTHS ENDED
DECEMBER 31, DECEMBER 31,
---------------------------------- ----------------------------------
% %
2006 2005 CHANGE 2006 2005 CHANGE
--------- --------- -------- --------- ---------- ---------
(AS RESTATED) (AS RESTATED)
Net income $18,462 $14,706 25.5% $40,645 $408 NM
Diluted earnings per
Class A share 0.33 0.27 22.2% 0.74 0.01 NM
Diluted earnings per
Class B share 0.29 0.23 26.1% 0.64 0.01 NM
For the nine-month period, the improvement in net income per share was
partially due to the $30.4 million of expense we recorded during the
nine months ended December 31, 2005 in connection with the FemmePharma
acquisition. Excluding the effect of the $30.4 million of expense
associated with the prior year acquisition of FemmePharma, net income
for the nine months ended December 31, 2006 would have increased $9.8
million, or 31.8%.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents and working capital were $55.6 million and
$349.3 million, respectively, at December 31, 2006, compared to $100.7
million and $305.0 million, respectively, at March 31, 2006. The
decrease in cash and cash equivalents resulted primarily from the $48.3
million of additional short-term marketable securities that were
purchased and classified as available for sale during the nine months
ended December 31, 2006. The increase in working capital resulted
primarily from a $30.3 million increase in receivables and a $10.9
million increase in inventories. The increase in receivables was
principally due to higher sales and the increase in inventories related
primarily to new products we introduced.
In addition, we had $117.0 million invested in auction rate securities
("ARS") at December 31, 2006. The ARS held by the Company are AAA rated
securities with long-term maturities secured by student loans which are
guaranteed by the U.S. Government. The interest rates on these
securities are reset through an auction process that resets the
applicable interest rate at pre-determined intervals, up to 35 days.
Subsequent to December 31, 2006 the ARS market has experienced liquidity
issues due to emerging instability in the broader credit and capital
markets. As a result, all of the ARS held by the Company have recently
experienced failed auctions as the amount of securities submitted for
sale has exceeded the amount of purchase orders. Given the failed
auctions, the Company's ARS are illiquid until there is a successful
auction for them. We cannot predict how long the current imbalance in
the auction rate market will continue. We are currently evaluating the
market for these securities to determine if impairment of the carrying
value of the securities has occurred due to the loss of liquidity.
However, the Company believes that as of December 31, 2007, based on its
current cash, cash equivalents and marketable securities balances of
$112 million (exclusive of ARS) and its current borrowing capacity under
its credit facility of $290 million, the current lack of liquidity in
the auction rate market will not have a material impact on its ability
to fund its operations or interfere with the Company's external growth
plans. (See Note 16 to the Notes to Consolidated Financial Statements)
The primary source of operating cash flow used in the funding of our
businesses continues to be internally generated funds from product
sales. Net cash flow from operating activities of $24.2 million was
favorably impacted by net income adjusted for non-cash items, offset in
part by the aforementioned increases in receivables and inventories.
Net cash flow used in investing activities included capital expenditures
of $21.6 million for the nine months ended December 31, 2006 compared to
$47.3 million for the corresponding prior year period. In June 2006,
the Company completed the purchase of a 126,000 square foot building in
the St. Louis metropolitan area for $4.9 million. The property had been
leased by the Company since June 2001 and is used as a manufacturing
facility and office space. The purchase price was paid in cash. The
remaining capital expenditures during the nine-month period were
primarily for purchasing machinery and equipment to upgrade and expand
our pharmaceutical manufacturing and distribution capabilities, and for
other building renovation projects. Other investing activities during
the nine-month period consisted of $48.3 million in purchases of short-
term marketable securities that were classified as available for sale
and a $0.4 million payment for preferred stock. For the prior year
nine-month period, other investing activities included the
46
acquisition of FemmePharma for a $25.0 million cash payment plus $0.6
million of transaction costs and the purchase of Strides redeemable
preferred stock for $11.3 million (see Note 3 to the Consolidated
Financial Statements).
Our debt balance, including current maturities, was $241.8 million at
December 31, 2006 compared to $243.0 million at March 31, 2006. In
March 2006, we entered into a $43.0 million mortgage loan agreement with
one of our primary lenders, in part, to refinance $9.9 million of
existing mortgages. The $32.8 million of net proceeds we received from
the mortgage loan was used for working capital and general corporate
purposes. The mortgage loan bears interest at a rate of 5.91% and
matures on April 1, 2021.
In May 2003, we issued $200.0 million principal amount of Convertible
Subordinated Notes that are convertible, under certain circumstances,
into shares of our Class A Common Stock at conversion price of $23.01
per share subject to possible adjustment. The Convertible Subordinated
Notes bear interest at a rate of 2.50% and mature on May 16, 2033. We
are also obligated to pay contingent interest at a rate equal to 0.5%
per annum during any six-month period commencing May 16, 2006, if the
average trading price of the Notes per $1,000 principal amount for the
five-trading day period ending on the third trading day immediately
preceding the first day of the applicable six-month period equals $1,200
or more. We may redeem some or all of the Convertible Subordinated
Notes at any time on or after May 21, 2006, at a redemption price,
payable in cash, of 100% of the principal amount of the Convertible
Subordinated Notes, plus accrued and unpaid interest (including
contingent interest, if any) to the date of redemption. Holders may
require us to repurchase all or a portion of their Convertible
Subordinated Notes on May 16, 2008, 2013, 2018, 2023 and 2028, or upon a
change in control, as defined in the indenture governing the Convertible
Subordinated Notes, at 100% of the principal amount of the Convertible
Subordinated Notes, plus accrued and unpaid interest (including
contingent interest, if any) to the date of repurchase, payable in cash.
The Convertible Subordinated Notes are subordinate to all of our
existing and future senior obligations.
On June 9, 2006, we replaced our $140.0 million credit line by entering
into a new syndicated credit agreement with ten banks that provides for
a revolving line of credit for borrowing up to $320.0 million. The new
credit agreement also includes a provision for increasing the revolving
commitment, at the lenders' sole discretion, by up to an additional
$50.0 million. The new credit facility is unsecured unless we, under
certain specified circumstances, utilize the facility to redeem part or
all of our outstanding Convertible Subordinated Notes. Interest is
charged under the facility at the lower of the prime rate or one-month
LIBOR plus 62.5 to 150 basis points depending on the ratio of our senior
debt to EBITDA. The new credit agreement contains financial covenants
that impose limits on dividend payments, require minimum equity, a
maximum senior leverage ratio and minimum fixed charge coverage ratio.
The new credit facility has a five-year term expiring in June 2011. As
of December 31, 2006, we were in compliance with all of our financial
covenants and there were no borrowings outstanding under the facility.
In addition, the agreement requires that we submit annual audited
financial statements to the lenders within 90 days of the close of the
year and quarterly financial statements within 45 days of the close of
each fiscal quarter. The Company has obtained the consent of the
lenders to extend the period for submission of the audited financial
statements for the year ended March 31, 2007 to March 31, 2008 and for
the submission of the quarterly financial statements for the quarters
ended June 30, 2007, September 30, 2007 and December 31, 2007 to May
31, 2008.
In December 2005, we entered into a financing arrangement with St. Louis
County, Missouri related to expansion of our operations in St. Louis
County (see Note 11 of the Notes to Consolidated Financial Statements).
Up to $135.5 million of industrial revenue bonds may be issued to us by
St. Louis County relative to capital improvements made through December
31, 2009. This agreement provides that 50% of the real and personal
property taxes on up to $135.5 million of capital improvements will be
abated for a period of ten years subsequent to the property being placed
in service. Industrial revenue bonds totaling $109.4 million were
outstanding at December 31, 2006. The industrial revenue bonds are
issued by St. Louis County to us upon our payment of qualifying costs of
capital improvements, which are then leased by us for a period ending
December 1, 2019, unless earlier terminated. We have the option at any
time to discontinue the arrangement and regain full title to the abated
property. The industrial revenue bonds bear interest at 4.25% per annum
and are payable as to principal and interest concurrently with payments
due under the terms of the lease. We have classified the leased assets
as property and equipment and have established a capital lease
obligation equal to the outstanding principal balance of the industrial
revenue bonds. Lease payments may be made by tendering an equivalent
portion of the industrial revenue bonds. As the capital lease payments
to St. Louis County may be satisfied by tendering industrial revenue
bonds (which is our intention), the capital lease obligation, industrial
revenue bonds and related interest expense and interest income,
respectively, have been offset for presentation purposes in the
Consolidated Financial Statements.
47
We believe our cash and cash equivalents balance, cash flows from
operations and funds available under our credit facilities, will be
adequate to fund operating activities for the presently foreseeable
future, including the payment of short-term and long-term debt
obligations, capital improvements, research and development
expenditures, product development activities and expansion of marketing
capabilities for the branded pharmaceutical business. In addition, we
continue to examine opportunities to expand our business through the
acquisition of or investment in companies, technologies, product rights,
research and development and other investments that are compatible with
our existing businesses. We intend to use our available cash to help in
funding any acquisitions or investments. As such, cash has been invested
in short-term, highly liquid instruments. We also may use funds
available under our credit facilities, or financing sources that
subsequently become available, including the future issuances of
additional debt or equity securities, to fund these acquisitions or
investments. If we were to fund one or more such acquisitions or
investments, our capital resources, financial condition and results of
operations could be materially impacted in future periods.
INFLATION
Inflation may apply upward pressure on the cost of goods and services
used by us in the future. However, we believe that the net effect of
inflation on our operations during the past three years has been
minimal. In addition, changes in the mix of products sold and the
effect of competition has made a comparison of changes in selling prices
less meaningful relative to changes in the overall rate of inflation
over the past three years.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our Consolidated Financial Statements are presented on the basis of
GAAP. Certain of our accounting policies are particularly important to
the presentation of our financial position and results of operations and
require the application of significant judgment by our management. As a
result, amounts determined under these policies are subject to an
inherent degree of uncertainty. In applying these policies, we make
estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses and related disclosures. We base our
estimates and judgments on historical experience, the terms of existing
contracts, observance of trends in the industry, information that is
obtained from customers and outside sources, and on various other
assumptions that we believe to be reasonable and appropriate 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. Although we believe that our estimates and
assumptions are reasonable, actual results may differ significantly from
our estimates. Changes in estimates and assumptions based upon actual
results may have a material impact on our results of operations and/or
financial condition. Our critical accounting estimates are described
below.
REVENUE RECOGNITION AND PROVISIONS FOR ESTIMATED REDUCTIONS TO GROSS
- --------------------------------------------------------------------
REVENUE. Revenue is generally realized or realizable and earned when
- --------
persuasive evidence of an arrangement exists, the seller's price to the
buyer is fixed or determinable, the customer's payment ability has been
reasonably assured and title and risk of ownership have been transferred
to the customer.
Simultaneously with the recognition of revenue, we reduce the amount of
gross revenues by recording estimated sales provisions for chargebacks,
sales rebates, sales returns, cash discounts and other allowances, and
Medicaid rebates. These sales provisions are established based upon
consideration of a variety of factors, including among other factors,
historical relationship to revenues, historical payment and return
experience, estimated and actual customer inventory levels, customer
rebate arrangements, and current contract sales terms with wholesale and
indirect customers.
