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 JUNE 30, 2007
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
- --------------------------------------------------------------------------------
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, a non-accelerated filer, or a smaller reporting company
(see the definitions of "large accelerated filer," "accelerated filer" and
"smaller reporting company" in Rule 12b-2 of the Exchange Act).
Large accelerated filer [ X ] Accelerated filer [ ]
Non-accelerated filer [ ] Smaller reporting company [ ]
Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act). Yes [ ] No [ X ]
As of June 6, 2008, the registrant had outstanding 37,755,099 and 12,256,159
shares of Class A and Class B Common Stock, respectively, exclusive of
treasury shares.
1
PART I. - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited; dollars in thousands)
THREE MONTHS ENDED JUNE 30,
-------------------------------
2007 2006
--------- --------
Net revenues............................................ $ 114,358 $ 96,200
Cost of sales........................................... 39,570 33,462
--------- --------
Gross profit............................................ 74,788 62,738
--------- --------
Operating expenses:
Research and development............................ 9,796 7,890
Purchased in-process research and
development..................................... 10,000 --
Selling and administrative.......................... 45,175 40,138
Amortization of intangibles......................... 1,185 1,197
--------- --------
Total operating expenses................................ 66,156 49,225
--------- --------
Operating income........................................ 8,632 13,513
--------- --------
Other expense (income):
Interest expense.................................... 2,130 2,236
Interest and other income........................... (3,415) (2,058)
--------- --------
Total other expense (income), net....................... (1,285) 178
--------- --------
Income before income taxes and cumulative
effect of change in accounting principle............ 9,917 13,335
Provision for income taxes.............................. 3,717 5,213
--------- --------
Income before cumulative effect of
change in accounting principle...................... 6,200 8,122
Cumulative effect of change in accounting
principle (net of $670 in taxes).................... -- 1,976
--------- --------
Net income.............................................. $ 6,200 $ 10,098
========= ========
(CONTINUED)
2
K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME - (CONTINUED)
(Unaudited; dollars in thousands)
THREE MONTHS ENDED JUNE 30,
----------------------------
2007 2006
------ ------
Earnings per share before effect of change
in accounting principle:
Basic - Class A common............................... $ 0.13 $ 0.17
Basic - Class B common............................... 0.11 0.14
Diluted - Class A common............................. 0.12 0.15
Diluted - Class B common............................. 0.10 0.13
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............................. - 0.04
Diluted - Class B common............................. - 0.03
Earnings per share:
Basic - Class A common............................... $ 0.13 $ 0.21
Basic - Class B common............................... 0.11 0.18
Diluted - Class A common............................. 0.12 0.19
Diluted - Class B common............................. 0.10 0.16
Shares used in per share calculation:
Basic - Class A common............................... 37,007 36,599
Basic - Class B common............................... 12,280 12,474
Diluted - Class A common............................. 59,092 58,849
Diluted - Class B common............................. 12,362 12,622
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3
K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited; dollars in thousands)
JUNE 30, MARCH 31,
2007 2007
---- ----
ASSETS
------
CURRENT ASSETS:
Cash and cash equivalents............................................................ $ 80,756 $ 82,574
Marketable securities................................................................ 160,161 157,812
Receivables, less allowance for doubtful accounts of $687 and $716
at June 30, 2007 and March 31, 2007, respectively................................. 71,022 78,634
Inventories, net..................................................................... 98,523 91,515
Prepaid and other assets............................................................. 5,775 6,571
Income taxes receivable.............................................................. 16,076 --
Deferred tax asset................................................................... 14,128 14,364
----------- -----------
Total Current Assets.............................................................. 446,441 431,470
Property and equipment, less accumulated depreciation of $60,529 and $56,186 at
June 30, 2007 and March 31, 2007, respectively................................... 184,861 186,900
Intangible assets and goodwill, net.................................................. 67,969 69,010
Other assets......................................................................... 21,732 20,403
----------- -----------
TOTAL ASSETS......................................................................... $ 721,003 $ 707,783
=========== ===========
LIABILITIES
-----------
CURRENT LIABILITIES:
Accounts payable..................................................................... $ 19,815 $ 18,506
Accrued liabilities.................................................................. 26,309 33,218
Income taxes payable................................................................. -- 5,558
Current maturities of long-term debt................................................. 201,926 1,897
----------- -----------
Total Current Liabilities......................................................... 248,050 59,179
Long-term debt....................................................................... 38,962 239,451
Other long-term liabilities.......................................................... 22,488 6,319
Deferred tax liability............................................................... 38,603 38,007
----------- -----------
TOTAL LIABILITIES.................................................................... 348,103 342,956
----------- -----------
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 June 30, 2007 and March 31, 2007
(convertible into Class A shares on a 8.4375-to-one basis)........................ -- --
Class A and Class B Common Stock, $.01 par value; 150,000,000 and
75,000,000 shares authorized, respectively;
Class A - issued 40,413,110 and 40,316,426 at June 30, 2007
and March 31, 2007, respectively.............................................. 404 403
Class B - issued 12,340,092 and 12,393,982 at June 30, 2007 and March 31, 2007,
respectively (convertible into Class A shares on a one-for-one basis)......... 123 124
Additional paid-in capital........................................................... 152,820 150,818
Retained earnings.................................................................... 275,612 269,430
Accumulated other comprehensive income............................................... 7 33
Less: Treasury stock, 3,240,399 shares of Class A and 92,902 shares of Class B
Common Stock at June 30, 2007, respectively, and 3,237,023 shares of Class A and
92,902 shares of Class B Common Stock at March 31, 2007, respectively, at cost.... (56,066) (55,981)
----------- -----------
TOTAL SHAREHOLDERS' EQUITY........................................................... 372,900 364,827
----------- -----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........................................... $ 721,003 $ 707,783
=========== ===========
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4
K-V PHARMACEUTICAL COMPANY AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited; dollars in thousands)
THREE MONTHS ENDED
JUNE 30,
------------------------------
2007 2006
------------- -----------
OPERATING ACTIVITIES:
Net income............................................................. $ 6,200 $ 10,098
Adjustments to reconcile net income to net cash provided by
operating activities:
Acquired in-process research and development........................ 10,000 --
Cumulative effect of change in accounting principle................. -- (1,976)
Depreciation, amortization and other non-cash charges............... 5,854 5,368
Deferred income tax provision....................................... 845 2,112
Deferred compensation............................................... 558 188
Stock-based compensation............................................ 1,647 936
Excess tax benefits associated with stock options................... (106) (210)
Changes in operating assets and liabilities:
Decrease in receivables, net........................................ 7,612 5,355
Increase in inventories, net........................................ (7,008) (4,639)
(Increase) decrease in prepaid and other assets..................... (1,003) 197
(Decrease) increase in income taxes payable......................... (6,023) 3,895
Decrease in accounts payable and accrued
liabilities...................................................... (5,717) (3,519)
------------- -----------
Net cash provided by operating activities.............................. 12,859 17,805
------------- -----------
INVESTING ACTIVITIES:
Purchase of property and equipment, net............................. (2,106) (15,200)
Purchase of marketable securities................................... (3,513) (45,496)
Sale of marketable securities....................................... 1,125 100
Product acquisition................................................. (10,000) --
------------- -----------
Net cash used in investing activities.................................. (14,494) (60,596)
------------- -----------
FINANCING ACTIVITIES:
Principal payments on long-term debt................................ (460) (292)
Dividends paid on preferred stock................................... (18) (18)
Purchase of common stock for treasury............................... (85) (31)
Excess tax benefits associated with stock options................... 106 210
Cash deposits received for stock options............................ 274 432
------------- -----------
Net cash provided by (used in) financing activities.................... (183) 301
------------- -----------
Decrease in cash and cash equivalents.................................. (1,818) (42,490)
Cash and cash equivalents:
Beginning of year................................................... 82,574 100,706
------------- -----------
End of period....................................................... $ 80,756 $ 58,216
============= ===========
SUPPLEMENTAL INFORMATION:
Interest paid....................................................... $ 3,122 $ 2,929
Income taxes paid................................................... 8,789 129
Stock options exercised (at expiration of two-year
forfeiture period)............................................... 249 347
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(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, acquisition, manufacture, 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 results of
operations and cash flows for the three-month period ended June 30, 2007 are
not necessarily indicative of the results of operations and cash flows that
may be expected for the fiscal year ended March 31, 2008. The interim
consolidated financial statements and accompanying notes should be read in
conjunction with the consolidated financial statements and footnotes thereto
included in the Company's Annual Report on Form 10-K for the fiscal year ended
March 31, 2007. The balance sheet information as of March 31, 2007 has been
derived from the Company's audited consolidated balance sheet as of that date.
2. ACQUISITION
In May 2007, the Company acquired the U.S. marketing rights to Evamist(TM), a
new 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 $141,500 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 $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.
