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Allergan Finance LLC 10-Q 2005

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 


 

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005

 

or

 

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)

 

Nevada

 

95-3872914

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

311 Bonnie Circle

Corona, CA 92880-2882

(Address of principal executive offices, including zip code)

 

(951) 493-5300

(Registrant’s 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

 

The number of shares outstanding of the Registrant’s only class of common stock as of June 30, 2005 was approximately 104,230,000.

 

 



 

WATSON PHARMACEUTICALS, INC.

 

TABLE OF CONTENTS

 

FORM 10-Q FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005

 

 

Part I. FINANCIAL INFORMATION

 

Item 1. Condensed Consolidated Financial Statements (Unaudited):

 

 

 

 

 

 

Condensed Consolidated Balance Sheets as of June 30, 2005 and December 31, 2004

 

 

 

 

 

 

 

Condensed Consolidated Statements of Income for the Three and Six Months Ended June 30, 2005 and 2004

 

 

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2005 and 2004

 

 

 

 

 

 

 

Notes to Condensed Consolidated Financial Statements

 

 

 

 

 

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

 

 

 

Item 3. Quantitative and Qualitative Disclosure about Market Risk

 

 

 

 

 

Item 4. Controls and Procedures

 

 

 

 

 

Part II. OTHER INFORMATION AND SIGNATURES

 

 

 

 

 

Item 1. Legal Proceedings

 

 

 

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

 

 

 

 

Item 4. Submission of Matters to a Vote of Security Holders

 

 

 

 

 

Item 6. Exhibits

 

 

 

 

 

Signatures

 

 

 



 

WATSON PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited; in thousands, except share amounts)

 

 

 

June 30,
2005

 

December 31,
2004

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

488,735

 

$

298,653

 

Marketable securities

 

161,049

 

381,679

 

Accounts receivable, net

 

271,258

 

251,459

 

Inventories

 

289,308

 

321,299

 

Prepaid expenses and other current assets

 

20,542

 

26,894

 

Deferred tax assets

 

90,181

 

90,202

 

Total current assets

 

1,321,073

 

1,370,186

 

 

 

 

 

 

 

Property and equipment, net

 

445,221

 

427,377

 

Investments and other assets

 

42,061

 

47,499

 

Deferred tax assets

 

29,523

 

30,280

 

Product rights and other intangibles, net

 

831,434

 

912,746

 

Goodwill

 

455,595

 

455,595

 

Total assets

 

$

3,124,907

 

$

3,243,683

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable and accrued expenses

 

$

186,808

 

$

192,701

 

Income taxes payable

 

49,310

 

57,851

 

Deferred revenue

 

4,024

 

5,077

 

Total current liabilities

 

240,142

 

255,629

 

 

 

 

 

 

 

Long-term debt

 

587,794

 

587,653

 

Deferred revenue

 

16,468

 

11,557

 

Other long-term liabilities

 

3,895

 

4,736

 

Deferred tax liabilities

 

126,376

 

140,959

 

Total liabilities

 

974,675

 

1,000,534

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock; no par value per share; 2,500,000 shares authorized; none issued

 

 

 

Common stock; $0.0033 par value per share; 500,000,000 shares authorized; 110,240,600 and 109,719,900 shares outstanding

 

364

 

362

 

Additional paid-in capital

 

893,408

 

880,202

 

Retained earnings

 

1,432,826

 

1,353,047

 

Accumulated other comprehensive income

 

6,219

 

9,538

 

Treasury stock, at cost: 6,010,600 shares and zero shares, respectively

 

(182,585

)

 

Total stockholders’ equity

 

2,150,232

 

2,243,149

 

Total liabilities and stockholders’ equity

 

$

3,124,907

 

$

3,243,683

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

1



 

WATSON PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited; in thousands, except per share amounts)

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

416,266

 

$

399,368

 

$

817,094

 

$

809,026

 

Cost of sales

 

211,213

 

198,854

 

418,163

 

395,335

 

Gross profit

 

205,053

 

200,514

 

398,931

 

413,691

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development

 

31,486

 

42,529

 

60,324

 