From time to time, we provide incentives to our wholesale customers,
such as trade show allowances or stocking allowances that they in turn
use to accelerate distribution to their end customers. We believe that
these incentives are normal and customary in the industry. Sales
allowances are accrued and revenue is recognized as sales are made in
accordance with the terms of the allowances offered to the customer. Due
to the nature of these allowances, we are able to accurately calculate
the required provisions for the allowances based on the specific terms
in each agreement. Additionally, customers will normally purchase
additional product ahead of regular demand to take advantage of the
temporarily lower cost resulting from the sales allowances. This
practice has been customary in the industry and we believe would be part
of a customer's ordinary course of business inventory level. We reserve
the right, with our major wholesale customers, to limit the amount of
these forward buys. Sales made as a result of allowances offered on our
specialty generics product line in conjunction with trade shows
sponsored by our major wholesale customers and for
48
other promotional programs accounted for 14.8% and 14.3% of total gross
revenues for the nine months ended December 31, 2006 and 2005,
respectively.
In addition, we understand that certain of our wholesale customers have
anticipated the timing of price increases and have made, and may
continue to make, business decisions to buy additional product in
anticipation of future price increases. This practice has been
customary in the industry and we believe would be part of a customer's
ordinary course of business inventory level.
We evaluate inventory levels at our wholesale customers, which accounted
for approximately 60% of our unit sales during the nine months ended
December 31, 2006, through an internal analysis that considers, among
other things, wholesaler purchases, wholesaler contract sales, available
end consumer prescription information and inventory data received from
our three largest wholesaler customers. We believe that our evaluation
of wholesaler inventory levels allows us to make reasonable estimates of
our reserve balances. Further, our products are typically sold with
adequate shelf life to permit sufficient time for our wholesaler
customers to sell our products in their inventory through to the end
consumer.
The following table reflects the activity during the nine months ended
December 31, 2006 for each accounts receivable reserve:
CURRENT CURRENT ACTUAL
PROVISION PROVISION RETURNS
RELATED TO RELATED TO OR CREDITS
SALES MADE IN SALES MADE IN IN THE
(in thousands) BEGINNING THE CURRENT THE PRIOR CURRENT ENDING
BALANCE PERIOD PERIODS PERIOD BALANCE
--------- ------------- ------------ --------- -------
NINE MONTHS ENDED
DECEMBER 31, 2006 (as restated)
Accounts Receivable Reserves:
Chargebacks $14,312 $ 72,831 $ - $ (70,048) $17,095
Sales Rebates 2,214 12,210 - (9,100) 5,324
Sales Returns 2,127 9,548 - (8,228) 3,447
Cash Discounts and Other
Allowances 4,226 13,417 - (13,235) 4,408
Medicaid Rebates 5,818 6,805 - (4,545) 8,078
------- -------- --------- --------- -------
TOTAL $28,697 $114,811 $ - $(105,156) $38,352
======= ======== ========= ========= =======
The increase in the reserve for chargebacks at December 31, 2006 was
primarily due to chargeback reserves established on certain specialty
generic products introduced in fiscal 2007. The higher reserve for
sales rebates at December 31, 2006 resulted from increased reserves on
rebates associated with branded product sales to managed care
organizations that began late in fiscal 2006. The increase in the
reserve for sales returns at December 31, 2006 was primarily due to an
increase in the estimated level of inventory in the distribution channel
at the end of the quarter coupled with reserves established on new
products sold with short shelf lives. The impact of increased
utilization of our branded products by state Medicaid programs during
the past two years resulted in a larger reserve for Medicaid rebates at
December 31, 2006.
The reserves for sales rebates and cash discounts and other allowances
require a lower degree of subjectivity, are less complex in nature and
are more readily ascertainable due to specific contract terms, rates and
consistent historical performance. The reserves for chargebacks, sales
returns and Medicaid rebates, however, are more complex and require
management to make more subjective judgments. These reserves and their
respective provisions are discussed in further detail below.
Chargebacks - We market and sell products directly to wholesalers,
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distributors, warehousing pharmacy chains, mail order pharmacies and
other direct purchasing groups. We also market products indirectly to
independent pharmacies, non-warehousing chains, managed care
organizations, and group purchasing organizations, collectively referred
to as "indirect customers." We enter into agreements with some indirect
customers to establish contract pricing for certain products. These
indirect customers then independently select a wholesaler from which to
purchase the products at
49
these contracted prices. Alternatively, we may pre-authorize
wholesalers to offer specified contract pricing to other indirect
customers. Under either arrangement, we provide credit to the
wholesaler for any difference between the contracted price with the
indirect customer and the wholesaler's invoice price. This credit is
called a chargeback.
Chargeback transactions are almost exclusively related to our specialty
generics business segment. During the nine months ended December 31,
2006 and 2005, the chargeback provision reduced the gross sales of our
specialty generics segment by $72.0 million and $74.0 million,
respectively. These amounts accounted for 99.3% and 99.4% of the total
chargeback provisions recorded during the nine months ended December 31,
2006 and 2005, respectively.
The provision for chargebacks is the most significant and complex
estimate used in the recognition of revenue. The primary factors we
consider in developing and evaluating the reserve for chargebacks
include:
* The amount of inventory in the wholesale distribution channel.
We receive actual inventory information from our three major
wholesaler customers and estimate the inventory position of the
remaining wholesalers based on historical buying patterns.
During the nine months ended December 31, 2006, unit sales to
our three major wholesaler customers accounted for 81% of our
total unit sales to all wholesalers, and the aggregate
inventory position of the three major wholesalers at December
31, 2006 was approximately equivalent to our last nine weeks of
shipments during the fiscal year. We currently use the last
six weeks of our shipments as an estimate of the inventory held
by the remaining wholesalers where we do not receive actual
inventory data, as our experience and buying patterns indicate
that our smaller wholesaler customers carry less inventory than
our large wholesaler customers. As of December 31, 2006, each
week of inventory for those remaining wholesalers represented
approximately $0.2 million, or 1.2%, of the reported reserve
for chargebacks.
* The percentage of sales to our wholesaler customers that will
result in chargebacks. Using our automated chargeback system
we track, at the product level, the percentage of sales units
shipped to our wholesaler customers that eventually result in
chargebacks to us. The percentage for each product, which is
based on actual historical experience, is applied to the
respective inventory units in the wholesale distribution
channel. As of December 31, 2006, the aggregate weighted
average percentage of sales to wholesalers assumed to result in
chargebacks was approximately 96%, with each 1% representing
approximately $0.2 million, or 1.0%, of the reported reserve
for chargebacks.
* Contract pricing and the resulting chargeback per unit. The
chargeback provision is based on the difference between our
invoice price to the wholesaler, or "WAC," and the contract
price negotiated with either our indirect customer or with the
wholesaler for sales by the wholesaler to the indirect
customers. We calculate the price difference, or chargeback per
unit, for each product and for each major wholesaler customer
using historical weighted average pricing, based on actual
chargeback experience. Use of weighted average pricing over
time compensates for changes in the mix of indirect customers
and products from period to period. As of December 31, 2006, a
5% shift in the calculated chargeback per unit in the same
direction across all products and customers would result in a
$0.8 million, or 4.6%, impact on the reported reserve for
chargebacks.
Shelf-Stock Adjustments - These adjustments represent credits issued to
- -----------------------
our wholesale customers that result from a decrease in our WAC.
Decreases in our invoice prices are discretionary decisions we make to
reflect market conditions. These credits are customary in the industry
and are intended to reduce a wholesale customer's inventory cost to
better reflect current market prices. Generally, we provide credits to
customers at the time the price reduction occurs based on the inventory
that is owned by them on the effective date of the price reduction.
Since a reduction in WAC reduces the chargeback per unit, or the
difference between WAC and the contract price, shelf-stock adjustments
are typically included as part of the reserve for chargebacks because
the price reduction credits act essentially as accelerated chargebacks.
Although we have contractually agreed to provide price adjustment
credits to our major wholesaler customers at the time they occur, the
impact of any such price reductions not included in the reserve for
chargebacks is immaterial to the amount of revenue recognized in any
given period. In the first quarter, our specialty generics segment
reduced the invoice price to our wholesaler customers on a number of
generic products. As a result of a WAC decrease to certain generic
products, we paid shelf-stock adjustments of $2.1 million and $8.0
million to our wholesale customers during the three and nine months
ended December 31, 2006, respectively. The $2.1 million of shelf-stock
adjustments that we paid during the third quarter were included in the
September 30, 2006 reserve for chargebacks.
50
Sales Returns - Consistent with industry practice, we maintain a returns
- -------------
policy that allows our direct and indirect customers to return product
six months prior to expiration and within one year after expiration.
This policy is applicable to both our branded and specialty generics
business segments. Upon recognition of revenue from product sales to
customers, we provide for an estimate of product to be returned. This
estimate is determined by applying a historical relationship of customer
returns to gross sales. We evaluate the reserve for sales returns by
calculating historical return rates using data from the last 12 months
on a product specific basis and by class of trade (wholesale versus
retail chain). The calculated percentages are applied against estimates
of inventory in the distribution channel on a product specific basis.
To determine the inventory levels in the wholesale distribution channel,
we utilize actual inventory information from our major wholesale
customers and estimate the inventory positions of the remaining
wholesalers based on historical buying patterns. For inventory held by
our non-wholesale customers, we use the last two months of sales to the
direct buying chains and the indirect buying retailers as an estimate.
A 10% change in the product specific historical return rates used in the
reserve analysis would have changed the reserve balance at December 31,
2006 by approximately $0.2 million, or 4.8%, of the reported reserve for
sales returns. A 10% change in the amount of estimated inventory in the
distribution channel would have changed the reserve balance at December
31, 2006 by approximately $0.2 million, or 5.9%, of the reported reserve
for sales returns.
Medicaid Rebates - Established in 1990, the Medicaid Drug Rebate Program
- ----------------
requires a drug manufacturer to provide to each state a rebate every
calendar quarter for covered outpatient drugs dispensed to Medicaid
patients. Medicaid rebates apply to both our branded and specialty
generic segments. Individual states invoice us for Medicaid rebates on
a quarterly basis using statutorily determined rates for generic (11%)
and branded (15%) products, which are applied to the Average
Manufacturer's Price, or "AMP," for a particular product to arrive at a
Unit Rebate Amount, or "URA." The amount owed is based on the number of
units dispensed by the pharmacy to Medicaid patients extended by the
URA. The reserve for Medicaid rebates is based on expected payments,
which are affected by patient usage and estimated inventory in the
distribution channel. We estimate patient usage by calculating a
payment rate as a percentage of net sales lagged six months, which is
then applied to an estimate of customer inventory. We currently use the
last two months of our shipments to wholesalers and direct buying chains
as an estimate of inventory in the wholesale and chain channels and an
additional month of wholesale sales as an estimate of inventory held by
the indirect buying retailer. A 10% change in the amount of customer
inventory subject to Medicaid rebates would have changed the reserve at
December 31, 2006 by $0.6 million, or 7.7% of the reported reserve for
Medicaid rebates. Similarly, a 10% change in estimated patient usage
would have changed the reserve at December 31, 2006 by $0.6 million, or
7.7% of the reported reserve for Medicaid rebates.
INVENTORY VALUATION. Inventories consist of finished goods held for
- --------------------
distribution, raw materials and work in process. Our inventories are
stated at the lower of cost or market, with cost determined on the
first-in, first-out basis. In evaluating whether inventory should be
stated at the lower of cost or market, we consider such factors as the
amount of inventory on hand and in the distribution channel, estimated
time required to sell existing inventory, remaining shelf life and
current and expected market conditions, including levels of competition.
We establish reserves, when necessary, for slow-moving and obsolete
inventories based upon our historical experience and management's
assessment of current product demand.
