Allergan Finance LLC 10-Q 2005
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005
o 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 0-20045
WATSON PHARMACEUTICALS, INC.
(Exact name of registrant as specified in its charter)
311 Bonnie Circle
Corona, CA 92880-2882
(Address of principal executive offices, including zip code)
(Registrants telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý
The number of shares outstanding of the Registrants only class of common stock as of November 3, 2005 was approximately 110,815,000.
WATSON PHARMACEUTICALS, INC.
TABLE OF CONTENTS
FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
WATSON PHARMACEUTICALS, INC.
(Unaudited; in thousands)
See accompanying Notes to Condensed Consolidated Financial Statements.
WATSON PHARMACEUTICALS, INC.
(Unaudited; in thousands, except per share amounts)
See accompanying Notes to Condensed Consolidated Financial Statements.
WATSON PHARMACEUTICALS, INC.
(Unaudited; in thousands)
See accompanying Notes to Condensed Consolidated Financial Statements.
WATSON PHARMACEUTICALS, INC.
NOTE 1 GENERAL
Watson Pharmaceuticals, Inc. (Watson, the Company, we, us or our) is primarily engaged in the development, manufacture, marketing, sale and distribution of brand and off-patent (generic) pharmaceutical products. Watson was incorporated in 1985 and began operations as a manufacturer and marketer of off-patent pharmaceuticals. Through internal product development and synergistic acquisitions of products and businesses, the Company has grown into a diversified specialty pharmaceutical company. Watson operates manufacturing, distribution, research and development and administrative facilities primarily in the United States of America (U.S.).
The accompanying Condensed Consolidated Financial Statements should be read in conjunction with the Companys Annual Report on Form 10-K for the year ended December 31, 2004. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted from the accompanying Condensed Consolidated Financial Statements. The year end balance sheet was derived from the audited financial statements. The accompanying interim Condensed Consolidated Financial Statements are unaudited, but reflect all adjustments which are, in the opinion of management, necessary to fairly state Watsons consolidated financial position, results of operations and cash flows for the periods presented. Unless otherwise noted, all such adjustments are of a normal, recurring nature. Certain reclassifications, none of which affected net income or retained earnings, have been made to prior period amounts to conform to current period presentation. The Companys results of operations and cash flows for the interim periods are not necessarily indicative of the results of operations and cash flows that it may achieve in future periods or for the full year.
Comprehensive income includes all changes in equity during a period except those that resulted from investments by or distributions to the Companys stockholders. Other comprehensive loss 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 stockholders equity. Watsons other comprehensive loss is comprised of unrealized losses on its holdings of publicly traded debt and equity securities, net of realized losses included in net income. The components of comprehensive income and related income taxes consisted of the following (in thousands):
Preferred and Common Stock
As of September 30, 2005 and December 31, 2004 there were 2,500,000 shares of preferred stock authorized, with none issued. As of September 30, 2005 and December 31, 2004, there were 500,000,000 shares of common stock authorized, with 111,085,400 and 109,719,900 shares issued, respectively. Of the issued shares, 9,399,800 and 0 shares were held as treasury shares as of September 30, 2005 and December 31, 2004, respectively.
Earnings per share
Basic earnings per share is computed by dividing net income by the weighted average common shares outstanding during a period. Diluted earnings per share is based on the treasury stock method and includes the effect from potential issuance of common stock, such as shares issuable upon conversion of the $575 million convertible contingent senior debentures (CODES), and shares issuable pursuant to the exercise of stock options, assuming the exercise of all in-the-money stock options. Other potential common share equivalents have been excluded where their inclusion would be antidilutive. In accordance with Emerging Issues Task Force (EITF) Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share (EITF No. 04-8), the Company is required to add approximately 14.4 million shares associated with the conversion of the CODES to the number of shares outstanding for the calculation of diluted earnings per share for all periods in which the securities were outstanding. Prior period comparatives have been restated to conform to the requirements of EITF No. 04-8. A reconciliation of the numerators and denominators of basic and diluted earnings per share consisted of the following (in thousands, except per share amounts):
Excluded from the computation of diluted earnings per share are outstanding common stock options with an exercise price greater than the average market price of the common shares for the periods reported. For each of the three month periods ended September 30, 2005 and 2004, stock options to purchase 6.2 million and 11.3 million common shares, respectively, were outstanding but were not included in the computation of diluted earnings per share because the options were antidilutive. For the nine month periods ended September 30, 2005 and 2004, stock options to purchase 6.3 million and 6.8 million common shares, respectively, were outstanding but were not included in the computation of diluted earnings per share because they were antidilutive.