Because the product had not 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 July 2007,
FDA approval for Evamist(TM) was received and a payment of $141,500 was made
to VIVUS, Inc. The preliminary purchase price allocation, which is subject to
change based on the final fair value assessment, resulted in estimated
identifiable intangible assets of $52,446 to product rights; $15,166 to
trademark rights; $66,417 to rights under a sublicense agreement; and, $7,471
to a covenant not to compete. Upon FDA approval in July 2007, the Company
began amortizing the product rights, trademark rights and rights under the
sublicense agreement over 15 years and the covenant not to compete over nine
years.
3. 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. 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.
6
The Company also presents 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. The Company
presents 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 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 earnings per share:
THREE MONTHS ENDED JUNE 30,
---------------------------------------------------------------
2007 2006
-------------------------- --------------------------
CLASS A CLASS B CLASS A CLASS B
------- ------- ------- -------
Basic earnings per share:
Numerator:
Allocation of undistributed earnings before
cumulative effect of change in accounting
principle $ 4,843 $ 1,339 $ 6,311 $ 1,793
Allocation of cumulative effect of
change in accounting principle - - 1,539 437
------- ------- ------- -------
Allocation of undistributed earnings $ 4,843 $ 1,339 $ 7,850 $ 2,230
======= ======= ======= =======
Denominator:
Weighted average shares outstanding 37,445 12,379 36,944 12,551
Less - weighted average unvested
common shares subject to repurchase (438) (99) (345) (77)
------- ------- ------- -------
Number of shares used in per
share computations 37,007 12,280 36,599 12,474
======= ======= ======= =======
Basic earnings per share before cumulative
effect of change in accounting principle $ 0.13 $ 0.11 $ 0.17 $ 0.14
Per share effect of cumulative effect of
change in accounting principle - - 0.04 0.04
------- ------- ------- -------
Basic earnings per share $ 0.13 $ 0.11 $ 0.21 $ 0.18
======= ======= ======= =======
7
The following table sets forth the computation of diluted earnings per share:
THREE MONTHS ENDED JUNE 30,
----------------------------------------------------------------
2007 2006
--------------------------- --------------------------
CLASS A CLASS B CLASS A CLASS B
------- ------- ------- -------
Diluted earnings per share:
Numerator:
Allocation of undistributed earnings
for basic computation before cumulative
effect of change in accounting principle $ 4,843 $ 1,339 $ 6,311 $ 1,793
Reallocation of undistributed earnings as a
result of conversion of Class B to
Class A shares 1,339 - 1,793 -
Reallocation of undistributed earnings to
Class B shares - (45) - (113)
Add - preferred stock dividends 18 - 18 -
Add - interest expense convertible notes 963 - 939 -
------- ------- ------- -------
Allocation of undistributed earnings
for diluted computation before cumulative
effect of change in accounting principle 7,163 1,294 9,061 1,680
Allocation of cumulative effect of
change in accounting principle - - 1,976 366
------- ------- ------- -------
Allocation of undistributed earnings $ 7,163 $ 1,294 $11,037 $ 2,046
======= ======= ======= =======
Diluted earnings per share:
Denominator:
Number of shares used in basic computation 37,007 12,280 36,599 12,474
Weighted average effect of dilutive securities:
Conversion of Class B to Class A shares 12,280 - 12,474 -
Employee stock options 775 82 746 148
Convertible preferred stock 338 - 338 -
Convertible notes 8,692 - 8,692 -
------- ------- ------- -------
Number of shares used in per share
computations 59,092 12,362 58,849 12,622
======= ======= ======= =======
Diluted earnings per share before cumulative
effect of change in accounting principle $ 0.12 $ 0.10 $ 0.15 $ 0.13
Per share effect of cumulative effect of
change in accounting principle - - 0.04 0.03
------- ------- ------- -------
Diluted earnings per share (1) $ 0.12 $ 0.10 $ 0.19 $ 0.16
======= ======= ======= =======
<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 June 30, 2007 and 2006, excluded from the
computation were options to purchase 52 and 928 shares of Class A and
Class B Common Stock, respectively.
8
4. STOCK-BASED COMPENSATION
On August 30, 2002, the Company's shareholders approved KV's 2001 Incentive
Stock Option Plan (the "2001 Plan"), 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) 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. The shares issuable upon exercise of these
options are accounted for as issued 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 were not expected to vest as of the
adoption date. The cumulative adjustment increased net income by $1,976, net
of tax, and increased diluted earnings per share for Class A and Class B
shares by $0.04 and $0.03, respectively.
The Company recognized, in accordance with SFAS 123R, stock-based compensation
of $1,647 and $936, respectively, and related tax benefits of $484 and $276,
respectively, for the three months ended June 30, 2007 and 2006. There was no
stock-based employee compensation cost capitalized as of June 30, 2007. Cash
received from stock option deposits was $274 and $432 for the three months
ended June 30, 2007 and 2006, respectively. The actual
9
tax benefit realized from tax deductions associated with stock option
exercises (at expiration of the two-year forfeiture period) was $123 and $278
for the three months ended June 30, 2007 and 2006, respectively.
The following weighted average assumptions were used for stock options granted
during the three months ended June 30, 2007 and 2006:
THREE MONTHS ENDED
JUNE 30,
------------------------
2007 2006
---- ----
Dividend yield........................................... None None
Expected volatility...................................... 43% 46%
Risk-free interest rate.................................. 4.93% 4.93%
Expected term ........................................... 9.0 years 9.0 years
Weighted average fair value per share
at grant date.......................................... $ 15.39 $ 11.34
A summary of the changes in the Company's stock option plans during the three
months ended June 30, 2007 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, 2007.................... 3,666 $ 16.11
Options granted............................ 345 26.21
Options exercised.......................... (21) 7.67 $ 410
Options canceled........................... (241) 19.48
---------
Balance, June 30, 2007..................... 3,749 16.87 5.6 $ 37,624
=========
Expected to vest at
June 30, 2007......................... 2,906 $ 16.87 5.6 $ 29,159
Options exercisable at June 30, 2007
(excluding shares in the two-year
forfeiture period)..................... 1,182 $ 15.18 5.2 $ 13,832
As of June 30, 2007, the Company had $38,786 of total unrecognized
compensation expense, related to stock option grants, which will be recognized
over the remaining weighted average period of 4.9 years.
5. 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 and actual customer inventory levels, customer rebate
arrangements, and current contract sales terms with wholesale and indirect
customers.
10
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.
Accruals for sales provisions are presented in the consolidated financial
statements as reductions to net revenues and accounts receivable. Sales
provisions totaled $40,919 and $35,970 for the three months ended June 30,
2007 and 2006, respectively. The reserve balances related to the sales
provisions totaled $29,840 and $31,281 at June 30, 2007 and March 31, 2007,
respectively, and are deducted from "Receivables, less allowance for doubtful
accounts" in the accompanying Consolidated Balance Sheets.
6. INVENTORIES
Inventories consist of the following:
JUNE 30, 2007 MARCH 31, 2007
------------- --------------
Finished goods..................... $ 36,561 $ 35,420
Work-in-process.................... 13,299 13,294
Raw materials...................... 48,663 42,801
----------- ----------
$ 98,523 $ 91,515
=========== ==========
Management establishes reserves for potentially obsolete or slow-moving
inventory based on an evaluation of inventory levels, forecasted demand, and
market conditions.
7. INTANGIBLE ASSETS AND GOODWILL
Intangible assets and goodwill consist of the following:
JUNE 30, 2007 MARCH 31, 2007
---------------------------- -----------------------------
GROSS GROSS
CARRYING ACCUMULATED CARRYING ACCUMULATED
AMOUNT AMORTIZATION AMOUNT AMORTIZATION
------ ------------ ------ ------------
Product rights - Micro-K(R).................. $ 36,140 $ (14,964) $ 36,140 $ (14,513)
Product rights - PreCare(R).................. 8,433 (3,338) 8,433 (3,233)
Trademarks acquired:
Niferex(R).............................. 14,834 (3,152) 14,834 (2,967)
Chromagen(R)/StrongStart(R)............... 27,642 (5,874) 27,642 (5,528)
License agreements......................... 4,400 (525) 4,400 (480)
Covenant not to compete.................... 375 (81) 375 (72)
Trademarks and patents..................... 4,339 (817) 4,196 (774)
---------- --------- ----------- ---------
Total intangible assets.................. 96,163 (28,751) 96,020 (27,567)
Goodwill................................... 557 - 557 -
---------- --------- ----------- ---------
$ 96,720 $ (28,751) $ 96,577 $ (27,567)
========== ========= =========== =========
As of June 30, 2007, the Company's intangible assets have a weighted average
useful life of approximately 19 years. Amortization expense for intangible
assets was $1,185 and $1,197 for the three months ended June 30, 2007 and
2006, 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 $3,576 for the remainder of fiscal 2008 and
approximately $4,768 in each of the four succeeding fiscal years.