INTANGIBLE ASSETS. Our intangible assets principally consist of product
- ------------------
rights, license agreements and trademarks resulting from product
acquisitions and legal fees and similar costs relating to the
development of patents and trademarks. Intangible assets that are
acquired are stated at cost, less accumulated amortization, and are
amortized on a straight-line basis over their estimated useful lives.
Costs associated with the development of patents and trademarks are
amortized on a straight-line basis over estimated useful lives ranging
from five to 17 years. We determine amortization periods for intangible
assets that are acquired based on our assessment of various factors
impacting estimated useful lives and cash flows of the acquired
products. Such factors include the product's position in its life cycle,
the existence or absence of like products in the market, various other
competitive and regulatory issues, and contractual terms. Significant
changes to any of these factors may result in a reduction in the
intangible asset's useful life and an acceleration of related
amortization expense.
We assess the impairment of intangible assets whenever events or changes
in circumstances indicate that the carrying value may not be
recoverable. Some factors we consider important which could trigger an
impairment review include the following: (1) significant
underperformance relative to expected historical or projected future
operating results; (2) significant changes in the manner of our use of
the acquired assets or the strategy for our overall business; and (3)
significant negative industry or economic trends.
51
When we determine that the carrying value of an intangible asset may not
be recoverable based upon the existence of one or more of the above
indicators of impairment, we first perform an assessment of the asset's
recoverability. Recoverability is determined by comparing the carrying
amount of an intangible asset against an estimate of the undiscounted
future cash flows expected to result from its use and eventual
disposition. If the sum of the expected future undiscounted cash flows
is less than the carrying amount of the intangible asset, an impairment
loss is recognized based on the excess of the carrying amount over the
estimated fair value of the intangible asset.
STOCK-BASED COMPENSATION. As discussed in Note 3 of the Notes to
- -------------------------
Consolidated Financial Statements, effective April 1, 2006, we adopted
SFAS 123R, which requires the measurement and recognition of
compensation expense, based on estimated fair values, for all share-
based compensation awards made to employees and directors over the
vesting period of the awards. The Company adopted SFAS 123R using the
modified prospective method and, as a result, did not retroactively
adjust results from prior periods. Under the modified prospective
method, stock-based compensation was recognized (1) for the unvested
portion of previously issued awards that were outstanding at the initial
date of adoption based on the grant date fair value estimated in
accordance with the pro forma provisions of SFAS 123 and (2) for any
awards granted on or subsequent to the effective date of SFAS 123R based
on the grant date fair value estimated in accordance with the provisions
of this statement. Prior to the adoption of SFAS 123R, the Company
measured compensation expense for its employee stock-based compensation
plans using the intrinsic value method prescribed by Accounting
Principles Board Opinion No. 25 ("APB 25"). The Company also applied
the disclosure provisions of SFAS 123, as amended by SFAS 148, as if the
fair-value-based method had been applied in measuring compensation
expense. Determining the fair value of share-based awards at the grant
date requires judgment to identify the appropriate valuation model and
estimate the assumptions, including the expected term of the stock
options and expected stock-price volatility, to be used in the
calculation. Judgment is also required in estimating the percentage of
share-based awards that are expected to be forfeited. We estimated the
fair value of stock options granted using the Black-Scholes option-
pricing model with assumptions based primarily on historical data. If
actual results differ significantly from these estimates, stock-based
compensation expense and our results of operations could be materially
impacted.
INCOME TAXES. Our deferred tax assets and liabilities are determined
- -------------
based on temporary differences between financial reporting and tax bases
of assets and liabilities. Deferred tax assets and liabilities are
measured using the currently enacted tax rates that apply to taxable
income in effect for the years in which those tax assets are expected to
be realized or settled. We record a valuation allowance to reduce
deferred tax assets to the amount that is believed more likely than not
to be realized. Management believes it is more likely than not that
forecasted income, including income that may be generated as a result of
certain tax planning strategies, together with the tax effects of the
deferred tax liabilities, will be sufficient to fully recover the
remaining deferred tax assets. If all or part of the net deferred tax
assets are determined not to be realizable in the future, an adjustment
to the valuation allowance would be charged to earnings in the period
such determination is made. Similarly, if we subsequently realize
deferred tax assets that were previously determined to be unrealizable,
the respective valuation allowance would be reversed, resulting in a
positive adjustment to earnings in the period such determination is
made.
Management regularly reevaluates the Company's tax positions taken on
filed tax returns using information about recent tax court decisions and
legislative activities. Many factors are considered in making these
evaluations, including past history, recent interpretations of tax law,
and the specific facts and circumstances of each matter. Because tax
regulations are subject to interpretation and tax litigation is
inherently uncertain, these evaluations can involve a series of complex
judgments about future events and can rely heavily on estimates and
assumptions. The recorded tax liabilities are based on estimates and
assumptions that have been deemed reasonable by management. However, if
our estimates are not representative of actual outcomes, recorded tax
liabilities could be materially impacted.
Our accounting for income taxes in fiscal 2008 will be affected by the
adoption of FASB Interpretation No. 48, "Accounting for Uncertainty in
Income Taxes - an interpretation of FASB Statement No. 109." See Note 15
of the Notes to Consolidated Financial Statements.
CONTINGENCIES. We are involved in various legal proceedings, some of
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which involve claims for substantial amounts. An estimate is made to
accrue for a loss contingency relating to any of these legal proceedings
if it is probable that a liability was incurred as of the date of the
financial statements and the amount of loss can be reasonably estimated.
Because of the subjective nature inherent in assessing the outcome of
litigation and because of the potential that an adverse outcome in legal
proceedings could have a material impact on our financial condition or
results of operations,
52
such estimates are considered to be critical accounting estimates.
After review, it was determined at December 31, 2006 that for each of
the various legal proceedings in which we are involved, the conditions
mentioned above were not met. We will continue to evaluate all legal
matters as additional information becomes available.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk is limited to fluctuating interest rates
associated with variable rate indebtedness and marketable securities
that are subject to interest rate changes.
Advances to us under our credit facilities bear interest at a rate that
varies consistent with increases or decreases in the publicly announced
prime rate and/or the LIBOR rate with respect to LIBOR-related loans, if
any. A material increase in such rates could significantly increase
borrowing expenses. We did not have any cash borrowings under our
credit facilities at December 31, 2006.
The majority of our investments in marketable securities are tax exempt
auction rate securities. The rates on these securities reset at pre-
determined interval up to 35 days. As of December 31, 2006 we had
invested $117.0 million in auction rate securities, primarily in high
quality (AAA rated) bonds secured by student loans which are guaranteed
by the U. S. Government. Recent developments in the capital and credit
markets subsequent to December 31, 2006, have adversely affected the
market for auction rate securities, which has resulted in a loss of
liquidity for these investments. We are currently evaluating these
securities to determine if impairment of the carrying value of the
securities has occurred due to the loss of liquidity. (See Note 16 to
the Consolidated Financial Statements for further discussion of our
investment in auction rate securities). However, the Company believes
that as of December 31, 2007, based on its current cash, cash
equivalents and marketable securities balances of $112 million
(exclusive of auction rate securities) and its current borrowing
capacity of $290 million under its credit facility, the current lack of
liquidity in the auction rate market will not have a material impact on
its ability to fund its operations or interfere with the Company's
external growth plans.
In May 2003, we issued $200.0 million principal amount of Convertible
Subordinated Notes. The interest rate on the Convertible Subordinated
Notes is fixed at 2.50% and therefore not subject to interest rate
changes. Beginning May 16, 2006, we are obligated to pay contingent
interest at a rate equal to 0.5% per annum during any six-month period,
if the average trading price of the Convertible Subordinated Notes per
$1,000 principal amount for the five-trading day period ending on the
third trading day immediately preceding the first day of the applicable
six-month period equals $1,200 or more. As of May 15, 2006, the average
trading price of the Convertible Subordinated Notes had not reached the
price that would result in the payment of contingent interest.
In March 2006, we entered into a $43.0 million mortgage loan secured by
three of our buildings that matures in April 2021. The interest rate on
this loan is fixed at 5.91% per annum and not subject to market interest
rate changes.
Item 4. CONTROLS AND PROCEDURES
Our management, with the participation of our Chief Executive Officer
and Chief Financial Officer, as of the end of the period of this report,
evaluated the effectiveness of our disclosure controls and procedures
(as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) and
determined that, as a result of material weaknesses in internal control
over financial reporting described below, as of December 31, 2006 our
disclosure controls and procedures were not effective to ensure that
information required to be disclosed by us in reports that we file or
submit under the Exchange Act is recorded, processed, summarized and
reported within the time periods specified in SEC rules and forms.
The Public Company Accounting Oversight Board's Auditing Standard No. 2
defines a material weakness as a significant deficiency, or a
combination of significant deficiencies, that results in there being a
more than remote likelihood that a material misstatement of the annual
or interim financial statements will not be prevented or detected.
The Company identified a material weakness in its internal control over
financial reporting as of March 31, 2007 related to the determination of
appropriate measurement dates and forfeiture provisions for stock option
grants to employees; accordingly, the measurement dates used for certain
option grants were not appropriate, and the accounting for those grants
was not in accordance with Accounting Principles Board Opinion 25,
Accounting for Stock Issued to Employees ("APB 25"). The material
weakness resulted from the combined effect of the following control
53
deficiencies:
The design of the Company's policies, procedures and control activities
did not adequately address the financial reporting risks associated with
stock options. Specifically, these deficiencies in the design of the
Company's controls resulted in a more than remote likelihood of a
material misstatement in the Company's financial statements in each of
the following areas:
* Determining measurement dates,
* Determining forfeiture provisions,
* Determining the tax treatment of stock option awards.
The Company's policies and procedures to ensure that the necessary
information was captured and communicated to those responsible for stock
option accounting were inadequate. This resulted in a more than remote
likelihood of a material misstatement in the Company's financial
statements.
The Company's finance and accounting personnel and personnel involved in
the stock option granting and administration process were inadequately
trained. This resulted in a more than remote likelihood of a material
misstatement in the Company's financial statements.
In addition, and unrelated to accounting for stock-based compensation,
in August 2006, our management identified additional liabilities
associated with tax positions taken on filed tax returns that should
have been recorded in accordance with GAAP, partially offset by certain
expected tax refunds for the years ended March 31, 2004 through 2006. We
have determined that these errors in our accounting for income taxes
resulted from a material weakness in our internal control over financial
reporting. Specifically, the design of the Company's policies,
procedures and control activities did not adequately address the
financial reporting risks associated with uncertain tax positions and
were inadequate in ensuring that the necessary information was captured
and communicated to those responsible for accounting for uncertain tax
positions. This resulted in a more than remote likelihood of a material
misstatement in the Company's financial statements.
In addition, management identified a material weakness in our internal
control over financial reporting as of March 31, 2007, related to revenue
recognition. Specifically, the design of the Company's policies,
procedures, and control activities did not adequately address the
financial reporting risks associated with customer shipping terms. This
resulted in a more than remote likelihood of a material misstatement in
the Company's financial statements.
As a result of financial statement errors attributable to the material
weaknesses described above, we will file a comprehensive Form 10-K for
the fiscal year ended March 31, 2007, in which we will restate our
Consolidated Statements of Earnings, of Shareholders' Equity and
Comprehensive Income and of Cash Flows for the years ended March 31,
2006 and 2005, our Consolidated Balance Sheet as of March 31, 2006 and
selected consolidated financial data for the years ended March 31, 2006,
2005, 2004, and 2003, and for each of the quarters in the year ended
March 31, 2006.
PART II. - OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
The information set forth under Note 14 - CONTINGENCIES - LITIGATION of
the Notes to Consolidated Financial Statements included in Part I of
this report is incorporated in this Part II, Item I by reference.