The Company accounts for its stock-based employee compensation plans using the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued
to Employees (APB 25) and related interpretations. No stock-based employee compensation expense has been recognized for the options in the accompanying condensed consolidated statements of income, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of grant.
The Company has elected to use the intrinsic value method under APB 25 as permitted by Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation (SFAS 123), subsequently amended by SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure (SFAS 148) to account for stock options issued to its employees. The Company makes pro forma fair value disclosures as required by SFAS 123 which reflect the impact on net income and earnings per share had the Company applied the fair value method of accounting for its stock-based compensation awards. The Company estimates the fair value of its stock-based awards using the Black-Scholes option pricing model. The pro forma effects on net income and earnings per share are as follows (in thousands, except per share amounts):
The weighted average fair values of the employee stock options and employee stock purchase plan (ESPP) have been estimated on the date of each grant using the Black-Scholes option pricing model. Weighted averages are used because of varying assumed exercise dates. The following weighted average
assumptions were used for stock options granted during the three and nine months ended September 30, 2005 and 2004:
The following weighted average assumptions were used for the ESPP during the three and nine months ended September 30, 2005 and 2004:
We implemented certain changes in employee and non-employee director (the Participants) share-based compensation during the second quarter of 2005 to help us strengthen our ability to attract, retain and motivate our Participants, and to better align Participant interests with those of our shareholders. Certain Participants are now granted restricted stock awards as well as stock options. The stock award program offers Participants the opportunity to earn shares of our common stock over time, rather than options that give Participants the right to purchase stock at a set price. Restricted stock awards are grants that entitle the holder to shares of common stock subject to certain restrictions. On June 29, 2005, approximately 38,000 restricted stock awards with a weighted-average fair value of $29.97 per share were granted to certain non-employee directors and the Companys Chief Executive Officer. During the three months ended September 30, 2005 approximately 268,000 restricted stock awards with a weighted average fair value of $35.10 per share were granted to employees of the company. Restricted stock awards generally have restrictions eliminated over a one to four year period. Restrictions generally lapse for non-employee directors after one year. Restrictions generally lapse for employees over a two to four year period.
We have repurchased approximately 9.4 million shares of our common stock at an aggregate cost of approximately $300.0 million under the Companys $300.0 million stock repurchase program approved by the Board of Directors (Board) on February 10, 2005. This completes our stock repurchase program under the existing Board authorization.
Recent accounting pronouncements
In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151, Inventory Costs-an Amendment of ARB No. 43, Chapter 4 (SFAS 151). SFAS 151 requires that accounting for items such as idle facility expense, freight, handling costs, and wasted materials (spoilage) be recognized as current period charges regardless of whether they meet the criterion of being abnormal. In addition, SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The provision of SFAS 151 shall be applied prospectively. The Company believes that the adoption of SFAS 151 will not have a material effect on our Condensed Consolidated Financial Statements.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (SFAS 123R), which replaces SFAS 123, and supercedes APB 25. Under SFAS 123R, the Company must determine the appropriate fair value model to be used for valuing share-based payment transactions with employees, the amortization method for compensation cost and the transition method to be used at the date of adoption. The transition methods include modified prospective and modified retrospective adoption options. Under the modified retrospective option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The modified prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123R, while the modified retrospective method would record compensation expense for all unvested stock options and restricted stock beginning with the first period restated. The Company is evaluating the requirements of SFAS 123R. The Company has not yet determined whether the adoption will result in share-based compensation expense amounts that are similar to the current pro forma disclosures under SFAS 123.