72,210

 

Selling, general and administrative

 

68,125

 

79,169

 

131,776

 

156,580

 

Amortization

 

41,101

 

17,983

 

81,739

 

35,915

 

Total operating expenses

 

140,712

 

139,681

 

273,839

 

264,705

 

Operating income

 

64,341

 

60,833

 

125,092

 

148,986

 

 

 

 

 

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Equity in losses of joint ventures

 

(578

)

(1,700

)

(158

)

(3,279

)

Loss on impairment of investments and other assets

 

 

 

 

(891

)

Gain on sales of securities

 

 

 

 

3,938

 

Loss on early extinguishment of debt

 

 

(3,746

)

 

(17,752

)

Interest income

 

4,546

 

1,015

 

8,652

 

2,222

 

Interest expense

 

(3,624

)

(1,647

)

(6,914

)

(5,390

)

Other income (expense)

 

185

 

(176

)

(39

)

(340

)

Total other income (expense), net

 

529

 

(6,254

)

1,541

 

(21,492

)

Income before income taxes

 

64,870

 

54,579

 

126,633

 

127,494

 

Provision for income taxes

 

24,002

 

19,652

 

46,854

 

45,908

 

Net income

 

$

40,868

 

$

34,927

 

$

79,779

 

$

81,586

 

 

 

 

 

 

 

 

 

 

 

Earnings per share (as restated per Note 1):

 

 

 

 

 

 

 

 

 

Basic

 

$

0.38

 

$

0.32

 

$

0.74

 

$

0.75

 

Diluted

 

$

0.35

 

$

0.29

 

$

0.68

 

$

0.67

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding (as restated per Note 1):

 

 

 

 

 

 

 

 

 

Basic

 

106,359

 

109,049

 

107,740

 

108,839

 

Diluted

 

121,253

 

124,682

 

122,671

 

124,973

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

2



 

WATSON PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited; in thousands)

 

 

 

Six Months Ended
June 30,

 

 

 

2005

 

2004

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

79,779

 

$

81,586

 

Reconciliation to net cash provided by operating activities:

 

 

 

 

 

Depreciation

 

19,639

 

15,075

 

Amortization

 

81,739

 

35,915

 

Deferred income tax (provision) benefit

 

(12,130

)

16,434

 

Equity in losses of joint ventures

 

158

 

3,279

 

Gain on sales of securities

 

 

(3,938

)

Loss on early extinguishment of debt

 

 

17,752

 

Loss on sale of fixed assets

 

620

 

 

Loss on impairment of investments and other assets

 

 

891

 

Tax benefits from employee stock plans

 

1,606

 

5,854

 

Mark to market on derivative

 

(841

)

(3,154

)

Other

 

(1,006

)

(626

)

Changes in assets and liabilities:

 

 

 

 

 

Accounts receivable, net

 

(19,799

)

555

 

Inventories

 

31,991

 

8,274

 

Prepaid expenses and other current assets

 

6,352

 

(5,355

)

Accounts payable and accrued expenses

 

(5,893

)

(4,715

)

Deferred revenue

 

3,858

 

(6,433

)

Income taxes payable

 

(8,541

)

(65,781

)

Other assets

 

1,412

 

933

 

Total adjustments

 

99,165

 

14,960

 

Net cash provided by operating activities

 

178,944

 

96,546

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Additions to property and equipment

 

(38,103

)

(43,094

)

Acquisitions of product rights

 

(427

)

(5,627

)

Additions to long-term investments

 

(1,500

)

(10,590

)

Distribution from joint venture

 

2,500

 

 

Proceeds from sales of marketable securities

 

220,083

 

26,706

 

Proceeds from sale of Halsey note receivable

 

 

5,381

 

Other investing activities, net

 

 

1,983

 

Net cash provided by (used in) investing activities

 

182,553

 

(25,241

)

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Payments to repurchase 1998 Senior Notes

 

 

(135,905

)

Premium paid on 1998 Senior Notes repurchase

 

 

(17,072

)

Repurchase of common stock

 

(182,585

)

 

Principal payments on acquisition liabilities

 