54
ITEM 1A. RISK FACTORS
We operate in a rapidly changing environment that involves a number of
risks, some of which are beyond our control. The following discussion
highlights some of these risks and others are discussed elsewhere in
this report. Additional risks presently unknown to us or that we
currently consider immaterial or unlikely to occur could also impair our
operations. These and other risks could materially and adversely affect
our business, financial condition, operating results or cash flows.
RISKS RELATED TO OUR BUSINESS
THE MATTERS RELATING TO THE INVESTIGATION BY THE SPECIAL COMMITTEE AND
THE RESTATEMENT OF THE COMPANY'S CONSOLIDATED FINANCIAL STATEMENTS MAY
RESULT IN ADDITIONAL LITIGATION AND GOVERNMENTAL ENFORCEMENT ACTIONS.
We announced at an earlier date that our Board of Directors had formed a
Special Committee of outside directors to conduct an investigation,
with the assistance of independent legal counsel and forensic accounting
experts, of our past stock option grant practices over the period
January 1, 1995 through October 31, 2006. The investigation concluded
that no employee, officer or director of the Company engaged in any
intentional wrongdoing or was aware that the Company's policies and
procedures for granting and accounting for stock options were materially
noncompliant with GAAP. The investigation also found no intentional
violation of law or accounting rules with respect to the Company's
historical stock option grant practices.
However, as a result of the independent investigation, the Special
Committee concluded, and based on its internal review, management
agrees, that incorrect measurement dates were used for financial
accounting purposes for stock option grants made in certain prior
periods. Therefore, we have recorded additional non-cash stock-based
compensation expense, and related tax effects, with regard to certain
past stock option grants, and we have restated certain previously filed
financial statements included in this Form 10-Q, as more fully described
in the Explanatory Note immediately preceding Part I, Item 1, in
"Management's Discussion and Analysis of Financial Condition and
Results of Operation" in Item 7, and in Note 2 "Restatement of
Consolidated Financial Statements" of the Notes to Consolidated
Financial Statements in this Form 10-Q.
The independent investigation, management's internal review and related
activities have required us to incur substantial expenses for legal,
accounting, tax and other professional services, have diverted some of
our management's attention from the Company's business, and could have a
material adverse effect on our business, financial condition and results
of operations.
While we believe we have made appropriate judgments in determining the
correct measurement dates for our stock option grants, based upon the
Special Committee's findings and in consultation with outside experts
and our independent registered public accounting firm, the SEC may
disagree with the manner in which we have accounted for and reported,
the financial impact in our Consolidated Financial Statements.
Accordingly, there is a risk we may have to further restate our prior
financial statements, amend prior filings with the SEC, or take other
actions not currently contemplated by us.
Our past stock option grant practices and the restatement of prior
financial statements have exposed the Company to risks associated with
litigation, regulatory proceedings and government enforcement actions.
As described in Note 14 to our Consolidated Financial Statements,
"Contingencies - Litigation," several derivative lawsuits have been
filed in state and federal courts against certain current and former
directors and executive officers pertaining to allegations relating to
stock option grants. Also, the Company was notified by the SEC in
December 2006 that it had initiated a confidential, informal inquiry
with respect to the Company's stock option plans, grants, exercises and
accounting practices. Outcomes of litigation or regulatory proceedings
relating to the Company's past stock option practices may have a
material adverse effect on our financial condition, results of
operations or cash flows. The resolution of these matters will continue
to be time-consuming, expensive, and a distraction of management from
the conduct of the Company's business. Furthermore, if we are subject to
adverse findings in litigation or regulatory proceedings we could be
required to pay damages or penalties or have other remedies imposed.
55
WE HAVE MATERIAL WEAKNESSES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
AND CANNOT ASSURE YOU THAT ADDITIONAL MATERIAL WEAKNESSES WILL NOT BE
IDENTIFIED IN THE FUTURE.
Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate
the effectiveness of our internal control over financial reporting as of
the end of each year, and to include a management report assessing the
effectiveness of our internal control over financial reporting in each
Annual Report on Form 10-K. Section 404 also requires our independent
registered public accounting firm to attest to, and report on,
management's assessment of the Company's internal control over financial
reporting.
In assessing the findings of the investigation as well as the
restatement, management concluded that there were material weaknesses,
as defined in the Public Company Accounting Oversight Board's Auditing
Standard No. 2, in our internal control over financial reporting as of
December 31, 2006. Management is implementing steps to remediate these
material weaknesses by March 31, 2008. However, we cannot assure you
that such remediation will be effective. See the discussion included in
Item 4 of this report for additional information regarding our internal
control over financial reporting.
Our internal control over financial reporting may not prevent all error
and all fraud. A control system, no matter how well designed and
operated, can provide only reasonable, not absolute, assurance that the
control system's objectives will be met. Further, the design of a
control system must reflect the fact that there are resource
constraints, and the benefits of controls must be considered relative to
their costs. Controls can be circumvented by the individual acts of some
persons, by collusion of two or more people, or by management override
of the controls. Over time, controls may become inadequate because
changes in conditions or deterioration in the degree of compliance with
policies or procedures may occur. Because of the inherent limitations in
a cost-effective control system, misstatements due to error or fraud may
occur and not be detected.
As a result, significant deficiencies or material weaknesses in our
internal control over financial reporting may be identified in the
future. Any failure to maintain or implement required new or improved
controls, or any difficulties we encounter in their implementation,
could result in significant deficiencies or material weaknesses, cause
us to fail to timely meet our periodic reporting obligations, or result
in material misstatements in our financial statements. Any such failure
could also adversely affect the results of periodic management
evaluations and annual auditor attestation reports regarding disclosure
controls and the effectiveness of our internal control over financial
reporting required under Section 404 of the Sarbanes-Oxley Act of 2002
and the rules promulgated there under. If our internal control over
financial reporting or disclosure controls and procedures are not
effective, there may be errors in our financial statements that could
require a restatement or our filings may not be timely and investors may
lose confidence in our reported financial information, which could lead
to a decline in our stock price.
OUR FUTURE GROWTH WILL LARGELY DEPEND UPON OUR ABILITY TO DEVELOP NEW
PRODUCTS.
We need to continue to develop and commercialize new branded products
and generic products utilizing our proprietary drug delivery systems to
maintain the growth of our business. To do this we will need to
identify, develop and commercialize technologically enhanced branded
products and identify, develop and commercialize drugs that are off-
patent and that can be produced and sold by us as generic/non-branded
products using our drug delivery technologies. If we are unable to
identify, develop and commercialize new products, we may need to obtain
licenses to additional rights to branded or generic products, assuming
they would be available for licensing, which could decrease our
profitability. We may not be successful in pursuing this strategy.
IF WE ARE UNABLE TO COMMERCIALIZE PRODUCTS UNDER DEVELOPMENT OR THAT WE
ACQUIRE, OUR FUTURE OPERATING RESULTS MAY SUFFER.
Certain products we develop or acquire will require significant
additional development and investment, including preclinical and
clinical testing, where required, prior to their commercialization. We
expect that many of these products will not be commercially available
for several years, if at all. We cannot assure you that such products
or future products will be successfully developed, prove to be safe and
effective in clinical trials (if required), meet applicable regulatory
standards, or be capable of being manufactured in commercial quantities
at reasonable cost or at all.
56
OUR ACQUISITION STRATEGY MAY NOT BE SUCCESSFUL.
We intend to continue to pursue our efforts to acquire pharmaceutical
products, novel drug delivery technologies and/or companies that fit
into our research, manufacturing, distribution or sales and marketing
operations or that could provide us with additional products,
technologies or sales and marketing capabilities. We may not be able to
successfully identify, evaluate and acquire any such products,
technologies or companies or, if acquired, we may not be able to
successfully integrate such acquisitions into our business. We compete
with many specialty and other types of pharmaceutical companies for
products and product line acquisitions. Many of these competitors have
substantially greater financial and managerial resources than we have.
WE DEPEND ON OUR PATENTS AND OTHER PROPRIETARY RIGHTS AND CANNOT BE
CERTAIN OF THEIR CONFIDENTIALITY AND PROTECTION.
Our success depends, in large part, on our ability to protect our
current and future technologies and products, to defend our intellectual
property rights and to avoid infringing on the proprietary rights of
others. We have been issued numerous patents in the United States and
in certain foreign countries, which cover certain of our technologies,
and have filed, and expect to continue to file, patent applications
seeking to protect newly developed technologies and products. The
pharmaceutical field is crowded and a substantial number of patents have
been issued. In addition, the patent position of pharmaceutical
companies can be highly uncertain and frequently involves complex legal
and factual questions. As a result, the breadth of claims allowed in
patents relating to pharmaceutical applications or their validity and
enforceability cannot be predicted. Patents are examined for
patentability at patent offices against bodies of prior art which by
their nature may be incomplete and imperfectly categorized. Therefore,
even presuming that the examiner has been able to identify and cite the
best prior art available to him during the examination process, any
patent issued to us could later be found by a court or a patent office
during post issuance proceedings to be invalid in view of newly-
discovered prior art or already considered prior art or other legal
reasons. Furthermore, there are categories of "secret" prior art
unavailable to any examiner, such as the prior inventive activities of
others, which could form the basis for invalidating any patent. In
addition, there are other reasons why a patent may be found to be
invalid, such as an offer for sale or public use of the patented
invention in the United States more than one year before the filing date
of the patent application. Moreover, a patent may be deemed
unenforceable if, for example, the inventor or the inventor's agents
failed to disclose prior art to the PTO that they knew was material to
patentability.
The coverage claimed in a patent application can be significantly
reduced before a patent is issued, either in the United States or
abroad. Consequently, our pending or future patent applications may not
result in the issuance of patents. Patents issued to us may be
subjected to further proceedings limiting their scope and may not
provide significant proprietary protection or competitive advantage.
Our patents also may be challenged, circumvented, invalidated or deemed
unenforceable. Patent applications in the United States filed prior to
November 29, 2000, are currently maintained in secrecy until and unless
patents issue, and patent applications in certain other countries
generally are not published until more than 18 months after they are
first filed (which generally is the case in the United States for
applications filed on or after November 29, 2000). In addition,
publication of discoveries in scientific or patent literature often lags
behind actual discoveries. As a result, we cannot be certain that we or
our licensors will be entitled to any rights in purported inventions
claimed in pending or future patent applications or that we or our
licensors were the first to file patent applications on such inventions.
Furthermore, patents already issued to us or our pending applications
may become subject to dispute, and any dispute could be resolved against
us. For example, we may become involved in re-examination, reissue or
interference proceedings in the PTO, or opposition proceedings in a
foreign country. The result of these proceedings can be the
invalidation or substantial narrowing of our patent claims. We also
could be subject to court proceedings that could find our patents
invalid or unenforceable or could substantially narrow the scope of our
patent claims. In addition, statutory differences in patentable subject
matter may limit the protection we can obtain on some of our inventions
outside of the United States. For example, methods of treating humans
are not patentable in many countries outside of the United States.
These and other issues may prevent us from obtaining patent protection
outside of the United States. Furthermore, once patented in foreign
countries, the inventions may be subjected to mandatory working
requirements and/or subject to compulsory licensing regulations.
We also rely on trade secrets, unpatented proprietary know-how and
continuing technological innovation that we seek to protect, in part by
confidentiality agreements with licensees, suppliers, employees and
consultants. These
57
agreements may be breached by the other parties to these agreements. We
may not have adequate remedies for any breach. Disputes may arise
concerning the ownership of intellectual property or the applicability
or enforceability of our confidentiality agreements and there can be no
assurance that any such disputes would be resolved in our favor.