In April 2005, the Securities and Exchange Commission announced an amendment to Regulation S-X to amend the date for compliance with SFAS 123R. The amendment requires each registrant that is not a small business issuer to adopt SFAS 123R in the first fiscal year commencing after June 15, 2005. The Company is required to adopt SFAS 123R beginning January 1, 2006. Adoption of SFAS 123R will have a material impact on our consolidated financial statements, as we will be required to expense the fair value of our stock option awards and ESPP grants rather than disclose the pro forma impact on our consolidated net income within the footnotes, as is our current practice.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS 154), which replaces APB Opinion No. 20, Accounting Changes (APB 20) and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements (SFAS 3). SFAS 154 applies to all voluntary changes in accounting principle and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS 154 also requires retrospective application to prior period financial statements involving changes in accounting principle unless it is impracticable to determine either the period-specific or cumulative effect of the change. This statement also requires that a change in the method of depreciation, amortization or depletion of long-lived assets be accounted for as a change in accounting estimate that is accounted for prospectively. SFAS 154 also retains many provisions of APB 20 including those related to reporting a change in accounting estimate, a change in the reporting entity and a correction of an error and also carries forward provisions of SFAS 3 governing the reporting of accounting changes in interim financial statements. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company believes that the adoption of SFAS 154 will not have a material effect on our Condensed Consolidated Financial Statements.
NOTE 2 INVESTMENTS
The Companys equity investments in publicly traded companies are classified as available-for-sale and are recorded at fair value based on quoted market prices using the specific identification method. These investments are classified as current marketable securities, or investments and other assets, as appropriate, on the Companys Condensed Consolidated Balance Sheets.
The Companys debt investments in U.S. Treasury securities are classified as available-for-sale and are recorded at fair value based on quoted market prices using the specific identification method.
The following table provides a summary of the fair value and unrealized holding gain (loss) related to Watsons available-for-sale securities at September 30, 2005 and December 31, 2004 (in thousands):
Our investments in auction rate securities were liquidated in May 2005 and approximately $50 million in U.S. Treasury securities matured in June 2005. Proceeds were deposited in cash and cash equivalents.
Gross unrealized gains at September 30, 2005 and December 31, 2004 primarily relate to our holdings in shares of Andrx Corporation (Andrx) common stock. The gross unrealized losses at September 30, 2005 and December 31, 2004 is attributable to adjustments, included in other comprehensive income, for the decline in fair value in the Companys investment in U.S. Treasury securities.
The Companys net unrealized losses related to its available-for-sale securities were $1.7 million and $5.0 million for the three and nine month periods ended September 30, 2005, respectively. During the three and nine month periods ended September 30, 2004, the Companys net unrealized losses related to its available-for-sale securities were $2.4 million and $3.6 million, respectively. Changes in the Companys net unrealized gains (losses) related to its available-for-sale securities are included in other comprehensive income (loss).
The Companys investment in the common stock of Andrx, publicly traded on the Nasdaq Stock Market under the symbol ADRX, is classified as a current investment on the Companys Condensed Consolidated Balance Sheets at September 30, 2005 and December 31, 2004.
The Company did not sell any of its shares of Andrx during the nine month period ended September 30, 2005. During the nine month period ended September 30, 2004, Watson sold 240,000 shares of its investment in the common stock of Andrx for gross proceeds of $6.3 million and recorded a pre-tax gain of $5.7 million. Realized gains are computed using the specific identification method to determine the cost basis for each investment.
The Companys investments in U.S. Treasury securities and auction rate securities, where applicable, are classified as a current investment on the Companys Condensed Consolidated Balance Sheets at September 30, 2005 and December 31, 2004.
The contractual maturities of the U.S. Treasury securities consisted of the following (in thousands):
The Companys investments in the common stock of Genelabs Technologies, Inc., NovaDel Pharma Inc. and Amarin Corporation plc are classified as non-current investments and are included in Investments and other assets on the Companys Condensed Consolidated Balance Sheets at September 30, 2005 and December 31, 2004.
NOTE 3 OPERATING SEGMENTS
Watson has two operating segments: Brand and Generic. The Brand business segment includes the Specialty Products and Nephrology product lines. Watson has aggregated its Brand product lines in a single segment because of similarities in regulatory environment, methods of distribution and types of customer. This segment includes patent-protected products and certain trademarked off-patent products that Watson sells and markets as brand pharmaceutical products. The Generic business segment includes off-patent pharmaceutical products that are therapeutically equivalent to proprietary products. The Company sells its brand and generic products primarily to pharmaceutical wholesalers, drug distributors and chain drug stores.