(5

)

(5

)

Proceeds from stock plans

 

11,175

 

22,663

 

Net cash used in financing activities

 

(171,415

)

(130,319

)

Net increase (decrease) in cash and cash equivalents

 

190,082

 

(59,014

)

Cash and cash equivalents at beginning of period

 

298,653

 

318,043

 

Cash and cash equivalents at end of period

 

$

488,735

 

$

259,029

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

3



 

WATSON PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1 – GENERAL

 

Watson Pharmaceuticals, Inc. (Watson or the Company) 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 Company’s 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 financial statements are unaudited, but reflect all adjustments which are, in the opinion of management, necessary to fairly state Watson’s 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 Company’s 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

 

Comprehensive income includes all changes in equity during a period except those that resulted from investments by or distributions to the Company’s 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.  Watson’s 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):

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

Net income

 

$

40,868

 

$

34,927

 

$

79,779

 

$

81,586

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive loss:

 

 

 

 

 

 

 

 

 

Unrealized holding loss on securities

 

(1,794

)

(686

)

(5,293

)

(783

)

Less related income taxes

 

669

 

247

 

1,974

 

282

 

Total unrealized loss on securities, net

 

(1,125

)

(439

)

(3,319

)

(501

)

 

 

 

 

 

 

 

 

 

 

Reclassification for losses included in net income

 

 

 

 

(1,092

)

Less related income taxes

 

 

 

 

393

 

Total reclassification, net

 

 

 

 

(699

)

Total other comprehensive loss

 

(1,125

)

(439

)

(3,319

)

(1,200

)

Total comprehensive income

 

$

39,743

 

$

34,488

 

$

76,460

 

$

80,386

 

 

4



 

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.  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):

 

 

 

Three months ended
June 30,

 

Six months ended
June 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - basic

 

 

 

 

 

 

 

 

 

Net income

 

$

40,868

 

$

34,927

 

$

79,779

 

$

81,586

 

 

 

 

 

 

 

 

 

 

 

Basic weighted average common shares outstanding

 

106,359

 

109,049

 

107,740

 

108,839

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - basic

 

$

0.38

 

$

0.32

 

$

0.74

 

$

0.75

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - assuming dilution

 

 

 

 

 

 

 

 

 

Net income

 

$

40,868

 

$

34,927

 

$

79,779

 

$

81,586

 

Add: Interest expense on CODES, net of tax

 

1,814

 

639

 

3,441

 

2,512

 

Net income, adjusted

 

$

42,682

 

$

35,566

 

$

83,220

 

$

84,098

 

 

 

 

 

 

 

 

 

 

 

Basic weighted average common shares outstanding

 

106,359

 

109,049

 

107,740

 

108,839

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Conversion of CODES

 

14,357

 

14,357

 

14,357

 

14,357

 

Dilutive stock options

 

537

 

1,276

 

574

 

1,777

 

Diluted weighted average common shares outstanding

 

121,253

 

124,682

 

122,671

 

124,973

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - diluted

 

$

0.35

 

$

0.29

 

$

0.68

 

$

0.67

 

 

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 June 30, 2005 and 2004, stock options to purchase 6.5 million common shares were outstanding but were not included in the computation of diluted earnings per share because the options were antidilutive.  For the six month periods ended June 30, 2005 and 2004 stock options to purchase 6.5 million and 6.1 million common shares, respectively, were outstanding but were not included in the computation of diluted earnings per share because they were anti-dilutive.

 

Stock-based compensation

 

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.