Furthermore, our trade secrets and proprietary technology may become
known or be independently developed by our competitors, or patents may
not be issued with respect to products or methods arising from our
research, and we may not be able to maintain the confidentiality of
information relating to those products or methods. Furthermore, certain
unpatented technology may be subject to intervening rights.
WE DEPEND ON OUR TRADEMARKS AND RELATED RIGHTS.
To protect our trademarks and goodwill associated therewith, domain
name, and related rights, we generally rely on federal and state
trademark and unfair competition laws, which are subject to change.
Some, but not all, of our trademarks are registered in the jurisdictions
where they are used. Some of our other trademarks are the subject of
pending applications in the jurisdictions where they are used or
intended to be used, and others are not.
It is possible that third parties may own or could acquire rights in
trademarks or domain names in the United States or abroad that are
confusingly similar to or otherwise compete unfairly with our marks and
domain names, or that our use of trademarks or domain names may infringe
or otherwise violate the intellectual property rights of third parties.
The use of similar marks or domain names by third parties could decrease
the value of our trademarks or domain names and hurt our business, for
which there may be no adequate remedy.
THIRD PARTIES MAY CLAIM THAT WE INFRINGE ON THEIR PROPRIETARY RIGHTS, OR
SEEK TO CIRCUMVENT OURS.
We may be required to defend against charges of infringement of patents,
trademarks or other proprietary rights of third parties. This defense
could require us to incur substantial expense and to divert significant
effort of our technical and management personnel, and could result in
our loss of rights to develop or make certain products or require us to
pay monetary damages or royalties to license proprietary rights from
third parties. If a dispute is settled through licensing or similar
arrangements, costs associated with such arrangements may be substantial
and could include ongoing royalties. Furthermore, we cannot be certain
that the necessary licenses would be available to us on acceptable
terms, if at all. Accordingly, an adverse determination in a judicial
or administrative proceeding or failure to obtain necessary licenses
could prevent us from manufacturing, using, selling and/or importing in
to the United States certain of our products. Litigation also may be
necessary to enforce our patents against others or to protect our know-
how or trade secrets. That litigation could result in substantial
expense or put our proprietary rights at risk of loss, and we cannot
assure you that any litigation will be resolved in our favor. There
currently are two patent infringement lawsuits pending against us. They
could have a material adverse effect on our future financial position,
results of operations or cash flows.
WE MAY BE UNABLE TO MANAGE OUR GROWTH.
Over the past ten years, our businesses and product offerings have grown
substantially. This growth and expansion has placed, and is expected to
continue to place, a significant strain on our management, operational
and financial resources. To manage our growth, we must continue to (1)
expand our operational, sales, customer support and financial control
systems and (2) hire, train and retain qualified personnel. If we are
unable to manage our growth effectively, our financial position, results
of operations or cash flows could be materially adversely affected.
WE MAY BE ADVERSELY AFFECTED BY THE CONTINUING CONSOLIDATION OF OUR
DISTRIBUTION NETWORK AND THE CONCENTRATION OF OUR CUSTOMER BASE.
Our principal customers are wholesale drug distributors, major retail
drug store chains, independent pharmacies and mail order firms. These
customers comprise a significant part of the distribution network for
pharmaceutical products in the United States. This distribution network
is continuing to undergo significant consolidation marked by mergers and
acquisitions among wholesale distributors and the growth of large retail
drug store chains. As a result, a small number of large wholesale
distributors control a significant share of the market, and the number
of independent drug stores and small drug store chains has decreased.
We expect that consolidation of drug wholesalers and retailers will
increase pricing and other competitive pressures on drug manufacturers.
For the fiscal year ended March 31, 2006, our
58
three largest customers, which are wholesale distributors, accounted for
27%, 16% and 13% of our gross sales. The loss of any of these customers
could materially and adversely affect our financial position, results of
operations or cash flows.
THE REGULATORY STATUS OF CERTAIN OF OUR GENERIC PRODUCTS MAY MAKE THEM
SUBJECT TO INCREASED COMPETITION OR TO REGULATORY DECISIONS TO REQUIRE
MARKET WITHDRAWAL OF ONE OR MORE OF OUR UNAPPROVED PRODUCTS.
Many of our products are manufactured and marketed without FDA approval. For
example, our prenatal products, which contain folic acid, are sold as
prescription multiple vitamin supplements. These types of prenatal vitamins
are typically regulated by the FDA as prescription drugs, but are not covered
by an NDA or ANDA. As a result, competitors may more easily and rapidly
introduce products competitive with our prenatal and other products that have
a similar regulatory status. In other cases, we sell unapproved products that
may become subject to FDA orders to the pharmaceutical industry to remove one
or more types of such products from the marketplace. During the past year,
such FDA orders have required manufacturers and distributors of certain
unapproved products containing guaifenesin and hydrocodone to cease
manufacture or distribution, including certain ETHEX products. In the future,
FDA may issue similar orders affecting other of our products. In addition, in
the event that FDA concludes that we have failed to comply with a notice
setting deadlines for discontinuation of the manufacture and sale of
unapproved products, or decides to take enforcement action against us on other
grounds, such as for alleged violations of current good manufacturing practice
requirements or for failure to obtain product approvals that FDA deems to be
necessary, FDA policies permit the agency to initiate broad action against the
marketing of additional categories of our unapproved drug products, even if
the agency has not instituted similar actions against the marketing of such
products by other parties.
One of the key motivations for challenging patents is the reward of a
180-day period of market exclusivity. Under the Hatch-Waxman Act, the
developer of a generic version of a product which is the first to have
its ANDA accepted for filing by the FDA, and whose filing includes a
certification that the patent is invalid, unenforceable and/or not
infringed (a so-called "Paragraph IV certification"), may be eligible to
receive a 180-day period of generic market exclusivity. This period of
market exclusivity provides the patent challenger with the opportunity
to earn a risk-adjusted return on legal and development costs associated
with bringing a product to market. In cases such as these where suit is
filed by the manufacturer of the branded product, final FDA approval of
an ANDA generally requires a favorable disposition of the suit, either
by judgment that the patents at issue are invalid and/or not infringed
or by settlement. We may not ultimately prevail in these litigations,
we may not receive final FDA approval of our ANDAs, and we may not
achieve our expectation of a period of generic exclusivity for certain
of these products when and if resolution of the litigations and receipt
of final approvals from the FDA occur.
Since enactment of the Hatch-Waxman Act in 1984, the interpretation and
implementation of the statutory provisions relating to the 180-day
period of generic market exclusively has been the subject of
controversy, court decisions, changes to FDA regulations and guidelines,
and other changes in FDA interpretation. In addition, in 2003,
significant changes were enacted in the statutory provisions themselves,
some of which were retroactive and others of which apply only
prospectively or to situations where the first ANDA filing with a
Paragraph IV certification occurs after the date of enactment. These
interpretations and changes, over time, have had significant effects on
the ability of sponsors of particular generic drug products to qualify
for or utilize fully the 180-day generic marketing exclusivity period.
These interpretations and changes have, in turn, affected the ability of
sponsors of corresponding innovator drugs to market their branded
products without any generic competition and the ability of sponsors of
other generic versions of the same products to market their products in
competition with the first generic applicant. Because application of
these provisions, and any changes in them or in the applicable
interpretations of them, depends almost entirely on the specific facts
of the particular NDA and ANDA filings at issue, many of which are not
in our control, we cannot predict whether any changes would, on balance,
have a positive or negative effect on our business as a whole, although
particular changes may have predictable, and potentially significant
positive or negative effects on particular pipeline products. In
addition, continuing uncertainty over the interpretation and
implementation of the original Hatch-Waxman provisions, as well as the
2003 statutory amendments, is likely to continue to impair our ability
to predict the likely exclusivity that we may be granted, or blocked by,
based on the outcome of particular patent challenges in which we are
involved.
COMMERCIALIZATION OF A GENERIC PRODUCT PRIOR TO THE FINAL RESOLUTION OF
PATENT INFRINGEMENT LITIGATION COULD EXPOSE US TO SIGNIFICANT DAMAGES IF
THE OUTCOME OF SUCH LITIGATION IS UNFAVORABLE AND COULD IMPAIR OUR
REPUTATION.
We could invest a significant amount of time and expense in the
development of our generic products only to be subject to significant
additional delay and changes in the economic prospects for our products.
If we receive FDA approval for our pending ANDAs, we may consider
commercializing the product prior to the final resolution of any related
patent infringement litigation. The risk involved in marketing a product
prior to the final resolution of the
59
litigation may be substantial because the remedies available to the
patent holder could include, among other things, damages measured by the
profits lost by such patent holder and not by the profits earned by us.
Patent holders may also recover damages caused by the erosion of prices
for its patented drug as a result of the introduction of our generic
drug in the marketplace. Further, in the case of a willful infringement,
which requires a complex analysis of the totality of the circumstances,
such damages may be trebled. However, in order to realize the economic
benefits of some of our products, we may decide to risk an amount that
may exceed the profit we anticipate making on our product. There are a
number of factors we would need to consider in order to decide whether
to launch our product prior to final resolution, including (1) outside
legal advice, (2) the status of a pending lawsuit, (3) interim court
decisions, (4) status and timing of a trial, (5) legal decisions
affecting other competitors for the same product, (6) market factors,
(7) liability sharing agreements, (8) internal capacity issues, (9)
expiration dates of patents, (10) strength of lower court decisions and
(11) potential triggering or forfeiture of exclusivity. An adverse
determination in the litigation relating to a product we launch at risk
could have a material adverse effect on our financial condition, results
of operations or cash flows.
After we filed ANDAs with the FDA seeking permission to market a generic
version of the 25 mg, 50 mg, 100 mg, and 200 mg strengths of Toprol-
XL(R) in extended-release capsule form, AstraZeneca filed lawsuits
against KV for patent infringement under the provisions of the Hatch-
Waxman Act. In our Paragraph IV certification, we contended that our
proposed generic versions do not infringe AstraZeneca's patents.
Pursuant to the Hatch-Waxman Act, the filing date of the suit against us
instituted an automatic stay of FDA approval of our ANDA until the
earlier of a judgment, or 30 months from the date of the suit. We filed
motions for summary judgment with the Federal District Court in Missouri
alleging, among other things, that AstraZeneca's patent is invalid and
unenforceable. These motions have been granted. AstraZeneca has
appealed. On July 23, 2007, the Court of Appeals for the Federal
Circuit affirmed the decision of the District Court below with respect
to the invalidity of AstraZeneca's patent but reversed and remanded with
respect to inequitable conduct by AstraZeneca. AstraZeneca filed for
rehearing by the Federal Circuit, which has been denied. The time has
not yet run with respect to any petition for certiorari by AstraZeneca
to the United States Supreme Court. We intend to vigorously defend our
interests regardless of the outcome of any further appeal by
AstraZeneca; however, we may not prevail.
WE FACE THE RISK OF PRODUCT LIABILITY CLAIMS, FOR WHICH WE MAY BE
INADEQUATELY INSURED.
Manufacturing, selling and testing pharmaceutical products involve a
risk of product liability. Even unsuccessful product liability claims
could require us to spend money on litigation, divert management's time,
damage our reputation and impair the marketability of our products. A
successful product liability claim outside of or in excess of our
insurance coverage could require us to pay substantial sums and
adversely affect our financial position, results of operations or cash
flows.
We have been advised that one of our former distributor customers is
being sued in Florida state court in a case captioned Darrian Kelly v.