Prior to January 1, 2005, the Company evaluated the performance of its segments based on net revenues and gross profit. As of January 1, 2005, the Company began to evaluate segment performance based on segment net revenues, gross profit and contribution. Segment contribution represents segment gross profit less direct research and development expenses and selling and marketing expenses. Segment financial data for prior periods have been reclassified to reflect this change in evaluating the associated segment results.
The Company does not report general and administrative expenses, amortization, depreciation expense, total assets, and capital expenditures by segment as such information is not used by management, or accounted for, at the segment level. Segment net revenues, segment gross profit and segment contribution information for the
Companys Brand and Generic segments, as reclassified, consisted of the following:
Three Months Ended September 30, 2005 Compared to the Three Months Ended September 30, 2004
Three months ended September 30, 2005
Three months ended September 30, 2004
Nine Months Ended September 30, 2005 Compared to the Nine Months Ended September 30, 2004
Nine months ended September 30, 2005
NOTE 4 INVENTORIES
Inventories consist of finished goods held for sale and distribution, raw materials and work-in-process. Included in inventory at September 30, 2005 and December 31, 2004 is approximately $3.6 million and $17.3 million, respectively, of inventory that is pending approval by the U.S. Food and Drug Administration (FDA) or has not been launched due to contractual restrictions. This inventory consists of generic pharmaceutical products that are capitalized only when the bioequivalence of the product is demonstrated or the product is already FDA approved and is awaiting a contractual triggering event to enter the marketplace.
Inventories are stated at the lower of cost (first-in, first-out method) or market (net realizable value) and consisted of the following (in thousands):
NOTE 5 GOODWILL AND OTHER INTANGIBLE ASSETS
Watson tests its goodwill and intangible assets with indefinite lives by comparing the fair value of each of the Companys reporting units to the respective carrying value of the reporting units. The Company performs this impairment testing annually during the second quarter and when events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The Company has aligned the reporting units to correspond with our Brand and Generic segments. The carrying value of each reporting unit is determined by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units. Goodwill is considered impaired if its carrying amount exceeds its implied fair value.
During the second quarter of 2005, Watson performed its annual test for the impairment of goodwill and determined there was no indication of impairment. There were no additions to goodwill recorded during the nine months ended September 30, 2005. At September 30, 2005 and December 31, 2004, goodwill for the Companys reporting units consisted of the following (in thousands):
Other intangible assets consist primarily of acquired product rights. We regularly review the appropriateness of the useful lives assigned to our product rights taking into consideration potential future changes in the markets for our products. As a result of reviews performed in 2004, we accelerated the amortization of several product rights including our Ferrlecit® product rights. The original cost and accumulated amortization of these intangible assets are as follows (in thousands):
The Companys current product rights and related intangibles have a weighted average useful life of approximately twelve years. Assuming no additions, disposals or adjustments are made to the carrying values and/or useful lives of the assets, remaining amortization expense on product rights and related intangibles is
estimated to be as follows (in thousands):
NOTE 6 LONG-TERM DEBT
Long-term debt consisted of the following (in thousands):
In March 2003, the Company issued $575 million of CODES. The CODES, which are convertible into shares of Watsons common stock upon the occurrence of certain events, are due in March 2023, with interest payments due semi-annually in March and September at an effective annual interest rate of 2.1%, excluding changes in fair value of the contingent interest derivative. At September 30, 2005 and at December 31, 2004, the unamortized discount for the CODES was $1.2 million and $1.4 million, respectively.