 

5



 

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 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 awards to employees.  The Company estimates the fair value of its stock-based awards to employees 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):

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

Net income, as reported

 

$

40,868

 

$

34,927

 

$

79,779

 

$

81,586

 

Deduct: Total stock-based employee compensation
expense determined under fair value based method for all awards, net of related tax effects

 

2,869

 

4,103

 

5,967

 

8,592

 

Pro forma net income

 

37,999

 

30,824

 

73,812

 

72,994

 

Add: Interest expense on CODES

 

1,814

 

639

 

3,441

 

2,512

 

Pro forma net income, adjusted

 

$

39,813

 

$

31,463

 

$

77,253

 

$

75,506

 

Earnings per share:

 

 

 

 

 

 

 

 

 

Basic - as reported

 

$

0.38

 

$

0.32

 

$

0.74

 

$

0.75

 

Basic - pro forma

 

$

0.36

 

$

0.28

 

$

0.69

 

$

0.67

 

 

 

 

 

 

 

 

 

 

 

Diluted - as reported

 

$

0.35

 

$

0.29

 

$

0.68

 

$

0.67

 

Diluted - pro forma

 

$

0.33

 

$

0.25

 

$

0.63

 

$

0.60

 

 

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 six months ended June 30, 2005 and 2004:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

Dividend yield

 

None

 

None

 

None

 

None

 

Expected volatility

 

44

%

49

%

37

%

38

%

Risk-free interest rate

 

3.96

%

3.78

%

3.98

%

3.78

%

Expected term in years

 

5.3

 

5.1

 

5.4

 

5.2

 

 

 

 

 

 

 

 

 

 

 

Weighted average fair value

 

 

 

 

 

 

 

 

 

per share at grant date

 

$

13.51

 

$

14.93

 

$

12.12

 

$

13.65

 

 

6



 

The following weighted average assumptions were used for the ESPP during the three and six months ended June 30, 2005 and 2004:

 

 

 

Three and Six Months Ended
June 30,

 

 

 

2005

 

2004

 

Dividend yield

 

None

 

None

 

Expected volatility

 

26%

 

38%

 

Risk-free interest rate

 

4.00%

 

3.78%

 

Expected term

 

6 months

 

6 months

 

 

 

 

 

 

 

Weighted average fair value per share at grant date

 

$

7.31

 

$

11.83

 

 

Stock Awards

 

We implemented certain changes in employee stock-based compensation during the second quarter of 2005 to help us strengthen our ability to attract, retain and motivate our employees, and to better align employee interests with those of our shareholders. Generally, employees are now granted restricted stock awards as well as stock options. The stock award program offers employees the opportunity to earn shares of our stock over time, rather than options that give employees the right to purchase stock at a set price. Restricted stock awards are grants that entitle the holder to shares of common stock as the award vests.  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 Company’s Chief Executive Officer.  These restricted stock awards generally vest over a one to four year period.

 

Stock Repurchases

 

We have repurchased approximately 6.0 million shares of our common stock at an aggregate cost of approximately $182.6 million under the Company’s $300.0 million stock repurchase program approved by the Board of Directors (Board) on February 10, 2005.  As of June 30, 2005, the Company had approximately $117.4 million available for future repurchases of its common stock under this Board authorization.  This program provides for purchases to be made in the open market or in privately negotiated transactions through February 10, 2006.

 

Recent accounting pronouncements

 

In November 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (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 “so 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

 

7



 

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 the method of adoption or the effect of adopting SFAS 123R, and it has not determined whether the adoption will result in 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 FAS 123R.  The amendment requires each registrant that is not a small business issuer to adopt FAS 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 FAS 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 to our consolidated financial statements, as is our current practice.

 

NOTE 2 – INVESTMENTS

 

The Company’s 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 Company’s Condensed Consolidated Balance Sheets.

 

The Company’s 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 Watson’s available-for-sale securities at June 30, 2005 and December 31, 2004 (in thousands):

 

At June 30, 2005

 

Cost, Including
Accrued Interest

 

Gross Unrealized
Gains

 

Gross Unrealized
Losses

 

Fair Value

 

Available-for-sale:

 

 

 

 

 

 

 

 

 

U.S. Treasury securities

 

$

149,947

 

$

 

$

(1,232

)

$

148,715

 

Equity securities - current

 

1,572

 

10,762

 

 

12,334

 

Current

 

151,519

 

10,762

 

(1,232

)

161,049

 

Equity securities - non-current

 

2,032

 

723

 

(300

)

2,455

 

Total

 

$

153,551

 

$

11,485

 

$

(1,532

)

$

163,504

 

 

At December 31, 2004

 

Cost, Including
Accrued Interest

 