K-Mart et. al. for personal injury allegedly caused by ingestion of
K-Mart diet caplets that are alleged to have been manufactured by us and
to contain phenylpropanolamine, or PPA. The distributor has tendered
defense of the case to us and has asserted a right to indemnification
for any financial judgment it must pay. We previously notified our
product liability insurer of this claim in 1999 and again in 2004, and
we demanded that the insurer assume our defense. The insurer has stated
that it has retained counsel to secure additional factual information
and will defer its coverage decision until that information is received.
We intend to vigorously defend our interests; however, we may be
impleaded into the action, and, if we are impleaded, we may not prevail.
Our product liability coverage for PPA claims expired for claims made
after June 15, 2002. Although we renewed our product liability coverage
for coverage after June 15, 2002, that policy excludes future PPA claims
in accordance with the standard industry exclusion. Consequently, as of
June 15, 2002, we will provide for legal defense costs and indemnity
payments involving PPA claims on a going forward basis as incurred.
Moreover, we may not be able to obtain product liability insurance in
the future for PPA claims with adequate coverage limits at commercially
reasonable prices for subsequent periods. From time to time in the
future, we may be subject to further litigation resulting from products
containing PPA that we formerly distributed. We intend to vigorously
defend our interests; however, we may not prevail.
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WE DEPEND ON LICENSES FROM OTHERS, AND ANY LOSS OF THESE LICENSES COULD
HARM OUR BUSINESS, MARKET SHARE AND PROFITABILITY.
We have acquired the rights to manufacture, use and/or market certain
products. We also expect to continue to obtain licenses for other
products and technologies in the future. Our license agreements
generally require us to develop the markets for the licensed products.
If we do not develop these markets, the licensors may be entitled to
terminate these license agreements.
We cannot be certain that we will fulfill all of our obligations under
any particular license agreement for any variety of reasons, including
insufficient resources to adequately develop and market a product, lack
of market development despite our efforts and lack of product
acceptance. Our failure to fulfill our obligations could result in the
loss of our rights under a license agreement.
Certain products we have the right to license are at certain stages of
clinical tests and FDA approval. Failure of any licensed product to
receive regulatory approval could result in the loss of our rights under
its license agreement.
WE EXPEND A SIGNIFICANT AMOUNT OF RESOURCES ON RESEARCH AND DEVELOPMENT
EFFORTS THAT MAY NOT LEAD TO SUCCESSFUL PRODUCT INTRODUCTIONS.
We conduct research and development primarily to enable us to
manufacture and market FDA-approved pharmaceuticals in accordance with
FDA regulations. Typically, research costs related to the development
of innovative compounds and the filing of NDAs are significantly greater
than those expenses associated with ANDA filings. As such, our
investment in research and development reflects our ongoing commitment
to develop new products and/or technologies through our internal
development programs, and with our external strategic partners. Because
of the inherent risk associated with research and development efforts in
our industry, particularly with respect to new drugs, our research and
development expenditures may not result in the successful introduction
of FDA approved new pharmaceutical products. Also, after we submit an
ANDA, the FDA may request that we conduct additional studies and as a
result, we may be unable to reasonably determine the total research and
development costs to develop a particular product. Finally, we cannot
be certain that any investment made in developing products will be
recovered, even if we are successful in commercialization. To the
extent that we expend significant resources on research and development
efforts and are not able, ultimately, to introduce successful new
products as a result of those efforts, our financial condition or
results of operations may be materially adversely affected.
ANY SIGNIFICANT INTERRUPTION IN THE SUPPLY OF RAW MATERIALS AND/OR
CERTAIN FINISHED PRODUCTS COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR
BUSINESS.
We typically purchase the active pharmaceutical ingredient (i.e., the
chemical compounds that produce the desired therapeutic effect in our
products) and other materials and supplies that we use in our
manufacturing operations, as well as certain finished products, from
many different domestic and foreign suppliers.
Additionally, we maintain safety stocks in our raw materials inventory,
and in certain cases where we have listed only one supplier in our
applications with the FDA, have received FDA approval to use alternative
suppliers should the need arise. However, there is no guarantee that we
will always have timely and sufficient access to a critical raw material
or finished product. A prolonged interruption in the supply of a single-
sourced raw material, including the active ingredient, or finished
product could cause our financial position and results of operations to
be materially adversely affected. In addition, our manufacturing
capabilities could be impacted by quality deficiencies in the products
which our suppliers provide, which could have a material adverse effect
on our business.
We utilize controlled substances in certain of our current products and
products in development and therefore must meet the requirements of the
Controlled Substances Act of 1970 and the related regulations
administered by the Drug Enforcement Administration ("DEA"). These
regulations relate to the manufacture, shipment, storage, sale and use
of controlled substances. The DEA limits the availability of the active
ingredients used in certain of our current products and products in
development and, as a result, our procurement quota of these active
ingredients may not be sufficient to meet commercial demand or complete
clinical trials. We must annually apply to the DEA for procurement quota
in order to obtain these substances. Any delay or refusal by the DEA in
establishing our procurement quota for controlled substances could delay
or stop our clinical trials or product launches, or could cause trade
inventory disruptions for those products that have already been
launched, which could have a material adverse effect on our financial
position, results of operations or cash flows.
61
OUR POLICIES REGARDING RETURNS, ALLOWANCES AND CHARGEBACKS, AND
MARKETING PROGRAMS ADOPTED BY WHOLESALERS, MAY REDUCE OUR REVENUES IN
FUTURE FISCAL PERIODS.
Based on industry practice, generic product manufacturers, including us,
have liberal return policies and have been willing to give customers
post-sale inventory allowances. Under these arrangements, from time to
time, we give our customers credits on our generic products that our
customers hold in inventory after we have decreased the market prices of
the same generic products. Therefore, if additional competitors enter
the marketplace and significantly lower the prices of any of their
competing products, we would likely reduce the price of our comparable
products. As a result, we would be obligated to provide significant
credits to our customers who are then holding inventories of such
products, which could reduce sales revenue and gross margin for the
period when the credits are accrued. Like our competitors, we also give
credits for chargebacks to wholesale customers that have contracts with
us for their sales to hospitals, group purchasing organizations,
pharmacies or other retail customers. A chargeback is the difference
between the price the wholesale customer pays and the price that the
wholesale customer's end-customer pays for a product. Although we
establish allowances based on our prior experience and our best
estimates of the impact that these policies may have in subsequent
periods, our allowances may not be adequate or our actual product
returns, allowances and chargebacks may exceed our estimates.
INVESTIGATIONS OF THE CALCULATION OF AVERAGE WHOLESALE PRICES MAY
ADVERSELY AFFECT OUR BUSINESS.
Many government and third-party payors, including Medicare, Medicaid,
health maintenance organizations, or HMOs, and managed care
organizations, or MCOs, reimburse doctors and others for the purchase of
certain prescription drugs based on a drug's average wholesale price, or
AWP. In the past several years, state and federal government agencies
have conducted ongoing investigations of manufacturers' reporting
practices with respect to AWP, in which they have asserted that
reporting of inflated AWP's have led to excessive payments for
prescription drugs.
The Company and/or ETHEX have been named as defendants in certain multi-
defendant cases alleging that the defendants reported improper or
fraudulent pharmaceutical pricing information, i.e., AWP, and/or
Wholesale Acquisition Cost, or WAC, information, which caused the
governmental plaintiffs to incur excessive costs for pharmaceutical
products under the Medicaid program. Cases of this type have been filed
against the Company and/or ETHEX and other pharmaceutical manufacturer
defendants by the States of Massachusetts, Alabama, Mississippi, Utah
and Iowa, New York City, and approximately 42 counties in New York
State. The State of Mississippi effectively voluntarily dismissed the
Company and ETHEX without prejudice on October 5, 2006 by virtue of the
State's filing an Amended Complaint on such date that does not name
either the Company or ETHEX as a defendant. On August 13, 2007, the
Company settled the Massachusetts lawsuit for $575,000 in cash and
agreed to supply $150,000 in free pharmaceuticals over the next two
years and the Company has received a general release; no admission of
liability was made. The New York City case and all New York county
cases (other than the Erie, Oswego and Schenectady County cases) have
been transferred to the U.S. District Court for the District of
Massachusetts for coordinated or consolidated pretrial proceedings under
the Average Wholesale Price Multidistrict Litigation (MDL No. 1456). The
cases pertaining to the State of Alabama, Erie County, Oswego County,
and Schenectady County were removed to federal court by a co-defendant
in October 2006, but all of these cases have since been remanded to the
state courts in which they originally were filed. Each of these actions
is in the early stages, with fact discovery commencing or ongoing. The
Company has been served with a complaint naming ETHEX and nine other
pharmaceutical companies as defendants in a pricing suit filed in state
court in Utah by the State of Utah. The time to file an answer or other
response in the Utah suit has not yet run. In October 2007, the State of
Iowa filed a complaint naming ETHEX and 77 other pharmaceutical
companies as defendants in a pricing suit in federal court in the State
of Iowa. ETHEX and the other defendants have moved to dismiss the Iowa
complaint. The Company intends to vigorously defend its interests in the
actions described above; however, the outcome may have a material
adverse effect on our future business, financial condition, results of
operations or cash flows.
We believe that various other governmental entities have commenced
investigations into the generic and branded pharmaceutical industry at
large regarding pricing and price reporting practices. Although we
believe our pricing and reporting practices have complied in all
material respects with our legal obligations, we may not prevail if
legal actions are instituted by these governmental entities.
RISING INSURANCE COSTS COULD NEGATIVELY IMPACT PROFITABILITY.
The cost of insurance, including workers' compensation, product
liability and general liability insurance, has risen significantly in
the past few years and is expected to continue to increase. In response,
we may increase deductibles
62
and/or decrease certain coverages to mitigate these costs. These
increases, and our increased risk due to increased deductibles and
reduced coverages, could have a negative impact on our financial
position, results of operations or cash flows.
OUR REVENUES, GROSS PROFIT AND OPERATING RESULTS MAY FLUCTUATE FROM
PERIOD TO PERIOD DEPENDING UPON OUR PRODUCT SALES MIX, OUR PRODUCT
PRICING, AND OUR COSTS TO MANUFACTURE OR PURCHASE PRODUCTS.
Our future results of operations, financial condition and cash flows
will depend to a significant extent upon our branded and generic/non-
branded product sales mix. Our sales of branded products generate higher
gross margins than our sales of generic/non-branded products. In
addition, the introduction of new generic products at any given time can
involve significant initial quantities being purchased by our wholesaler
customers, as they supply initial quantities to pharmacies and purchase
product for their own wholesaler inventories. As a result, our sales
mix (the proportion of total sales between branded products and
generic/non-branded products) will significantly impact our gross profit
from period to period. During fiscal 2006, sales of our branded products
and generic/non-branded products accounted for 39.6% and 55.4%,
respectively, of our net revenues. During that same year, branded
products and generic/non-branded products contributed gross margins of
88.4% and 54.9%, respectively, to our consolidated gross profit margin
of 66.3% in fiscal 2006. Factors that may cause our sales mix to vary
include:
* the amount and timing of new product introductions;
* marketing exclusivity, if any, which may be obtained on certain
new products;
* the level of competition in the marketplace for certain
products;
* the availability of raw materials and finished products from
our suppliers;
* the buying patterns of our three largest wholesaler customers;
* the scope and outcome of governmental regulatory action that
may involve us;
* periodic dependence on a relatively small number of products
for a significant portion of net revenue or income; and
* legal actions brought by our competitors.