The CODES are convertible into Watsons common stock at a conversion price of approximately $40.05 per share (subject to certain adjustments upon certain events such as (i) stock splits or dividends, (ii) material stock distributions or reclassifications, (iii) distribution of stock purchase rights at less than current market rates, or (iv) a distribution of assets or common stock to our shareholders or subsidiaries). The CODES may be converted, at the option of the holders, prior to maturity under any of the following circumstances:
during any quarterly conversion period (period from and including the thirtieth trading day in a fiscal quarter to, but not including, the thirtieth trading day in the immediately following fiscal quarter) if the closing sale price per share of Watsons common stock for a period of at least 20 trading days during the 30 consecutive trading-day period ending on the first day of such conversion period is more than 125% ($50.06) of the conversion price in effect on that thirtieth day;
on or before March 15, 2018, during the five business-day period following any 10 consecutive trading-day period in which the daily average trading price for the CODES for such ten-day period was less than 105% of the average conversion value for the debentures during that period. This conversion feature represents an embedded derivative. However, based on the de minimis value associated with this feature, no value has been assigned at issuance or at September 30, 2005;
during any period, following the earlier of (a) the date the CODES are rated by both Standard & Poors Rating Services and Moodys Investor Services, Inc., and (b) April 21, 2003, when the long-term credit
rating assigned to the CODES by either Standard & Poors or Moodys (or any successors to these entities) is lower than BB or Ba3, respectively, or when either of these rating agencies does not have a rating then assigned to the CODES for any reason, including any withdrawal or suspension of a rating assigned to the CODES. This conversion feature represents an embedded derivative. However, based on the de minimis value associated with this feature, no value has been assigned at issuance or at September 30, 2005;
if the CODES have been called for redemption; or
upon the occurrence of specified corporate transactions.
The Company may redeem some or all of the CODES for cash, on or after March 20, 2008, for a price equal to 100% of the principal amount of the CODES plus accrued and unpaid interest (including contingent interest) to, but excluding, the redemption date.
The CODES contain put options which may require the Company to repurchase for cash all or a portion of the CODES on March 15 of 2010, 2015 and 2018 at a repurchase price equal to 100% of the principal amount of the CODES plus any accrued and unpaid interest (including contingent interest) to, but excluding, the date of repurchase.
In addition, the holders of the CODES have the right to receive contingent interest payments during any six-month period from March 15 to September 14 and from September 15 to March 14, commencing on September 15, 2003, if the average trading price of the CODES for the five trading days ending on the second trading day immediately preceding the relevant six-month period equals 120% or more of the principal amount of the CODES. The interest rate used to calculate the contingent interest is the greater of 5% of the Companys then-current estimated per annum borrowing rate for senior non-convertible fixed-rate debt with a maturity date and other terms comparable to that of the CODES or 0.33% per annum. This contingent interest payment feature is an embedded derivative and has been bifurcated and recorded separately in the Condensed Consolidated Balance Sheets in other long-term liabilities. The initial fair value assigned to the embedded derivative was $1.9 million, which is recorded as a discount to the CODES. Changes to the fair value of this embedded derivative are reflected as an adjustment to interest expense. At September 30, 2005 and December 31, 2004 the fair value of the embedded derivative was approximately $1.7 million.
1998 Senior Notes
In May 1998, Watson issued $150 million of its 1998 Senior Notes. The 1998 Senior Notes are due in May 2008 but may be redeemed earlier under certain circumstances. The Company is required to make interest only payments due semi-annually in May and November. The effective annual interest rate is 7.2%. At September 30, 2005 and December 31, 2004, the unamortized discount for the 1998 Senior Notes was $46,000 and $59,000, respectively.
In February 2004, the Company initiated a tender offer to purchase all of its outstanding 1998 Senior Notes and a related consent solicitation. The Company received tenders of its 1998 Senior Notes and deliveries of related consents from holders of approximately $101.6 million of the $150 million aggregate principal amount of 1998 Senior Notes outstanding. As a result, the Company received the required consents to eliminate substantially all of the restrictive covenants of the indenture governing the 1998 Senior Notes and to make certain amendments. The Company executed and delivered a supplemental indenture setting forth the amendments.
In May 2004, the Company acquired an additional $34.3 million of its outstanding 1998 Senior Notes in an open market transaction. The Company recorded charges of $14.0 million and $3.7 million in the first and second quarters of 2004, respectively, related to fees, expenses, unamortized discount, and premiums paid for the bond repurchases.