11
8. REVOLVING CREDIT AGREEMENT
The Company has a credit agreement with ten banks that provides for a
revolving line of credit for borrowing up to $320,000. This credit facility
also includes a provision for increasing the revolving commitment, at the
lenders' sole discretion, by up to an additional $50,000. The credit agreement
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 credit 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 credit facility has a five-year term
expiring in June 2011. The 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. As of June 30, 2007,
there were no borrowings outstanding under the credit facility.
9. LONG-TERM DEBT
Long-term debt consists of the following:
JUNE 30, 2007 MARCH 31, 2007
------------- --------------
Building mortgages.......................... $ 40,888 $ 41,348
Convertible notes........................... 200,000 200,000
----------- ----------
240,888 241,348
Less current portion........................ (201,926) (1,897)
----------- ----------
$ 38,962 $ 239,451
=========== ==========
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 the loan was
used for working capital and general corporate purposes. This 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, 2007, 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
Company has classified the Notes as a current liability as of June 30, 2007
due to the right the holders have to require the Company to repurchase the
Notes on May 16, 2008. Since the holders did not elect to cause the Company to
repurchase any of the Notes, the Notes will be reclassified as long-term
beginning with the Company's consolidated balance sheet as of June 30, 2008.
The Notes are subordinate to all of the Company's existing and future
senior obligations.
12
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:
o 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;
o if the Company has called the Notes for redemption;
o during the five trading day period immediately following any
nine consecutive trading day 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
o 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.
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 June 30, 2007, 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.
10. 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 June 30, 2007.
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.
11. 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 was $6,174 and $10,066
for the three months ended June 30, 2007 and 2006, respectively.
13
12. SEGMENT REPORTING
The reportable operating segments of the Company are branded products,
specialty generic/non-branded and specialty materials. The branded products
segment includes patent-protected products and certain trademarked off-patent
products that the Company sells and markets as brand 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/non-branded 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.
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 property and equipment, intangible and
other assets and all income tax related assets.
The following represents information for the Company's reportable operating
segments for the three months ended June 30, 2007 and 2006.
THREE MONTHS
ENDED BRANDED SPECIALTY SPECIALTY ALL
JUNE 30, PRODUCTS GENERICS MATERIALS OTHER ELIMINATIONS CONSOLIDATED
-------- -------- -------- --------- ----- ------------ ------------
Net revenues 2007 $ 50,053 $ 60,501 $ 3,614 $ 190 $ - $ 114,358
2006 42,313 48,401 4,882 604 - 96,200
Segment profit (loss) 2007 22,177 30,800 661 (43,721) - 9,917
2006 18,002 23,863 1,046 (29,576) - 13,335
Identifiable assets 2007 32,239 78,417 7,980 603,525 (1,158) 721,003
2006 20,102 60,784 7,629 542,962 (1,158) 630,319
Property and 2007 - - 47 2,059 - 2,106
equipment additions 2006 93 - - 15,107 - 15,200
Depreciation and 2007 177 80 44 5,553 - 5,854
amortization 2006 177 84 41 5,066 - 5,368
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.
13. CONTINGENCIES - LITIGATION
The Company and its subsidiaries Drugtech Corporation and Ther-Rx Corporation
were named as defendants in a declaratory judgment case filed in the U.S.
District Court for the District of Delaware by Lannett Company, Inc.
("Lannett") on June 6, 2008 and styled Lannett Company Inc. v. KV
Pharmaceuticals et. al. Lannett has subsequently amended its complaint. The
action seeks a declaratory judgment of patent invalidity, patent
non-infringement, and patent unenforceability for inequitable conduct with
respect to five patents owned by, and two patents licensed to, the Company or
its subsidiaries and pertaining to the PrimaCare ONE(R) product marketed by
Ther-Rx Corporation; unfair competition; deceptive trade practices; and
antitrust violations. No specific amount of damages was stated in the
complaint or amended complaint. We have not yet been served with either the
complaint or the amended complaint. However, on June 17 2008, the Company
filed a counterclaim against Lannett in that action asserting patent
14
infringement; federal and common law trademark infringement, false
advertising, and unfair competition; federal false designation of origin,
false description and false representation; and common law misappropriation.
The Company has requested a temporary restraining order and preliminary
injunction against Lannett's continued sale of its product and continued
infringement of the Company's trademarks and patents, unfair competition or
misappropriation, and to require Lannett to recall all of its shipped product.
A briefing schedule has been set by the court on the Company's motion and a
hearing has been scheduled before the court on the Company's motion on June
25, 2008. No discovery has yet commenced nor a trial date been set.
The Company is named as a defendant in a patent infringement case filed in the
U.S. District Court for the District of Delaware by UCB, Inc. and Celltech
Manufacturing CA, Inc. (collectively, "UCB") on April 21, 2008 and styled UCB,
Inc. et al. v. KV Pharmaceutical Company. After the Company filed an ANDA with
the FDA seeking permission to market a generic version of the 40 mg, 50 mg and
60 mg strengths of Metadate CD(R) methylphenidate hydrochloride
extended-release capsules, UCB filed this lawsuit under a patent owned by
Celltech. In a Paragraph IV certification accompanying the ANDA, KV contended
that its proposed 40mg generic formulation would not infringe Celltech's
patent. Because the patent was not listed in the Orange Book for the 50mg and
60mg dosages, a Paragraph I certification was filed with respect to them.
Pursuant to the Hatch-Waxman Act, the filing of the suit against the Company
instituted an automatic stay of FDA approval of the Company's ANDA with
respect to the 40 mg strength of this product until the earlier of a judgment
in the Company's favor, or 30 months from the date of suit. Inasmuch as the
Celltech patent was not listed in the Orange Book with respect to the 50 mg
and 60 mg strengths, it is the Company's belief that the automatic stay does
not apply to the Company's 50 mg and 60 mg strengths of this product. UCB may,
however, seek to keep these strengths tied up in the litigation. The Company
has filed an answer, asserted certain affirmative defenses (including that
Plaintiffs are estopped to assert infringement of the 50 mg and 60 mg dosages
due to their not listing the Celltech patent in the Orange Book for these
dosages), and has asserted a counterclaim in which it seeks a declaratory
judgment of invalidity and non-infringement of the claims in the Celltech
patent, and an award of attorneys fees and costs. The case has recently
commenced 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 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 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 this lawsuit 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. Discovery is on-going, but no trial date has yet been
set. Following the Company's filing of an ANDA pertaining to a generic version
of the 24 mg strength of Razadyne(R) ER (formerly Reminyl(R)) galantamine
hydrobromide extended-release capsules and the Company's giving of notice of
this filing to Janssen, Janssen has filed in June 2008 a second complaint in
the same federal court, naming the Company as a defendant in a related patent
infringement case under the same Janssen patent with respect to such 24 mg
generic version. The time to answer the new complaint has not yet run. The
Company anticipates that both cases will be coordinated before the court. 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
15
inequitable conduct in obtaining the patents. The case is just commencing and
no trial date has yet been set. Celgene has moved to disqualify the Company's
counsel in the case, asserting a conflict of interest despite its signing of
an advance waiver with such counsel, and this motion is pending before the
court. Should this motion be granted, the Company will need to retain new
counsel. The Company does not believe that this would materially delay the
progress of the lawsuit. The Company has filed a motion for sanctions against
plaintiffs pursuant to Rule 11 of the Federal Rules of Civil Procedure for
bringing an action without proper basis and is seeking an order dismissing the
patent infringement complaint filed by plaintiffs, and awarding the Company
its costs and attorneys' fees. Celgene has asked the court to dismiss the
Company's Rule 11 motion, and the matter is pending before the court. 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 Purdue's patents are invalid, unenforceable, or will not be
infringed by KV's proposed generic versions. 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
similar lawsuits pending against additional unrelated companies in federal
court in New York.
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. The
Company, among others, has asked the court to lift the stay so that the
remainder of the case may resume but the stay has not yet been lifted.
Discovery in the suit has not yet commenced but is expected to commence
shortly after the stay is lifted on the case. 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 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. The product involved
in this lawsuit is currently subject to a hold on the Company's inventory of
certain unapproved products notified to the Company in March 2008 by
representatives of the Missouri Department of Health and Senior Services and
the FDA. In the event that such hold is lifted, ETHEX intends to resume
marketing the
16
product during the stay in the lawsuit with CIMA. The Company intends to
vigorously defend its interests when or if the stay is lifted; however, it
cannot give any assurance it will prevail or that the stay will be lifted.
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. Plaintiffs
have recently filed a motion to amend their complaint to seek declaratory
judgments that Axcan does not have "unclean hands" nor violated any antitrust
or unfair competition laws. This motion is pending before the court. 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.
The Company was named as a defendant in a case filed in U.S. District Court in
Missouri by AstraZeneca AB, Aktiebolaget Hassle and AstraZeneca LP
(collectively, "AstraZeneca") and styled AstraZeneca AB et. al. v. KV
Pharmaceutical Company. After the Company 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 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 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
continued to proceed 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. In May 2008, the
Company entered into a settlement agreement with AstraZeneca and settled its
remaining counterclaims against AstraZeneca in exchange for a payment of
$2,700.