Gross Unrealized
Gains

 

Gross Unrealized
Losses

 

Fair Value

 

Available-for-sale:

 

 

 

 

 

 

 

 

 

U.S. Treasury securities

 

$

198,828

 

$

 

$

(105

)

$

198,723

 

Auction rate securities

 

169,699

 

 

 

169,699

 

Equity securities - current

 

1,572

 

11,685

 

 

13,257

 

Current

 

370,099

 

11,685

 

(105

)

381,679

 

Equity securities - non-current

 

2,032

 

3,290

 

 

5,322

 

Total

 

$

372,131

 

$

14,975

 

$

(105

)

$

387,001

 

 

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.

 

8



 

Gross unrealized gains at June 30, 2005 and December 31, 2004 primarily relate to our holdings in shares of Andrx Corporation (Andrx) common stock.  The gross unrealized holding loss at June 30, 2005 and December 31, 2004 is attributable to adjustments, included in other comprehensive income, for the decline in fair value in the Company’s investment in U.S. Treasury securities.

 

Net unrealized holding gains related to available-for-sale securities were $9.9 million and $20.4 million for the six month periods ended June 30, 2005 and 2004, respectively.  Changes in the Company’s net unrealized holding gains (losses) are included in other comprehensive income (loss).

 

Current investments

 

The Company’s 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 Company’s Condensed Consolidated Balance Sheets at June 30, 2005 and December 31, 2004.

 

The Company did not sell any of its shares of Andrx during the six month period ended June 30, 2005.     During the six month period ended June 30, 2004, Watson sold 150,000 shares of its investment in the common stock of Andrx for proceeds of $4.3 million and recorded a pre-tax gain of $3.9 million.  Realized gains are computed using the specific identification method to determine the cost basis for each investment.

 

The Company’s investments in U.S. Treasury securities and auction rate securities are classified as a current investment on the Company’s Condensed Consolidated Balance Sheet at June 30, 2005 and December 31, 2004.

 

The contractual maturities of the U.S. Treasury securities consisted of the following (in thousands):

 

 

 

June 30,
2005

 

December 31,
2004

 

Mature within one year

 

$

 

$

49,502

 

Mature within two years

 

148,715

 

149,221

 

 

 

$

148,715

 

$

198,723

 

 

Non-current investments

 

The Company’s 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 Company’s Condensed Consolidated Balance Sheets at June 30, 2005 and December 31, 2004.

 

NOTE 3 – OPERATING SEGMENTS

 

Watson has two operating segments: brand and generic.  The brand business segment includes the Company’s lines of Specialty Products and Nephrology products. 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 gross profit and contribution. Segment contribution represents segment gross profit less direct research and

 

9



 

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 has not reported 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.  Net revenues, segment gross profit and segment contribution information for the Company’s brand and generic segments, as reclassified, consisted of the following:

 

Three Months Ended June 30, 2005 Compared to the Three Months Ended June 30, 2004

 

 

 

Brand

 

Generic

 

Total

 

Three months ended June 30, 2005

 

 

 

 

 

 

 

Product sales

 

$

100,746

 

$

312,453

 

$

413,199

 

Other

 

1,918

 

1,149

 

3,067

 

Net revenues

 

102,664

 

313,602

 

416,266

 

Cost of revenue

 

23,072

 

188,141

 

211,213

 

Gross profit

 

79,592

 

125,461

 

205,053

 

Gross margin

 

78

%

40

%

49

%

 

 

 

 

 

 

 

 

Research and development

 

9,668

 

21,818

 

31,486

 

Selling and marketing

 

30,532

 

11,688

 

42,220

 

Contribution

 

$

39,392

 

$

91,955

 

131,347

 

Contribution margin

 

38

%

29

%

32

%

 

 

 

 

 

 

 

 

General and administrative

 

 

 

 

 

25,905

 

Amortization

 

 

 

 

 

41,101

 

Operating income

 

 

 

 

 

$

64,341

 

 

 

 

Brand

 

Generic

 

Total

 

Three months ended June 30, 2004

 

 

 

 

 

 

 

Product sales

 

$

84,510

 