In May 2003, the Company entered into an agreement with a syndicate of lenders for a five-year, $300 million senior, unsecured revolving credit facility (the Credit Facility) for working capital and other general corporate purposes. On September 8, 2005, we entered into a Second Amendment to the Credit Facility on substantially the same terms and conditions except the fee structure was reduced and certain defined terms were added or amended. Watsons assets generally are held by, and its operations generally are conducted through, its subsidiaries. Within the meaning of Regulation S-X, Rule 3-10, the Company has no assets or operations independent of its subsidiaries. The terms of the Credit Facility require each subsidiary, other than minor subsidiaries, to provide full and unconditional guarantees on a joint and several basis. In order to provide subsidiary guarantees in connection with this Credit Facility, the Company was also required, by the terms of the Indenture for the 1998 Senior Notes, to grant similar subsidiary guarantees in favor of the 1998 Senior Note holders. The subsidiary guarantees related to both the Credit Facility and the 1998 Senior Notes are full and unconditional, on a joint and several basis, and are given by all subsidiaries other than minor subsidiaries. Watson is subject to certain financial and operational covenants, all of which, as of September 30, 2005 and December 31, 2004, the Company was in compliance. As of September 30, 2005 and December 31, 2004, the Company had not drawn any funds from the Credit Facility.
NOTE 7 FINANCIAL INSTRUMENTS
Fair value of financial instruments
The Companys financial instruments consist primarily of cash and cash equivalents, marketable securities, accounts and other receivables, investments, trade accounts payable, 1998 Senior Notes, CODES and embedded derivatives related to the issuance of the CODES. The carrying amounts of cash and cash equivalents, marketable securities, accounts and other receivables and trade accounts payable are representative of their respective fair values due to their relatively short maturities. The fair values of investments in companies that are publicly traded are based on quoted market prices. The fair value of investments in privately held companies, or cost-method investments, are based on historical cost, adjusted for any write-down related to impairment. The Company estimates the fair value of its fixed rate long-term obligations based on quoted market rates of interest and maturity schedules for similar issues. The carrying value of these obligations approximates their fair value. The fair value of the embedded derivatives related to the CODES is based on a present value technique using discounted expected future cash flows.
Derivative financial instruments
The Companys derivative financial instruments consist of embedded derivatives related to its CODES. These embedded derivatives include certain conversion features and a contingent interest feature. See Note 6 for a more detailed description of these features of the CODES. Although the conversion features represent embedded derivative financial instruments, based on the de minimis value of these features at the time of issuance and at September 30, 2005, no value has been assigned to these instruments. The contingent interest feature provides unique tax treatment under the Internal Revenue Services Contingent Debt Regulations. In essence, interest accrues, for tax purposes, on the basis of the instruments comparable yield (the yield at which the issuer would issue a fixed rate instrument with similar terms). This embedded derivative is reported on the Companys Condensed Consolidated Balance Sheets at fair value and the changes in the fair value of the embedded derivative are reported (as gains or losses) within interest expense in the Companys Condensed Consolidated Statements of Income.
The carrying value of the Companys derivative financial instruments, which approximates fair value, was approximately $1.7 million at December 31, 2004 and at September 30, 2005. Changes in fair value are recognized as an adjustment to interest expense during the respective period.
NOTE 8 COMMITMENTS AND CONTINGENCIES
Facility and equipment leases
The Company has entered into long-term operating leases for certain facilities and equipment. The terms of the operating leases for the Companys facilities require the Company to pay property taxes, normal maintenance expenses and maintain minimum insurance coverage. Total rental expense for operating leases for the nine months ended September 30, 2005 and 2004 were $7.8 million and $8.7 million, respectively.
Remaining future minimum lease payments under all non-cancelable operating leases are as follows (in thousands):
Employee retirement plans
The Company maintains certain defined contribution retirement plans covering substantially all employees. The Company contributes to the plans based upon the employee contributions. The Company does not sponsor any defined benefit retirement plans or postretirement benefit plans. Watsons contributions to these retirement plans for the three and nine months ended September 30, 2005 were $1.4 million and $4.8 million, respectively. Watsons contributions to these retirement plans for the three and nine months ended September 30, 2004 were $1.6 million and $5.5 million, respectively.
The Company is party to certain lawsuits and legal proceedings, which are described in Part I, Item 3. Legal Proceedings, of our Annual Report on Form 10-K for the year ended December 31, 2004. The following is a description of material developments during the period covered by this Quarterly Report and through the filing of this Quarterly Report, and should be read in conjunction with the Annual Report referenced above.