17
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
pharmaceutical products valued at $150, both of which are to be paid or
delivered 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 court 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 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, as well as a
motion to dismiss the lawsuit based on expiration of the statute of
limitations. This motion is pending before the court, with a hearing scheduled
by the court on July 7, 2008. A trial date has been set for November 2008. 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
18
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 moved to terminate the
litigation based on a determination by members of a Special Committee of the
Board of Directors that continuation of the litigation was not in the best
interest of KV and its shareholders. All individual officer and director
defendants joined in that motion. Plaintiffs filed a motion for rule to show
cause why the defendants' motion to terminate the lawsuit should not be
stricken and dismissed. On February 15, 2008, the court stayed proceedings in
the case until April 9, 2008, to permit mediation pursuant to the parties'
stipulation. Mediation occurred on April 2, 2008. On May 23, 2008, all
remaining parties to the litigation filed a proposed settlement with the court
which, if approved by the court, would resolve all claims asserted in the
Action. The proposed settlement provides for a payment of fees and expenses to
plaintiffs' counsel not to exceed $1,650, which amount is expected to be
covered by insurance. The proposed settlement received preliminary approval by
the court on June 3, 2008. Notice of the terms of the settlement has been
mailed to all shareholders of record as of May 23, 2008 and a final fairness
hearing has been scheduled by the court to be conducted on August 26, 2008.
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. In December 2007, the SEC
staff, pursuant to a formal order of investigation, issued subpoenas for
additional documents and testimony by certain employees. The production of
additional documents called for by the subpoena and the testimony of the
employees was completed in May 2008.
The Company has received a subpoena from the Office of Inspector General of
the Department of Health and Human Services, seeking documents with respect to
two of ETHEX's nitroglycerin products. Both are unapproved products, that is,
they have not received FDA approval. (FDA approval is not necessarily required
for all drugs to be sold in the marketplace, such as pre-1938 "grandfathered"
products or certain drugs reviewed under the so-called DESI process. The
Company believes that its two products come within these exceptions.) The
subpoena states that it is in connection with an investigation into potential
false claims under Title 42 of the U.S. Code, and appears to pertain to
whether these products are eligible for reimbursement under federal health
care programs, such as Medicaid and VA programs.
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 the
ultimate outcome of such other proceedings will not have a material adverse
effect on its results of operations or financial condition.
19
There are uncertainties and risks associated with all litigation and there can
be no assurance the Company will prevail in any particular litigation.
14. INCOME TAXES
The Company adopted FASB Interpretation 48, "Accounting for Uncertainty in
Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48")
effective April 1, 2007. FIN 48 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 50% 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. The Company's adoption of FIN 48 was
not material to its consolidated financial position; however, certain
reclassifications of various income tax-related balance sheet amounts were
required.
As of April 1, 2007, after the implementation of FIN 48, the Company's
liability for unrecognized tax benefits was $12,980, excluding liabilities for
interest and penalties. If the Company were to recognize these benefits, the
effective tax rate would be favorably impacted by $12,980. In addition, at
April 1, 2007, liabilities for accrued interest and penalties relating to the
unrecognized tax benefits totaled $1,950. As of June 30, 2007, the
consolidated balance sheet reflects a liability for unrecognized tax benefits
of $13,317, excluding liabilities for interest and penalties. Accrued interest
and penalties included in the consolidated balance sheet were $2,295 as of
June 30, 2007.
The Company recognizes interest and penalties associated with uncertain tax
positions as a component of income tax expense in the consolidated statement
of income.
It is anticipated the Company will recognize approximately $2,600 of
unrecognized tax benefits within the next 12 months as a result of the
expected expiration of the relevant statute of limitations.
The Company is subject to taxation in the U.S. and various states and is
subject to examination by those authorities. The Company's federal statute of
limitations has expired for fiscal years prior to 2004 and the relevant state
statutes vary. The Company currently is being audited by the IRS for its March
31, 2006 and 2007 tax years. The IRS is also currently auditing the employment
tax returns of the Company for calendar years 2004, 2005, 2006 and 2007.
Various information requests with respect to the periods under audit have been
received and responded to. The Company expects the IRS to issue additional
information requests. The Company does not have any state examinations in
progress at this time.
An income tax benefit has resulted from the determination that certain
non-qualified stock options for which stock-based compensation expense was
recorded will create an income tax deduction. This 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 asset is recorded to paid-in capital in the
period in which the taxable event or forfeiture occurs.
The Company determined that certain options previously classified as Incentive
Stock Option ("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, which creates a
taxable event. The Company and the affected employees may also be subject to
interest and penalties for failing to properly withhold taxes and report the
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 IRS in an effort to reach agreement on
the resulting tax liability. The Company
20
recorded liabilities related to this matter of $6,684 as of June 30, 2007, in
accrued liabilities on the consolidated balance sheet.
Management regularly reevaluates the Company's tax positions taken on filed
tax returns using information about recent 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 law and 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 the Company's estimates are not representative of actual outcomes,
recorded tax liabilities could be materially impacted.
15. RECENTLY ISSUED ACCOUNTING STANDARDS
In September 2006, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 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
disclosure 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 February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for
Financial Assets and Financial Liabilities" ("SFAS 159"), which permits
companies to choose to measure many financial instruments and certain other
items at fair value. The objective is to improve financial reporting by
providing companies with the opportunity to mitigate volatility in reported
earnings caused by measuring related assets and liabilities differently
without having to apply complex hedge accounting provisions. SFAS 159 is
effective for fiscal years beginning after November 15, 2007. Companies are
not allowed to adopt SFAS 159 on a retrospective basis unless they choose
early adoption. The Company plans to adopt SFAS 159 at the beginning of fiscal
2009 and is evaluating the impact, if any, the adoption of SFAS 159 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 ("EITF") 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 for fiscal years beginning after 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 plans to adopt Issue 07-3 at the beginning of fiscal 2009 and is
evaluating the impact of the adoption of this issue on its financial condition
and results of operations.
21
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 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, 2008, 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
2010 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 No. 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 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 business combinations for which the acquisition date is on or
after the beginning of the first annual reporting period beginning on or after
December 15, 2008 and early adoption is prohibited. 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 No. 160, "Non-controlling Interests in
Consolidated Financial Statements" ("SFAS 160") an amendment of ARB No. 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.
In May 2008, the FASB issued FASB Staff Position No. APB 14-a, "Accounting for
Convertible Debt Instruments That May Be Settled in Cash Upon Conversion
(Including Partial Cash Settlement)." Under the new rules for convertible debt
instruments that may be settled entirely or partially in cash upon conversion,
an entity should separately account for the liability and equity components of
the instrument in a manner that reflects the issuer's economic interest cost.
The effect of the proposed new rules for the debentures is that the equity
component would be included in the paid-in-capital section of shareholders'
equity on an entity's consolidated balance sheet and the value of the equity
component would be treated as original issue discount for purposes of
accounting for the debt component of convertible debt. The FSP will be
effective for fiscal years beginning after December 15, 2008, and for interim
periods within those fiscal years, with retrospective application required.
Early adoption is not permitted. The Company is currently evaluating the
proposed new rules and the impact on its financial condition and results of
operations.
22
16. SUBSEQUENT EVENTS
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). The NDA for Gestiva(TM) is currently before the FDA, pending
approval for use 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 $82,000 for Gestiva(TM), $7,500 of which was paid at
closing and recorded as in-process research and development. The remainder is
payable on the completion of two milestones: (1) $2,000 on the earlier to
occur of CYTYC's receipt of acknowledgement from the FDA that their response
to the FDA's October 20, 2006 "approvable" letter is sufficient for the FDA to
proceed with their review of the NDA or the receipt of FDA's approval of the
Gestiva(TM) NDA and (2) $72,500 on FDA approval of a Gestiva(TM) NDA, transfer
of all rights in the NDA to the Company and receipt by the Company of defined
launch quantities of finished Gestiva(TM) suitable for commercial sale.
In January 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 was recorded as an expense in the
fourth quarter of fiscal year 2008.
At March 31, 2008, the Company had invested $83,900 in the principal amount of
auction rate securities ("ARS"). The Company's investments in ARS represent
interests in securities that have student loans as collateral that are
guaranteed by the U.S. Government. Accordingly, ARS that are backed by student
loans are viewed as having low default risk and very low risk of downgrade.
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. The auctions have historically provided a liquid market for these
securities. The ARS investments held by the Company all had AAA credit ratings
at the time of purchase and at the end of the Company's fiscal 2008 year end.