The profitability of our product sales is also dependent upon the prices
we are able to charge for our products, the costs to purchase products
from third parties, and our ability to manufacture our products in a
cost-effective manner. If our revenues and gross profit decline or do
not grow as anticipated, we may not be able to correspondingly reduce
our operating expenses.
WE ARE INVOLVED IN VARIOUS LEGAL PROCEEDINGS AND CERTAIN GOVERNMENT
INQUIRIES AND MAY EXPERIENCE UNFAVORABLE OUTCOMES OF SUCH PROCEEDINGS OR
INQUIRIES, WHICH COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR FINANCIAL
CONDITION, RESULTS OF OPERATIONS OR CASH FLOWS.
We are involved in various legal proceedings and certain government
inquiries, including, but not limited to, patent infringement, product
liability, breach of contract and claims involving Medicaid and Medicare
reimbursements, some of which are described in our periodic reports and
involve claims for, or the possibility of fines and penalties involving,
substantial amounts of money or for other relief. If any of these legal
proceedings or inquiries were to result in an adverse outcome, the
impact could have a material adverse effect on our financial condition,
results of operations or cash flows.
With respect to product liability, we maintain commercial insurance to
protect against and manage a portion of the risks involved in conducting
our business. Although we carry insurance, we believe that no reasonable
amount of insurance can fully protect against all such risks because of
the potential liability inherent in the business of producing
pharmaceuticals for human consumption. To the extent that a loss occurs,
depending on the nature of the loss and the level of insurance coverage
maintained, it could have a material adverse effect on our financial
position, results of operations or cash flows.
INCREASED INDEBTEDNESS MAY IMPACT OUR FINANCIAL CONDITION, RESULTS OF
OPERATIONS OR CASH FLOWS.
At December 31, 2006, we had $241.8 million of outstanding debt,
consisting of $200.0 million principal amount of 2.5% Contingent
Convertible Subordinated Notes (the "Notes") and the remaining principal
balance of a $43.0 million mortgage loan entered into in March 2006. In
June 2006, we replaced our $140.0 million credit line by entering into a
new credit agreement with ten banks that provides for a revolving line
of credit for borrowing up to $320.0 million.
63
The new credit agreement also includes a provision for increasing the
revolving commitment, at the lenders' sole discretion, by up to an
additional $50.0 million. The new credit facility is unsecured unless
we, under certain specified circumstances, utilize the facility to
redeem part or all of our outstanding Convertible Subordinated Notes.
The new credit facility has a term expiring in June 2011. At December
31, 2006, we had no cash borrowings under our credit facility. Our
level of indebtedness may have several important effects on our future
operations, including:
* we will be required to use a portion of our cash flow from
operations for the payment of any principal or interest due on
our outstanding indebtedness;
* our outstanding indebtedness and leverage will increase the
impact of negative changes in general economic and industry
conditions, as well as competitive pressures and increases in
interest rates; and
* the level of our outstanding debt and the impact it has on our
ability to meet debt covenants associated with our revolving
line of credit arrangement may affect our ability to obtain
additional financing for working capital, capital expenditures,
acquisitions or general corporate purposes.
General economic conditions, industry cycles and financial, business and
other factors affecting our operations, many of which are beyond our
control, may affect our future performance. As a result, our business
might not continue to generate cash flow at or above current levels. If
we cannot generate sufficient cash flow from operations in the future to
service our debt, we may, among other things:
* seek additional financing in the debt or equity markets;
* refinance or restructure all or a portion of our indebtedness;
* sell selected assets;
* reduce or delay planned capital expenditures; or
* reduce or delay planned research and development expenditures.
These measures might not be sufficient to enable us to service our debt.
In addition, any financing, refinancing or sale of assets might not be
available on economically favorable terms or at all.
We may also consider issuing additional debt or equity securities in the
future to fund potential acquisitions or investments, to refinance
existing debt and/or for general corporate purposes. If a material
acquisition or investment is completed, our financial position, results
of operations or cash flows could change materially in future periods.
However, additional funds may not be available on satisfactory terms, or
at all, to fund such activities.
Holders of the Notes may require us to offer to repurchase their Notes
for cash upon the occurrence of a change in control or on May 16, 2008,
2013, 2018, 2023 and 2028. As a result of this, we classified the
Convertible Subordinated Notes as a current liability as of June 30,
2007 due to the right the holders have to require us to repurchase the
Convertible Subordinated Notes on May 16, 2008. The source of funds for
any repurchase required as a result of any such events will be our
available cash or cash generated from operating activities or other
sources, including borrowings, sales of assets, sales of equity or funds
provided by a new controlling entity. The use of available cash to fund
the repurchase of the Notes may impair our ability to obtain additional
financing in the future.
WE MAY HAVE FUTURE CAPITAL NEEDS AND FUTURE ISSUANCES OF EQUITY
SECURITIES WILL RESULT IN DILUTION.
We anticipate that funds generated internally, together with funds
available under our credit facility will be sufficient to implement our
business plan for the foreseeable future, subject to additional needs
that may arise if acquisition opportunities become available. We also
may need additional capital if unexpected events occur or opportunities
arise. We may raise additional capital through the public or private
sale of debt or equity securities. If we sell equity securities,
holders of our common stock could experience dilution. Furthermore,
those securities could have rights, preferences and privileges more
favorable than those of the Class A or Class B common stock. Additional
funding may not be accessible or available to us on favorable terms or
at all. If the funding is not available, we may not be able to fund our
expansion, take advantage of acquisition opportunities or respond to
competitive pressures.
64
WE MAY BE ADVERSELY IMPACTED BY ECONOMIC FACTORS BEYOND OUR CONTROL AND
MAY INCUR IMPAIRMENT CHARGES TO OUR INVESTMENT PORTFOLIO.
The Company has funds invested in auction rate securities ("ARS").
Consistent with the Company's investment policy guidelines, the ARS held
by the Company are AAA rated securities with long-term nominal
maturities secured by student loans which are guaranteed by the U.S.
Government. The interest rates on these securities are reset through an
auction process at pre-determined intervals, up to 35 days. There may be
liquidity issues which arise in the credit and capital markets and the
ARS held by the Company may experience failed auctions as the amount of
securities submitted for sale may exceed the amount of purchase orders.
As a result, the Company may not be able to liquidate some or all of its
auction rate securities prior to their maturities at prices
approximating their face amounts.
During 2008, disruption in the credit and capital markets have adversely
affected the auction market for the type of securities held by the
Company. If uncertainties in these credit and capital markets continue
or these markets deteriorate further the Company may incur impairments
to the carrying value of its investments in ARS, which could negatively
affect the Company's financial condition, cash flow and reported
earnings. (See Note 16 to the Consolidated Financial Statements for
further discussion of the Company's investment in ARS). However, the
Company believes that as of December 31, 2007, based on its current
cash, cash equivalents and marketable securities balances of $112
million (exclusive of auction rate securities) and its current borrowing
capacity of $290 million under its credit facility, the current lack of
liquidity in the auction rate market will not have a material impact on
its ability to fund its operations or interfere with the Company's
external growth plans.
WE MAY INCUR CHARGES FOR INTANGIBLE ASSET IMPAIRMENT.
When we acquire the rights to manufacture and sell a product, we record
the aggregate purchase price, along with the value of the product
related liabilities we assume, as intangible assets. We use the
assistance of valuation experts to help us allocate the purchase price
to the fair value of the various intangible assets we have acquired.
Then, we must estimate the economic useful life of each of these
intangible assets in order to amortize their cost as an expense in our
consolidated statements of income over the estimated economic useful
life of the related asset. The factors that affect the actual economic
useful life of a pharmaceutical product are inherently uncertain, and
include patent protection, physician loyalty and prescribing patterns,
competition by products prescribed for similar indications, future
introductions of competing products not yet FDA-approved and the impact
of promotional efforts, among many others. We consider all of these
factors in initially estimating the economic useful lives of our
products, and we also continuously monitor these factors for indications
of decline in carrying value.
In assessing the recoverability of our intangible assets, we must make
assumptions regarding estimated undiscounted future cash flows and other
factors. If the estimated undiscounted future cash flows do not exceed
the carrying value of the intangible assets we must determine the fair
value of the intangible assets. If the fair value of the intangible
assets is less than its carrying value, an impairment loss will be
recognized in an amount equal to the difference. If these estimates or
their related assumptions change in the future, we may be required to
record impairment charges for these assets. We review intangible assets
for impairment at least annually and whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. If we determine that an intangible asset is impaired, a
non-cash impairment charge would be recognized.
Because circumstances after an acquisition can change, the value of
intangible assets we record may not be realized by us. If we determine
that impairment has occurred, we would be required to write-off the
impaired portion of the unamortized intangible assets, which could have
a material adverse effect on our results of operations in the period in
which the write-off occurs. In addition, in the event of a sale of any
of our assets, we might not recover our recorded value of associated
intangible assets.
THERE ARE INHERENT UNCERTAINTIES INVOLVED IN THE ESTIMATES, JUDGMENTS
AND ASSUMPTIONS USED IN THE PREPARATION OF OUR FINANCIAL STATEMENTS, AND
ANY CHANGES IN THOSE ESTIMATES, JUDGMENTS AND ASSUMPTIONS COULD HAVE A
MATERIAL ADVERSE EFFECT ON OUR FINANCIAL CONDITION, RESULTS OF
OPERATIONS OR CASH FLOWS.
The consolidated and condensed consolidated financial statements that we
file with the SEC are prepared in accordance with GAAP. The preparation
of financial statements in accordance with GAAP involves making
estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and the related disclosure
65
of contingent assets and liabilities. The most significant estimates we
are required to make under GAAP include, but are not limited to, those
related to revenue recognition and reductions to gross revenues,
inventory valuation, intangible assets, stock-based compensation, income
taxes and loss contingencies related to legal proceedings. We
periodically evaluate estimates used in the preparation of the
consolidated financial statements for reasonableness, including
estimates provided by third parties. Appropriate adjustments to the
estimates will be made prospectively, as necessary, based on such
periodic evaluations. We base our estimates on, among other things,
currently available information, market conditions, historical
experience and various assumptions, which together form the basis of
making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Although we believe
that our assumptions are reasonable under the circumstances, estimates
would differ if different assumptions were utilized and these estimates
may prove in the future to have been inaccurate.
RISKS RELATED TO OUR INDUSTRY
LEGISLATIVE PROPOSALS, REIMBURSEMENT POLICIES OF THIRD PARTIES, COST-
CONTAINMENT MEASURES AND HEALTH CARE REFORM COULD AFFECT THE MARKETING,
PRICING AND DEMAND FOR OUR PRODUCTS.
Various legislative proposals, including proposals relating to
prescription drug benefits, could materially impact the pricing and sale
of our products. Further, reimbursement policies of third parties may
affect the marketing of our products. Our ability to market our products
will depend in part on reimbursement levels for the cost of the products
and related treatment established by health care providers, including
government authorities, private health insurers and other organizations,
such as HMOs and MCOs. Insurance companies, HMOs, MCOs, Medicaid and
Medicare administrators and others regularly challenge the pricing of
pharmaceutical products and review their reimbursement practices. In
addition, the following factors could significantly influence the
purchase of pharmaceutical products, which could result in lower prices
and a reduced demand for our products:
* the trend toward managed health care in the United States;
* the growth of organizations such as HMOs and MCOs;
* legislative proposals to reform health care and government
insurance programs; and
* price controls and non-reimbursement of new and highly priced
medicines for which the economic therapeutic rationales are not
established.
These cost-containment measures and health care reform proposals could
affect our ability to sell our products.