Phen-fen litigation. With respect to the phentermine hydrochloride product liability lawsuits pending against the Company, certain subsidiaries, and others, additional actions raising similar issues have been filed, and some actions have been settled or otherwise dismissed. As of November 4, 2005, approximately 35 cases were pending against Watson and its affiliates in numerous state and federal courts. Most of the cases involve multiple plaintiffs, and several were filed or certified as class actions. The Company believes it will be fully indemnified by Rugbys former owner, Aventis Pharmaceuticals (Aventis, formerly known as Hoechst Marion Roussel, Inc., and now known as Sanofi-Aventis) for the defense of all such cases and for any liability that may arise out of these cases. Aventis is currently controlling the defense of all these matters as the indemnifying party under its agreements with the Company.
Cipro® Litigation. On August 25, 2005, defendants filed a motion to transfer the appeals of the judgment in defendants favor in the consolidated action from the United States Court of Appeals for the Second Circuit to the United States Court of Appeals for the Federal Circuit. Appellants filed their briefs in opposition to the motion to transfer on or about September 26, 2005. Defendants filed their reply in support of the motion to transfer on October 21, 2005. All parties have requested oral argument on the motion.
In the New York State court Cipro® action, which the court dismissed in 2004, and in which the plaintiffs filed a Notice of Appeal in October 2004, the appellants filed their appellate brief on July 27, 2005. The defendants/appellees filed their joint response brief on September 7, 2005. The court has scheduled oral argument of the appeal on November 22, 2005.
Governmental Reimbursement Investigations and Drug Pricing Litigation. With respect to the Drug Pricing Litigation pending against the Company and certain subsidiaries, an additional action raising similar allegations was filed by the Attorney General of the State of Mississippi on October 20, 2005, in the Chancery Court of Hinds County, Mississippi (State of Mississippi v. Abbott Laboratories, Inc. et al, Civil Action No. G2005-2021 S/2). With respect to the actions filed by governmental subdivisions of New York State, 27 of the 36 New York State county actions and the action filed by the City of New York have been consolidated into the Consolidated Action pending in the United States District Court for the District of Massachusetts (In re Pharmaceutical Industry Average Wholesale Price Litigation, MDL Docket No. 1456, Civil Action No. 01-CV-12257-PBS). Several federal district courts have remanded cases to state court that the defendants had removed to federal court. Additional actions are anticipated. The Company intends to defend these actions vigorously. However, if successful, these actions could adversely affect the Company and may have a material adverse effect on the Companys business, results of operations, financial condition and cash flows.
Hormone Replacement Therapy Litigation. With respect to the hormone replacement therapy product liability lawsuits pending against the Company, certain of its subsidiaries, and other third parties, additional actions raising similar allegations have been filed, and some actions have been dismissed. As of November 4, 2005, there were approximately 85 cases pending against the Company and its affiliates in various state and federal courts, representing claims by approximately 750 plaintiffs. Many of the cases seek certification as class actions. These actions, if successful, could adversely affect the Company and could have a material adverse effect on the Companys business, results of operations, financial condition and cash flows.
Watson and its affiliates are involved in various other disputes, governmental and/or regulatory inspections, inquires, investigations and proceedings, and litigation matters that arise from time to time in the ordinary course of business. The process of resolving matters through litigation or other means is inherently uncertain and it is possible that an unfavorable resolution of these matters will adversely affect the Company, its results of operations, financial condition and cash flows.
NOTE 9 SUBSEQUENT EVENT
On October 11, 2005 the Company initiated a plan to consolidate certain manufacturing facilities as part of an ongoing effort to optimize the capacity utilization of the Companys manufacturing operations. As a result, we plan to transfer existing product manufacturing from our Humacao, Puerto Rico site to our facilities located in Carmel, New York and Corona, California over the next 18 to 24 months. In conjunction with the closure of our Puerto Rico facility, we may record a non-cash asset impairment charge in the fourth quarter of 2005. A current estimate of charges, if any, relating to this restructuring has not been determined. The net book value of property and equipment located in Puerto Rico as at September 30, 2005 is approximately $41 million. Under SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, costs associated with exit or disposal activities are recognized when the liability is incurred rather than at the date of a commitment to an exit or disposal plan. Accordingly, additional cash costs will be recognized in future periods as we transition production to other sites and we incur product transfer, severance and decommissioning costs.