With the liquidity issues experienced in global credit and capital markets,
the ARS held by the Company at March 31, 2008 experienced failed auctions
beginning in February 2008 as the amount of securities submitted for sale
exceeded the amount of purchase orders. Given the failed auctions, the
Company's ARS will continue to be illiquid until there is a successful auction
for them. The Company cannot predict how long the current imbalance in the
auction rate market will continue. The estimated fair value of the Company's
ARS holdings at March 31, 2008 was $81,516, which reflected a $2,384
difference from the principal amount of $83,900. The estimated fair value of
the ARS was based on a discounted cash flow model that considered, among other
factors, the time to work out the market disruption in the traditional trading
mechanism, the stream of cash flows (coupons) earned until maturity, the
prevailing risk free yield curve, credit spreads applicable to a portfolio of
student loans with various tenures and ratings and an illiquidity premium.
These factors were used in a Monte Carlo simulation based methodology to
derive the estimated fair value of the ARS. Although the ARS continue to pay
interest according to their stated terms, the Company recorded during the
fourth quarter of fiscal 2008 an unrealized loss of $1,550, net of tax, as a
reduction to shareholders' equity in accumulated other comprehensive loss,
reflecting adjustments to the ARS holdings that the Company has concluded have
a temporary decline in value.
ARS have historically been classified as short-term marketable securities in
the Company's consolidated balance sheet. Given the failed auctions, the
Company has reclassified the $81,516 million of ARS as of March 31, 2008 from
current assets to non-current assets. The Company believes that as of March
31, 2008, based on its current cash, cash equivalents and marketable
securities balances of $126,893 and its current borrowing capacity under its
credit facility of $290,000, 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 its external growth plans, although the Company cannot
assure you that this will continue to be the case.
In March 2008, representatives of the Missouri Department of Health and Senior
Services, accompanied by representatives of the FDA, notified the Company of a
hold on its inventory of certain unapproved drug products, restricting the
Company's ability to remove or dispose of those inventories without
permission.
The hold relates to a misinterpretation about the intended scope of recent FDA
notices setting limits on the marketing of unapproved guaifenesin products. In
response to notices issued by the FDA in 2002 and 2003 with respect to
single-
23
entity timed-release guaifenesin products, and a further notice issued in 2007
with respect to combination timed-released guaifenesin products, the Company
timely discontinued a number of its guaifenesin products and believed that, by
doing so, had complied with those notices. The recent action to place a hold
on certain of the Company's products indicates that additional guaifenesin
products should also have been discontinued. In addition, the FDA expanded the
hold to include other products that did not contain guaifenesin but were being
marketed by the Company without FDA approval under certain "grandfather
clauses" and statutory and regulatory exceptions to the pre-market approval
requirement for "new drugs" under the FDCA. FDA policies permit the agency to
initiate broad action against the marketing of additional categories of the
Company's unapproved products, if the FDA deems approval necessary, even if
the agency has not instituted similar actions against the marketing of such
products by other parties. Pursuant to discussions with the Missouri
Department of Health and Senior Services and with the FDA, the affected
Morphine and Oxycodone products have been released from the hold. The Company
will discontinue manufacturing and marketing substantially all unapproved
products subject to the hold.
The FDA has not proposed, nor does the Company expect them to propose, that
the products subject to the hold be recalled from the distribution channel. As
such, the Company has written-off the value of the products subject to the
hold in its inventory as of March 31, 2008. The Company also evaluated the
active pharmaceutical ingredients and excipients used in the manufacture of
the hold products and determined that they should also be written-off since
the Company will be discontinuing further manufacturing and many of them
cannot be returned or sold to other manufacturers. The write-off included in
the results of operations for the fourth quarter of fiscal 2008 totaled
$5,500.
During most of fiscal 2008, the Company marketed approximately 30 products in
its generic/non-branded respiratory line, which consisted primarily of
cough/cold products. The cough/cold line accounted for $38,536, or 10.5%, of
its specialty generic net revenues in fiscal 2008. As a result of the FDA hold
discussed above, the Company is currently marketing one generic cough/cold
product with four strengths that has been approved by the FDA. Since its
launch in December 2007, this approved product generated sales of $884 during
fiscal 2008.
24
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, 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," "expects," "aims," "believes," "projects," "anticipates," "commits,"
"intends," "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 strategy for growth,
product development, product launches, regulatory approvals, market position,
market share increases, 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 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 us 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 operating
results; (10) the difficulty of predicting international regulatory approval,
including 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) actions by the Securities and Exchange
Commission and the Internal Revenue Service with respect to our stock option
grants and accounting practices; (15) the impact of credit market disruptions
on the fair value of auction rate securities that we acquired as
short-term investments and have now become illiquid; (16) whether any recalled
products will have any material financial impact or result in litigation,
agency actions or material damages; and (17) the risks detailed from time to
time in our filings with the Securities and Exchange Commission.
This discussion is by no means exhaustive, but is designed to highlight
important factors that may impact the Company's outlook. We undertake no
obligation to update any of the forward-looking statements after the date of
this report.
25
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND
FINANCIAL CONDITION
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 those
forward-looking statements. These risks, uncertainties and other factors are
discussed above under the caption "Cautionary Statement Regarding
Forward-Looking Information." In addition, the following discussion and
analysis of financial condition and results of operations 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, and the unaudited
interim consolidated financial statements and related notes to unaudited
interim consolidated financial statements included in Part I, Item 1 of this
Quarterly Report on Form 10-Q.
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 broad 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 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
For the three months ended June 30, 2007, we reported net income of $6.2
million compared to net income of $10.1 million in the first quarter of fiscal
2007. The 38.6% decrease in net income was primarily due to in-process
research and development expense of $10.0 million we recorded in connection
with the Evamist(TM) acquisition (see Note 2 to the Notes to Consolidated
Financial Statements). Excluding this amount, net income for the three months
ended June 30, 2007 would have increased $2.4 million, or 23.3%.
Net revenues for the quarter increased $18.2 million, or 18.9%, as we
experienced sales growth of 25.0% in our specialty generics segment and 18.3%
in our branded products segment. The resulting $12.1 million increase in gross
profit was offset in part by a $6.9 million increase in operating expenses
before taking into account the $10.0 million of expense associated with the
acquisition of Evamist(TM). The increase in operating expenses was primarily
due to increases in personnel costs, branded marketing and promotions expense,
legal and professional expenses, and research and development expense.
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NET REVENUES BY SEGMENT
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THREE MONTHS ENDED JUNE 30,
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CHANGE
-------------------
($ IN THOUSANDS): 2007 2006 $ %
------------ ----------- ---------- -------
Branded products $ 50,053 $ 42,313 $ 7,740 18.3%
as % of net revenues 43.8% 44.0%
Specialty generics/non-branded 60,501 48,401 12,100 25.0%
as % of net revenues 52.9% 50.3%
Specialty materials 3,614 4,882 (1,268) (26.0)%
as % of net revenues 3.2% 5.1%
Other 190 604 (414) (68.5)%
------------ ----------- ----------
Total net revenues $ 114,358 $ 96,200 $ 18,158 18.9%
The increase in branded product sales was due primarily to the continued sales
growth of our prescription prenatal product, PrimaCare(R) ONE, and increased
sales of our anti-infective brand, Gynazole-1(R). Sales of PrimaCare(R) ONE
increased $8.8 million, or 88.0%, as its share of the branded prenatal
nutritional supplement market increased to 23.7% at the end of the first
quarter. This sales increase was also heavily impacted by larger-than-normal
customer purchases made during the quarter in anticipation of a June 2007
price increase. Gynazole-1(R) experienced a sales increase of $2.2 million, or
31.7%, during the quarter due primarily to price increases that occurred over
the past 12 months and additional customer purchases made during the quarter
in anticipation of a future price increase. These increases were offset in
part by sales reductions of 10.4% and 7.1% in Clindesse(TM) and the
hematinics, respectively. These sales declines were primarily the result of
larger-than-normal customer purchases made in the fourth quarter of fiscal
2007 as customers responded to upcoming price increases.
The growth in specialty generic sales resulted primarily from increases
experienced by our cardiovascular and cough/cold product lines. The
cardiovascular product line, which comprised 47.0% of specialty generic sales
during the quarter compared to 41.5% for the prior quarter, contributed sales
growth of $8.3 million, or 41.5%. This increase was primarily due to $4.2
million of incremental sales volume from six strengths of Diltiazem HCI ER
Capsules (AB rated to Tiazac(R)) which were introduced after receiving ANDA
approval in September 2006. The remaining increase was primarily attributable
to higher prices. During the quarter, our cough/cold product line registered
sales growth of $3.4 million, or 56.4%, due primarily to sales volume growth
on one existing product, Pseudovent(TM) 400 Capsules. Sales for the pain
management product line were $11.4 million during the quarter compared to
$11.0 million for the three months ended June 30, 2006 as volume increases
associated primarily with Oxycodone hydrochloride tablets were substantially
offset by the impact of pricing pressures on certain products in the pain
management product line. Our cardiovascular product sales for the remainder of
fiscal 2008 are expected to be significantly enhanced by the FDA approval we
received in May 2007 to market the 100 mg and 200 mg strengths of metoprolol
succinate extended-release tablets, the generic version of Toprol-XL(R)
(marketed by AstraZeneca). In fiscal 2006, we received a favorable court
ruling in a Paragraph IV patent infringement action filed against us by
AstraZeneca based on our ANDA submissions to market these generic
formulations. Since we were the first company to file with the FDA for generic
approval of the 100 mg and 200 mg dosage strengths, we were accorded the
opportunity for a 180-day exclusivity period for marketing these two dosage
strengths. We began shipping these two products in July 2007.