The reimbursement status of a newly approved pharmaceutical product may
be uncertain. Reimbursement policies may not include some of our
products. Even if reimbursement policies of third parties grant
reimbursement status for a product, we cannot be sure that these
reimbursement policies will remain in effect. Limits on reimbursement
could reduce the demand for our products. The unavailability or
inadequacy of third party reimbursement for our products could reduce or
possibly eliminate demand for our products. We are unable to predict
whether governmental authorities will enact additional legislation or
regulation which will affect third party coverage and reimbursement that
reduces demand for our products.
Our ability to market generic pharmaceutical products successfully
depends, in part, on the acceptance of the products by independent third
parties, including pharmacies, government formularies and other
retailers, as well as patients. We manufacture a number of prescription
drugs which are used by patients who have severe health conditions.
Although the brand-name products generally have been marketed safely for
many years prior to our introduction of a generic/non-branded
alternative, there is a possibility that one of these products could
produce a side effect which could result in an adverse effect on our
ability to achieve acceptance by managed care providers, pharmacies and
other retailers, customers and patients. If these independent third
parties do not accept our products, it could have a material adverse
effect on our financial condition, results of operations or cash flows.
OUR INDUSTRY EXPERIENCES RAPID TECHNOLOGICAL CHANGE.
The drug delivery industry is a rapidly evolving field. A number of
companies, including major pharmaceutical companies, are developing and
marketing advanced delivery systems for the controlled delivery of
drugs. Products
66
currently on the market or under development by competitors may deliver
the same drugs, or other drugs to treat the same indications, as many of
the products we market or are developing. The first pharmaceutical
branded or generic/non-branded product to reach the market in a
therapeutic area often obtains and maintains significant market share
relative to later entrants to the market. Our products also compete
with drugs marketed not only in similar delivery systems but also in
traditional dosage forms. New drugs, new therapeutic approaches or
future developments in alternative drug delivery technologies may
provide advantages over the drug delivery systems and products that we
are marketing, have developed or are developing.
Changes in drug delivery technology may require substantial investments
by companies to maintain their competitive position and may provide
opportunities for new competitors to enter the industry. Developments
by others could render our drug delivery products or other technologies
uncompetitive or obsolete. If others develop drugs which are cheaper or
more effective or which are first to market, sales or prices of our
products could decline.
EXTENSIVE INDUSTRY REGULATION HAS HAD, AND WILL CONTINUE TO HAVE, A
SIGNIFICANT IMPACT ON OUR INDUSTRY AND OUR BUSINESS, ESPECIALLY OUR PRODUCT
DEVELOPMENT, MANUFACTURING AND DISTRIBUTION CAPABILITIES.
All pharmaceutical companies, including us, are subject to extensive, complex,
costly and evolving regulation by the federal government, principally the FDA
and, to a lesser extent, the DEA and state government agencies. The Federal
Food, Drug and Cosmetic Act, the Controlled Substances Act and other federal
statutes and regulations govern or influence the testing, manufacturing,
packing, labeling, storing, record keeping, safety, approval, advertising,
promotion, sale and distribution of our products. Failure to comply with
applicable FDA or other regulatory requirements may result in criminal
prosecution, civil penalties, injunctions or holds, recall or seizure of
--------
products and total or partial suspension of production, as well as other
regulatory actions against our products and us.
In addition to compliance with current Good Manufacturing Practice, or cGMP,
requirements, drug manufacturers must register each manufacturing facility
with the FDA. Manufacturers and distributors of prescription drug products are
also required to be registered in the states where they are located and in
certain states that require registration by out-of-state manufacturers and
distributors. Manufacturers also must be registered with the Drug Enforcement
Administration, or DEA, and similar applicable state and local regulatory
authorities if they handle controlled substances, and with the Environmental
Protection Agency, or EPA, and similar state and local regulatory authorities
if they generate toxic or dangerous wastes, and must also comply with other
applicable DEA and EPA requirements. We believe that we are currently in
material compliance with cGMP and are registered with the appropriate state
and federal agencies. Non-compliance with applicable cGMP requirements or
other rules and regulations of these agencies can result in fines, recall or
seizure of products, total or partial suspension of production and/or
distribution, refusal of governmental agencies to grant pre-market approval or
other product applications and criminal prosecution. Despite our ongoing
efforts, cGMP requirements and other regulatory requirements, and related
enforcement priorities and policies may evolve over time and we may not be
able to remain continuously in material compliance with all of these
requirements.
From time to time, governmental agencies have conducted investigations of
pharmaceutical companies relating to the distribution and sale of drug
products to government purchasers or subject to government or third party
reimbursement. We believe that we have marketed our products in compliance
with applicable laws and regulations. However, standards sought to be applied
in the course of governmental investigations can be complex and may not be
consistent with standards previously applied to our industry generally or
previously understood by us to be applicable to our activities.
The process for obtaining governmental approval to manufacture and market
pharmaceutical products is rigorous, time-consuming and costly, and we cannot
predict the extent to which we may be affected by legislative and regulatory
developments. We are dependent on receiving FDA and other governmental or
third-party approvals prior to manufacturing, marketing and shipping many of
our products. Consequently, there is always the chance that we will not obtain
FDA or other necessary approvals, or that the rate, timing and cost of such
approvals, will adversely affect our product introduction plans or results of
operations.
RISKS RELATED TO OUR COMMON STOCK
THE MARKET PRICE OF OUR STOCK HAS BEEN AND MAY CONTINUE TO BE VOLATILE.
The market prices of securities of companies engaged in pharmaceutical
development and marketing activities historically have been highly
volatile. In addition, any or all of the following may have a
significant impact on the market price of our common stock: developments
regarding litigation and an investigation regarding our former stock
option granting practices; announcements by us or our competitors of
technological innovations or new commercial products; delays in the
development or approval of products; regulatory withdrawals of our
products from the market; the filing or results of litigation;
developments or disputes concerning patent or other proprietary rights;
publicity regarding actual or potential medical results relating to
products marketed by us or products under development; regulatory
developments in both the United States and foreign countries; publicity
regarding actual or potential acquisitions; public concern as to the
safety of drug technologies or products; financial results which are
different from securities analysts' forecasts; economic and other
external factors; and period-to-period fluctuations in our financial
results.
FUTURE SALES OF COMMON STOCK COULD ADVERSELY AFFECT THE MARKET PRICE OF
OUR CLASS A OR CLASS B COMMON STOCK.
As of March 31, 2006, an aggregate of 3,162,307 shares of our Class A
Common Stock and 356,849 shares of our Class B Common Stock were
issuable upon exercise of outstanding stock options under our stock
option plans, and an additional 611,494 shares of our Class A Common
Stock and 1,230,000 shares of Class B Common Stock were reserved for the
issuance of additional options and shares under these plans. In
addition, as of March 31, 2006, 8,691,880 shares of Class A Common Stock
were reserved for issuance upon conversion of $200.0 million principal
amount of convertible notes, and 337,500 shares of our Class A Common
Stock were reserved for issuance upon conversion of our outstanding 7%
Cumulative Convertible Preferred Stock.
Future sales of our common stock and instruments convertible or
exchangeable into our common stock and transactions involving equity
derivatives relating to our common stock, or the perception that such
sales or transactions could occur, could adversely affect the market
price of our common stock. This could, in turn, have an adverse effect
on the trading price of the Notes resulting from, among other things, a
delay in the ability of holders to convert their Notes into our Class A
Common Stock.
MANAGEMENT SHAREHOLDERS CONTROL OUR COMPANY.
At March 31, 2006, our directors and executive officers beneficially own
approximately 13% of our Class A Common Stock and approximately 62% of
our Class B Common Stock. As a result, these persons control
approximately 55% of the combined voting power represented by our
outstanding securities. These persons will retain effective voting
control of our Company and are expected to continue to have the ability
to effectively determine the outcome of any matter being voted on by our
shareholders, including the election of directors and any merger, sale
of assets or other change in control of our Company.
Future sales of our common stock and instruments convertible or
exchangeable into our common stock and transactions involving equity
derivatives relating to our common stock, or the perception that such
sales or transactions could occur, could adversely affect the market
price of our common stock. This could, in turn, have an adverse effect
on the trading price of the Notes resulting from, among other things, a
delay in the ability of holders to convert their Notes into our Class A
Common Stock.
67
OUR CHARTER PROVISIONS AND DELAWARE LAW MAY HAVE ANTI-TAKEOVER EFFECTS.
Our Amended Certificate of Incorporation authorizes the issuance of
common stock in two classes, Class A Common Stock and Class B Common
Stock. Each share of Class A Common Stock entitles the holder to one-
twentieth of one vote on all matters to be voted upon by shareholders,
while each share of Class B Common Stock entitles the holder to one full
vote on each matter considered by the shareholders. In addition, our
directors have the authority to issue additional shares of preferred
stock and to determine the price, rights, preferences, privileges and
restrictions of those shares without any further vote or action by the
shareholders. The rights of the holders of common stock will be subject
to, and may be adversely affected by, the rights of the holders of any
preferred stock that may be issued in the future. The existence of two
classes of common stock with different voting rights and the ability of
our directors to issue additional shares of preferred stock could make
it more difficult for a third party to acquire a majority of our voting
stock. Other provisions of our Amended Certificate of Incorporation and
Bylaws, such as a classified board of directors, also may have the
effect of discouraging, delaying or preventing a merger, tender offer or
proxy contest, which could have an adverse effect on the market price of
our Class A Common Stock.
In addition, certain provisions of Delaware law applicable to our
Company could also delay or make more difficult a merger, tender offer
or proxy contest involving our Company, including Section 203 of the
Delaware General Corporation Law, which prohibits a Delaware corporation
from engaging in any business combination with any "interested
shareholder" (as defined in the statute) for a period of three years
unless certain conditions are met. In addition, our senior management is
entitled to certain payments upon a change in control and all of our
stock option plans provide for the acceleration of vesting in the event
of a change in control of our Company.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.
PURCHASE OF EQUITY SECURITIES BY THE COMPANY
The following table provides information about purchases the Company
made of its common stock during the quarter ended December 31, 2006:
TOTAL NUMBER OF
SHARES PURCHASED MAXIMUM NUMBER
TOTAL NUMBER AS PART OF A OF SHARES THAT MAY
OF SHARES AVERAGE PRICE PUBLICLY ANNOUNCED YET BE PURCHASED
PERIOD PURCHASED PAID PER SHARE PROGRAM UNDER THE PROGRAM
October 1-31, 2006 8,231 $ 18.17 -- --
November 1-30, 2006 -- -- -- --
December 1-31, 2006 3,734 $ 23.79 -- --
------
Total 11,965 $ 19.92 -- --
======
Shares were purchased from employees upon their termination pursuant to
the terms of the Company's stock option plan or were purchased from
certain individuals who sold existing shares to the Company as a means
to exercise stock options.
ITEM 6. EXHIBITS
Exhibits. See Exhibit Index.
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SIGNATURES
----------
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.
K-V PHARMACEUTICAL COMPANY
Date: March 25, 2008 By /s/ Marc S. Hermelin
------------- ------------------------------
Marc S. Hermelin
Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)
Date: March 25, 2008 By /s/ Ronald J. Kanterman
------------- ------------------------------
Ronald J. Kanterman
Vice President and Chief
Financial Officer
(Principal Financial Officer)
Date: March 25, 2008 By /s/ Richard H. Chibnall
------------- ------------------------------
Richard H. Chibnall
Vice President, Finance
(Principal Accounting Officer)
69
EXHIBIT INDEX
Exhibit No. Description
- ----------- -----------
31.1 Certification of Chief Executive Officer.
31.2 Certification of Chief Financial Officer.
32.1 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
32.2 Certification pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
70