The following discussion of our financial condition and the results of our operations should be read in conjunction with the Condensed Consolidated Financial Statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q (Quarterly Report). This discussion contains forward-looking statements that are subject to known and unknown risks, uncertainties and other factors that may cause our actual results to differ materially from those expressed or implied by such forward-looking statements. These risks, uncertainties and other factors include, among others, those identified under Cautionary Note Regarding Forward-Looking Statements and elsewhere in this Quarterly Report and under Risks Related to our Business in our Annual Report on Form 10-K for the year ended December 31, 2004.
Watson Pharmaceuticals, Inc. (Watson, the Company, we, us or our) was incorporated in 1985 and is engaged in the development, manufacture, marketing, sale and distribution of brand and off-patent (generic) pharmaceutical products. Watson operates manufacturing, distribution, research and development, and administrative facilities primarily in the United States (U.S.).
Prescription pharmaceutical products in the U.S. are generally marketed as either generic or brand pharmaceuticals. Generic pharmaceutical products are bioequivalents of their respective brand products and provide a cost-efficient alternative to brand products. Brand pharmaceutical products are marketed under brand names through programs that are designed to generate physician and consumer loyalty. As a result of the differences between the two types of products, we operate and manage our business as two segments: Generic and Brand.
Results of Operations
Three Months Ended September 30, 2005 Compared to the Three Months Ended September 30, 2004
Our Generic segment develops, manufactures, markets, sells and distributes generic products that are the therapeutic equivalent to their brand name counterparts and are generally sold at prices significantly less than the brand product. As such, generic products provide an effective and cost-efficient alternative to brand products. When patents or other regulatory exclusivities no longer protect a brand product, opportunities exist to introduce off-patent or generic counterparts to the brand product. Our portfolio of generic products includes products we have internally developed, products we have licensed from third parties, and products we distribute for third parties.
Sales from our Generic segment during the three months ended September 30, 2005 increased $11.9 million or 3.9% over sales from the same period of the prior year. Increased sales of certain oral contraceptives and several products launched since the third quarter of 2004 were partially offset by a decrease in sales of nicotine gum related to the entry of a competitor in that product line in December 2004.
Sales of our generic oral contraceptive products represented 26% and 25% of total generic sales for the three months ended September 30, 2005 and 2004, respectively.
Our Brand segment develops, manufactures, markets, sells and distributes products within two sales and marketing groups: Specialty Products and Nephrology.
Our Specialty Products product line includes products for the treatment of urologic disorders, including palliative cancer treatment, and also includes: (i) hormone replacement therapy products and (ii) a genital warts treatment.
Our Nephrology product line consists of products for the treatment of iron deficiency anemia and is generally marketed to nephrologists and dialysis centers. The major product within the Nephrology product line is Ferrlecit®, which is used to treat low iron levels in patients undergoing hemodialysis in conjunction with erythropoietin therapy.
The $6.0 million or 6.2% decrease in sales from our Brand segment for the three months ended September 30, 2005, as compared to the same prior year period, was attributable to a decrease in sales within our Specialty Products group. The decrease in sales within Specialty Products resulted primarily from a decline in prescription volumes which was offset in part by sales of our Trelstar® Depot and Trelstar® LA (collectively Trelstar®) products launched earlier this year for the palliative treatment of advanced prostate cancer.
Sales from our Nephrology product line increased $1.7 million or 3.9% due to an increase in unit sales of our Ferrlecit® product. For the three months ended September 30, 2005 and 2004, Ferrlecit® represented approximately 81% and 80% of sales, respectively, from our Nephrology product line.
Other revenues include revenues earned under research and development agreements, other agreements and royalties. Revenues recognized from research, development and licensing agreements (including milestone payments) are deferred and recognized over the entire contract performance period, starting with the contracts commencement, but not prior to the removal of any contingencies for each individual milestone. We recognize this revenue based upon the pattern in which the revenue is earned or the obligation is fulfilled.
The decrease in other revenues in the three months ended September 30, 2005 was primarily related to a decline in the amount of deferred revenue recognized in the quarter.
Gross Profit Margin (Gross Margin)