27
GROSS PROFIT BY SEGMENT
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THREE MONTHS ENDED JUNE 30,
---------------------------------------------------
CHANGE
-------------------
($ IN THOUSANDS): 2007 2006 $ %
------------ ----------- ---------- -------
Branded products $ 43,937 $ 37,301 $ 6,636 17.8%
as % of net revenues 87.8% 88.2%
Specialty generics/non-branded 33,896 27,376 6,520 23.8%
as % of net revenues 56.0% 56.6%
Specialty materials 1,279 1,998 (719) (36.0)%
as % of net revenues 35.4% 40.9%
Other (4,324) (3,937) (387) (9.8)%
------------ ----------- ---------
Total gross profit $ 74,788 $ 62,738 $ 12,050 19.2%
as % of total net revenues 65.4% 65.2%
The increase in gross profit was principally due to the sales growth
experienced by our branded products and specialty generics segments. The gross
profit percentage on a consolidated basis remained strong at 65.4% due to the
consistency of the gross profit percentages at both our branded products and
specialty generics segments. Impacting the Other category are contract
manufacturing revenues, pricing and production variances, and charges to
inventory reserves associated with production. Any inventory reserve charges
associated with finished goods are reflected in the applicable segment. The
fluctuation in the Other category was primarily due to the timing of contract
manufacturing revenues as the related provision for obsolete inventory was
consistent with the level reflected in the comparative prior year quarter.
RESEARCH AND DEVELOPMENT
- ------------------------
THREE MONTHS ENDED JUNE 30,
---------------------------------------------------
CHANGE
-------------------
($ IN THOUSANDS): 2007 2006 $ %
------------ ----------- ---------- -------
Research and development $ 9,796 $ 7,890 $ 1,906 24.2%
as % of net revenues 8.6% 8.2%
The increase in research and development expense was due to increased spending
on bioequivalency studies as we continued active development of various
branded and generic/non-branded products in our internal and external
pipelines and increased personnel expenses related to the growth of our
research and development staff.
PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT
- ---------------------------------------------
THREE MONTHS ENDED JUNE 30,
---------------------------------------------------
CHANGE
-------------------
($ IN THOUSANDS): 2007 2006 $ %
----------- ----------- ---------- -------
Purchased in-process research and development $ 10,000 $ - $ 10,000 NM
as % of net revenues 8.7% - %
In May 2007, we completed the acquisition of the U.S. marketing rights to
Evamist(TM), a new estrogen replacement therapy product delivered with a
patented metered-dose transdermal spray system, from VIVUS, Inc (see Note 2 to
the
28
Notes to Consolidated Financial Statements). Under terms of the Agreement, the
Company paid $10.0 million in cash at closing and made a cash payment of
$141.5 million in July 2007 when final approval of the product was received
from the FDA. Since the product had not yet obtained FDA approval when the
initial payment was made at closing, we recorded a $10.0 million in-process
research and development charge during the three months ended June 30, 2007.
SELLING AND ADMINISTRATIVE
- --------------------------
THREE MONTHS ENDED JUNE 30,
---------------------------------------------------
CHANGE
-------------------
($ IN THOUSANDS): 2007 2006 $ %
------------ ----------- ---------- -------
Selling and administrative $ 45,175 $ 40,138 $ 5,037 12.6%
as % of net revenues 39.5% 41.7%
The increase in selling and administrative expense was primarily due to
greater personnel costs associated with increases in management, sales and
other personnel, an increase in branded marketing and promotions expense and
increases in legal and professional fees. The increase in legal costs was
primarily due to a $0.8 million reimbursement of legal fees received during
the comparative prior year quarter. The increase in professional fees resulted
principally from costs associated with the Special Committee investigation
into our stock option granting practices.
OPERATING INCOME
- ----------------
THREE MONTHS ENDED JUNE 30,
---------------------------------------------------
CHANGE
-------------------
($ IN THOUSANDS): 2007 2006 $ %
------------ ----------- ---------- -------
Operating income $ 8,632 $ 13,513 $ (4,881) (36.1)%
The decrease in operating income was primarily due to the $10.0 million of
expense we recorded during the quarter in connection with the Evamist(TM)
acquisition. Without taking into account this expense, operating income for
the three months ended June 30, 2007 would have increased $5.1 million, or
37.9%.
INTEREST EXPENSE
- ----------------
THREE MONTHS ENDED JUNE 30,
---------------------------------------------------
CHANGE
-------------------
($ IN THOUSANDS): 2007 2006 $ %
------------ ----------- ---------- -------
Interest expense $ 2,130 $ 2,236 $ (106) (4.7)%
The decrease in interest expense was primarily due to normal amortization on
the $43.0 million mortgage loan we entered into in March 2006 and the reduced
level of interest expense thereon.
29
INTEREST AND OTHER INCOME
- -------------------------
THREE MONTHS ENDED JUNE 30,
---------------------------------------------------
CHANGE
-------------------
($ IN THOUSANDS): 2007 2006 $ %
------------ ----------- ---------- -------
Interest and other income $ 3,415 $ 2,058 $ 1,357 65.9%
The increase in interest and other income was primarily due to an increase in
the average balance of invested cash coupled with a higher weighted average
interest rate earned on short-term investments. The increase in the weighted
average interest rate resulted principally from a restructuring of the
investment portfolio from short-term tax-exempt securities to short-term
taxable securities.
PROVISION FOR INCOME TAXES
- --------------------------
THREE MONTHS ENDED JUNE 30,
---------------------------------------------------
CHANGE
-------------------
($ IN THOUSANDS): 2007 2006 $ %
------------ ----------- ---------- -------
Provision for income taxes $ 3,717 $ 5,213 $ (1,496) (28.7)%
effective tax rate 37.5% 39.1%
The decrease in the provision for income taxes was mainly due to the impact of
the $10.0 million of expense we recorded during the quarter in connection with
the Evamist(TM) acquisition. The effective tax rate for the prior year quarter
was adversely affected by the expiration of Federal research and
experimentation tax credits on December 31, 2005. Additional credits could not
be recognized until passed by Congress and signed into law. The effective tax
rates for all periods were favorably impacted by the domestic manufacturer's
deduction.
NET INCOME AND DILUTED EARNINGS PER SHARE
- -----------------------------------------
THREE MONTHS ENDED JUNE 30,
---------------------------------------------------
CHANGE
-------------------
($ IN THOUSANDS): 2007 2006 $ %
------------ ----------- ---------- -------
Net income $ 6,200 $ 10,098 $ (3,898) (38.6)%
Diluted earnings per Class A share 0.12 0.19 (0.07) (36.8)%
Diluted earnings per Class B share 0.10 0.16 (0.06) (37.5)%
The decrease in net income was primarily due to the $10.0 million of expense
we recorded during the quarter in connection with the Evamist(TM) acquisition.
Excluding the effect of the $10.0 million of expense associated with the
Evamist(TM) acquisition, net income for the quarter would have increased $2.4
million, or 23.3%.
30
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents and working capital were $80.8 million and $198.4
million, respectively, at June 30, 2007, compared to $82.6 million and $372.3
million, respectively, at March 31, 2007. The decrease in working capital
resulted primarily from the $200.0 million of Convertible Subordinated Notes
(the "Notes") that were classified as a current liability as of June 30, 2007
due to the holders having the right to require us to repurchase all or a
portion of their Notes on May 16, 2008. The primary source of operating cash
flow used in the funding of our businesses continues to be internally
generated funds from product sales. For the three months ended June 30, 2007,
our net cash flow from operations of $12.9 million resulted primarily from net
income adjusted for non-cash items.
Net cash flow used in investing activities included capital expenditures of
$2.1 million for the three months ended June 30, 2007 compared to $15.2
million for the corresponding prior year period. The decrease in capital
expenditures was primarily due to the comparative prior year amount including
the cost of a building purchased in June 2006, additional costs associated
with the development of a new lab facility and equipment purchases for
metoprolol production. Other investing activities during the quarter consisted
of $3.5 million in purchases, net of $1.1 million in sales, of short-term
marketable securities that were classified as available for sale and the $10.0
million cash payment we made at closing of the Evamist(TM) acquisition in May
2007 (see Note 2 of Notes to Consolidated Financial Statements).
Our debt balance, including current maturities, was $240.9 million at June 30,
2007 compared to $241.3 million at March 31, 2007. In March 2006, we entered
into a $43.0 million mortgage loan 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 new 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 Notes that are
convertible, under certain circumstances, into shares of our Class A Common
Stock at an initial conversion price of $23.01 per share. The 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 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) to the date of redemption. Holders may
require us 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 100% of the principal amount of the Notes,
plus accrued and unpaid interest (including contingent interest, if any) to
the date of repurchase, payable in cash. As a result, we have classified the
Notes as a current liability as of June 30, 2007 due to the right the holders
have to require us to repurchase the Notes on May 16, 2008. Since the holders
did not elect to cause us to repurchase any of the Notes, the Notes will be
reclassified as long-term beginning with our consolidated balance sheet as of
June 30, 2008. The Notes are subordinate to all of our existing and future
senior obligations.
We have a credit agreement with ten banks that provides for a revolving line
of credit for borrowing up to $320.0 million. The credit agreement also
includes a provision for increasing the revolving commitment, at the lenders'
sole discretion, by up to an additional $50.0 million. This 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
senior debt to EBITDA. The 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 credit facility
has a five-year term expiring in June 2011. As of June 30, 2007, 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 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 quarterly financial statements for this
quarter and the quarters ended September 30, 2007 and December 31, 2007 to
June 30, 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 10 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
31
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 10 years subsequent to the property being placed in
service. Industrial revenue bonds totaling $109.4 million were outstanding at
June 30, 2007. 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.
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 (see Note 16 of the Notes to
Consolidated Financial Statements for a discussion of our investments in
auction rate securities). 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.
GOVERNMENT REGULATION
In March 2008, representatives of the Missouri Department of Health and Senior
Services, accompanied by representatives of the FDA, notified us of a hold on
our inventory of certain unapproved drug products, restricting our ability to
remove or dispose of those inventories without permission.
The hold relates to a misinterpretation about the intended scope of recent FDA
notices setting limits on the marketing of unapproved guaifenesin products. In
response to notices issued by the 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, we
timely discontinued a number of our guaifenesin products and believed that, by
doing so, had complied with those notices. The recent action to place a hold
on certain of our products indicates that additional guaifenesin products
should also have been discontinued. In addition, the FDA expanded the hold to
include other products that did not contain guaifenesin but were being
marketed by us without FDA approval under certain "grandfather clauses" and
statutory and regulatory exceptions to the pre-market approval requirement for
"new drugs" under the FDCA. FDA policies permit the agency to initiate broad
action against the marketing of additional categories of our unapproved
products, if the FDA deems approval necessary, even if the agency has not
instituted similar actions against the marketing of such products by other
parties. Pursuant to discussions with the Missouri Department of Health and
Senior Services and with the FDA, the affected Morphine and Oxycodone products
have been released from the hold. We will discontinue manufacturing and
marketing substantially all unapproved products subject to the hold.
The FDA has not proposed, nor do we expect them to propose, that the products
subject to the hold be recalled from the distribution channel. As such, we
have written-off the value of the products subject to the hold in our
inventory as of March 31, 2008. We also evaluated the active pharmaceutical
ingredients and excipients used in the manufacture of the hold products and
determined that they should also be written-off since we will be discontinuing
further manufacturing and many of them cannot be returned or sold to other
manufacturers. The write-off included in the results of operations for the
fourth quarter of fiscal 2008 totaled $5.5 million.
32
During most of fiscal 2008, we marketed approximately 30 products in our
generic/non-branded respiratory line, which consisted primarily of cough/cold
products. The cough/cold line accounted for $38.5 million, or 10.5%, of our
specialty generic net revenues in fiscal 2008. As a result of the FDA hold
discussed above, we are currently marketing one generic cough/cold product
with four strengths that has been approved by the FDA. Since its launch in
December 2007, this approved product generated sales of $0.9 million during
fiscal 2008.
On June 6, 2008, ETHEX initiated a voluntary recall of a single lot of
morphine sulfate 60 mg extended-release tablets due to a report that a tablet
with as much as double the appropriate thickness was identified and therefore
the possibility that other oversized tablets could have been commercially
released in the affected lot. On June 13, 2008, the recall was expanded to
include additional specific lots of morphine sulfate 60 mg extended-release
tablets and specific lots of morphine sulfate 30 mg extended release tablets.
We accrued a liability of $0.9 million in the fourth quarter of fiscal 2008
for the anticipated cost of the recall. No oversized tablets have been
identified in any additional distributed lot of these products and based on
our investigation, there are likely to be few, if any, oversized tablets in
the recalled lots. In addition, under ordinary pharmacy dispensing procedures,
any significantly oversized tablets would likely be identified at the time of
dispensing. However, the decision to recall the additional lots has been taken
as a responsible precaution because of the possibility that there may be
oversized tablets in the recalled lots.
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 ESTIMATES
Our consolidated financial statements are presented on the basis of U.S.
generally accepted accounting principles. Certain of our accounting policies
are particularly important to the portrayal of our financial condition and
results of operations and require the application of significant judgment by
our management. As a result, 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 are believed 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 REVENUES.
- ------------------------------------------------------------------------------
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 but not limited to, 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 such
incentives are normal and customary in the industry. Sales allowances are
accrued and revenue is recognized as sales are made pursuant to the terms of
the allowances offered to the customer. Due to the nature of these allowances,
we believe 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
33
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 other promotional programs accounted for 11.7% and
14.7% of total gross revenues for the three months ended June 30, 2007 and
2006, 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 62% of our unit sales during the three months ended June 30,
2007, 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
wholesale 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 three months ended June
30, 2007 for each accounts receivable reserve:
CURRENT PROVISION CURRENT PROVISION ACTUAL RETURNS
RELATED TO SALES RELATED TO SALES OR CREDITS
(IN THOUSANDS) BEGINNING MADE IN THE MADE IN IN THE ENDING
BALANCE CURRENT PERIOD PRIOR PERIODS CURRENT PERIOD BALANCE
----------- ------------------ ------------------- ----------------- ------------
THREE MONTHS ENDED JUNE 30, 2007
Accounts Receivable Reserves:
Chargebacks $ 13,005 $ 25,414 $ - $ (25,712) $ 12,707
Sales Rebates 5,386 4,853 - (4,846) 5,393
Sales Returns 2,873 3,911 - (4,189) 2,595
Cash Discounts and Other Allowances 3,511 4,833 - (4,588) 3,756
Medicaid Rebates 6,506 1,908 - (3,025) 5,389
----------- ------------------ ------------------- ----------------- ------------
TOTAL $ 31,281 $ 40,919 $ - $ (42,360) $ 29,840
=========== ================== =================== ================= ============
The decrease in the reserve for chargebacks at June 30, 2007 was primarily due
to a decline in customer inventory levels of our specialty generic products at
the end of the quarter. The decrease in the reserve for Medicaid rebates at
June 30, 2007 resulted primarily from the timing of when certain Medicaid
rebate payments were processed.
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,
- -----------
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 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.
34
Chargeback transactions are almost exclusively related to our specialty
generics business segment. During the three months ended June 30, 2007 and
2006, the chargeback provision reduced the gross sales of our specialty
generics segment by $25.1 million and $23.5 million, respectively. These
amounts accounted for 99.3% and 99.2% of the total chargeback provisions
recorded during the three months ended June 30, 2007 and 2006, 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:
o The amount of inventory in the wholesale distribution channel. We
receive actual inventory information from our three major wholesale
customers and estimate the inventory position of the remaining
wholesalers based on historical buying patterns. During the three
months ended June 30, 2007, unit sales to our three major wholesale
customers accounted for 82% of our total unit sales to all
wholesalers, and the aggregate inventory position of the three major
wholesalers at June 30, 2007 was approximately equivalent to our
last seven weeks of shipments during the fiscal quarter. 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 wholesale customers carry less inventory
than our large wholesale customers. As of June 30, 2007, each week
of inventory for those remaining wholesalers represented
approximately $0.2 million, or 1.4%, of the reported reserve for
chargebacks.
o The percentage of sales to our wholesale 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
wholesale 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 June 30, 2007, the aggregate
weighted average percentage of sales to wholesalers assumed to
result in chargebacks was approximately 96%, with each 1%
representing approximately $0.1 million, or 1.1%, of the reported
reserve for chargebacks.
o 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 wholesale 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 June 30, 2007, a
5% shift in the calculated chargeback per unit in the same direction
across all products and customers would result in a $0.6 million, or
5.0%, 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 wholesale 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.
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
35
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 June 30, 2007 by approximately $0.2
million, or 7.0%, 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 June 30, 2007 by approximately $0.3 million, or
10.1%, 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 driven 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 June 30, 2007 by $0.5 million, or 8.9% of the reported
reserve for Medicaid rebates. Similarly, a 10% change in estimated patient
usage would have changed the reserve at June 30, 2007 by $0.5 million, or 8.9%
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, which range from 10 to 20 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.
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. 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
36
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. 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 was affected by the adoption of FASB
Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an
interpretation of FASB Statement No. 109" on April 1, 2007. See Note 14 of the
Notes to Consolidated Financial Statements.
CONTINGENCIES. We are involved in various legal proceedings, some of 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, such estimates are
considered to be critical accounting estimates. After review, it was
determined at June 30, 2007 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.
37
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.
The majority of our investments in marketable securities are taxable auction
rate securities. The rates on these securities reset at a pre-determined
interval up to 35 days. As of June 30, 2007 and March 31, 2007, we had
invested $121.1 million and $119.2 million, respectively, 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 June 30, 2007 have adversely affected
the market for auction rate securities, which has resulted in a loss of
liquidity for these investments. We have evaluated these securities to
determine if other-than-temporary impairment of the carrying value of the
securities has occurred due to the loss of liquidity. At March 31, 2008, the
fair value of auction rate securities was $81.5 million and the resultant
difference of $2.4 million was recorded in accumulated other comprehensive
loss as the unrealized losses were considered to be temporary (See Note 16 of
the Notes to the Consolidated Financial Statements for further discussion of
our investment in auction rate securities). We believe that as of March 31,
2008, based on our cash, cash equivalents and short-term marketable securities
balances of $126.9 million and our current borrowing capacity of $290.0
million under our credit facility, the current lack of liquidity in the
auction rate market will not have a material impact on our ability to fund our
operations or interfere with our external growth plans, although we cannot
assure you that this will continue to be the case.
The annual favorable impact on our net income as a result of a 25, 50 or 100
basis point (where 100 basis points equals 1%) increase in short-term interest
rates would be approximately $0.6 million, $1.2 million or $2.5 million,
respectively, based on our average cash, cash equivalents and short-term
marketable investment balances during the quarter ended June 30, 2007 compared
to an increase of $0.6 million, $1.1 million or $2.2 million, respectively,
during the fiscal year ended March 31, 2007.
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 June 30, 2007.
In May 2003, we issued $200.0 million of Convertible Subordinated Notes (the
"Notes"). The interest rate on the Notes is fixed at 2.50% and therefore not
subject to interest rate changes. Beginning May 16, 2006, we became 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 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. Holders may require us 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 100% of the
principal amount of the Notes, plus accrued and unpaid interest (including
contingent interest, if any) to the date of repurchase, payable in cash. As a
result, we have classified the Notes as a current liability as of June 30,
2007 due to the right the holders have to require us to repurchase the Notes
on May 16, 2008. Since the holders did not elect to cause us to repurchase any
of the Notes, the Notes will be reclassified as long-term beginning with our
consolidated balance sheet as of June 30, 2008.
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.
38
ITEM 4. CONTROLS AND PROCEDURES
(a) EVALUATION OF DISCLOSURE 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 June 30, 2007 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.
Exchange Act Rule 12b-2 defines a material weakness as a deficiency, or
combination of deficiencies, in internal control over financial reporting,
such that there is a reasonable possibility that a material misstatement of
the company's annual or interim financial statements will not be prevented or
detected on a timely basis.
During the completion of its fiscal 2008 financial statements, the Company
determined that a material weakness in its internal control over financial
reporting existed as of June 30, 2007 related to revenue recognition.
Specifically, the design of the Company's policies and procedures did not
adequately address the financial reporting risk associated with customer
rebate agreements and were inadequate in ensuring that the necessary
information for new or modified rebate agreements was communicated to those
responsible for evaluating the accounting implications of the agreements. This
resulted in a reasonable possibility that a material misstatement of the
Company's annual or interim financial statements will not be prevented or
detected on a timely basis.
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 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:
o Determining measurement dates,
o Determining forfeiture provisions, and
o 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 for the years ended March 31, 2004
through 2006 that should have been recorded in accordance with GAAP, partially
offset by certain expected tax refunds. 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
39
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 identified as of August 2006 and March 31, 2007 described above, we
have filed a comprehensive Form 10-K for the fiscal year ended March 31, 2007
in which we restated our consolidated statements of income, comprehensive
income, shareholders' equity and 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 fiscal years ended March 31, 2006, 2005,
2004, and 2003, and for each of the quarters in the year ended March 31, 2006.
(b) CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING
SEC regulations require that Company management evaluate any change in our
internal controls over financial reporting that occurred during each of our
fiscal quarters that has materially affected, or is reasonably likely to
materially affect the Company's internal control over financial reporting.
There were no changes in our internal control over financial reporting (as
such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)
during the quarter ended June 30, 2007 that have materially affected, or are
reasonably likely to materially affect the Company's internal control over
financial reporting.
(c) INHERENT LIMITATIONS OF DISCLOSURE CONTROLS AND PROCEDURES
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Projections of any evaluation of
effectiveness to future periods are subject to risks that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies and procedures may deteriorate.
(d) REMEDIATION ACTIVITIES
Subsequent to March 31, 2008, the Company is taking steps to remediate the
material weakness related to rebate agreements by designing policies and
procedures that require all new or modified customer agreements to be reviewed
by accounting personnel with relevant GAAP knowledge to determine the
appropriate accounting treatment.
Subsequent to June 30, 2007, we have taken several steps to begin to remediate
the material weaknesses related to accounting for stock-based compensation,
income taxes and revenue recognition described in (a) above as follows:
Stock-Based Compensation
o Expanded the General Counsel's role to include oversight of the
process of documenting stock option grants in order to assure that
grants are properly awarded under the approved plan document and
proper grant dates are associated with awards.
o Engaged an outside professional services firm to advise us on
improving the design of the internal controls over our stock option
processes and controls over the preparation and review of stock-based
compensation information in the Company's financial reports.
o Established an Employee Compensation Reporting Committee comprised of
senior tax, legal, human resource, and accounting/finance personnel,
to assure that grants are properly awarded under the plan document,
proper grant dates are assigned for measurement purposes, the
reasonableness of key assumptions used in the valuation of stock
options are reviewed for appropriateness and any modifications to the
standard terms of outstanding awards are reviewed for appropriate
accounting treatment.
o Established a procedure whereby senior financial management reviews
employment agreements, employment offers, and other employee
agreements to ensure proper accounting based upon the terms and
conditions of such agreements.
40
o Training and education to ensure that all relevant personnel involved
in the administration of and accounting for stock option grants,
including tax personnel, understand the terms of the Company's stock
option plans and the relevant accounting guidance under U.S.
generally accepted accounting principles.
o Established quarterly testing by the Company's Internal Audit
Department of controls relating to stock option activity and the
accuracy of the model used in valuing the Company's stock options.
Income Taxes
o Established quarterly meetings between the tax department, operating
division executives and other management personnel to facilitate
communication of relevant business issues impacting accounting for
income taxes, and;
o Implemented procedures that require the documentation of tax
liabilities and facilitate an effective review of the recognition and
measurement of tax liabilities.
Revenue Recognition
o Implemented a procedure to verify actual customer receipt dates of
shipments made during the last several days of a period end for the
FOB destination customers.
o Implemented a policy requiring that shipping terms for all customers
are properly documented and reviewed by finance/accounting personnel
to verify the appropriate timing of revenue recognition.
41
PART II. - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The information set forth under Note 13 - CONTINGENCIES - LITIGATION of the
Notes to the Consolidated Financial Statements included in Part I, Item I of
this report is incorporated in this Part II, Item 1 by reference.
ITEM 1A. RISK FACTORS
There are no material changes from the risk factors set forth in Item 1A,
"Risk Factors," of the Company's Annual Report on Form 10-K for the fiscal
year ended March 31, 2007. Please refer to that section for disclosures
regarding the risks and uncertainties related to the Company's business.
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 June 30, 2007:
TOTAL NUMBER OF SHARES
TOTAL NUMBER OF PURCHASED AS PART OF A MAXIMUM NUMBER OF SHARES
SHARES PURCHASED AVERAGE PRICE PAID PUBLICLY ANNOUNCED THAT MAY YET BE
PERIOD (a) PER SHARE PROGRAM PURCHASED UNDER THE PROGRAM
April 1-30, 2007 2,880 $ 25.39 -- --
May 1-31, 2007 496 $ 26.15 -- --
June 1-30, 2007 -- -- -- --
----- ------- ---- ----
Total 3,376 $ 25.50 -- --
===== =======
Shares were purchased from employees upon their termination pursuant to the
terms of the Company's stock option plan.
42
ITEM 6. EXHIBITS
Exhibits. See Exhibit Index.
43
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: June 25, 2008 By /s/ Marc S. Hermelin
--------------------------------------------
Marc S. Hermelin
Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)
Date: June 25, 2008 By /s/ Ronald J. Kanterman
--------------------------------------------
Ronald J. Kanterman
Vice President and Chief Financial Officer
(Principal Financial Officer)
Date: June 25, 2008 By /s/ Richard H. Chibnall
---------------------------------------------
Richard H. Chibnall
Vice President, Finance
(Principal Accounting Officer)
44
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.
45