$

305,566

 

$

390,076

 

Other

 

2,637

 

6,655

 

9,292

 

Net revenues

 

87,147

 

312,221

 

399,368

 

Cost of revenue

 

19,577

 

179,277

 

198,854

 

Gross profit

 

67,570

 

132,944

 

200,514

 

Gross margin

 

78

%

43

%

50

%

 

 

 

 

 

 

 

 

Research and development

 

25,479

 

17,050

 

42,529

 

Selling and marketing

 

42,066

 

11,156

 

53,222

 

Contribution

 

$

25

 

$

104,738

 

104,763

 

Contribution margin

 

0

%

34

%

26

%

 

 

 

 

 

 

 

 

General and administrative

 

 

 

 

 

25,947

 

Amortization

 

 

 

 

 

17,983

 

Operating income

 

 

 

 

 

$

60,833

 

 

10



 

Six Months Ended June 30, 2005 Compared to the Six Months Ended June 30, 2004

 

 

 

Brand

 

Generic

 

Total

 

Six months ended June 30, 2005

 

 

 

 

 

 

 

Product sales

 

$

205,272

 

$

605,616

 

$

810,888

 

Other

 

3,971

 

2,235

 

6,206

 

Net revenues

 

209,243

 

607,851

 

817,094

 

Cost of revenue

 

46,832

 

371,331

 

418,163

 

Gross profit

 

162,411

 

236,520

 

398,931

 

Gross margin

 

78

%

39

%

49

%

 

 

 

 

 

 

 

 

Research and development

 

19,362

 

40,962

 

60,324

 

Selling and marketing

 

58,000

 

22,948

 

80,948

 

Contribution

 

$

85,049

 

$

172,610

 

257,659

 

Contribution margin

 

41

%

28

%

32

%

 

 

 

 

 

 

 

 

General and administrative

 

 

 

 

 

50,828

 

Amortization

 

 

 

 

 

81,739

 

Operating income

 

 

 

 

 

$

125,092

 

 

 

 

Brand

 

Generic

 

Total

 

Six months ended June 30, 2004

 

 

 

 

 

 

 

Product sales

 

$

172,886

 

$

611,588

 

$

784,474

 

Other

 

8,659

 

15,893

 

24,552

 

Net revenues

 

181,545

 

627,481

 

809,026

 

Cost of revenue

 

37,228

 

358,107

 

395,335

 

Gross profit

 

144,317

 

269,374

 

413,691

 

Gross margin

 

79

%

43

%

51

%

 

 

 

 

 

 

 

 

Research and development

 

37,250

 

34,960

 

72,210

 

Selling and marketing

 

84,668

 

20,449

 

105,117

 

Contribution

 

$

22,399

 

$

213,965

 

236,364

 

Contribution margin

 

12

%

34

%

29

%

 

 

 

 

 

 

 

 

General and administrative

 

 

 

 

 

51,463

 

Amortization

 

 

 

 

 

35,915

 

Operating income

 

 

 

 

 

$

148,986

 

 

NOTE 4 – INVENTORIES

 

Inventories consist of finished goods held for sale and distribution, raw materials and work-in-process. Included in inventory at June 30, 2005 and December 31, 2004 is approximately $6.7 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.

 

11



 

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):

 

 

 

June 30,
2005

 

December 31,
2004

 

Raw materials

 

$

107,309

 

$

109,422

 

Work-in-process

 

61,624

 

70,207

 

Finished goods

 

120,375

 

141,670

 

Total inventories

 

$

289,308

 

$

321,299

 

 

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 Company’s 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’s two reporting units are brand and generic pharmaceutical products.  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 the carrying amount exceeds the fair value of the asset.

 

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 six months ended June 30, 2005.  At June 30, 2005 and December 31, 2004, goodwill for the Company’s reporting units consisted of the following (in thousands):

 

Brand pharmaceutical products

 

$

368,105

 

Generic pharmaceutical products

 

87,490

 

Total goodwill

 

$

455,595

 

 

Other intangible assets consist primarily of product rights.  The original cost and accumulated amortization of these intangible assets are as follows (in thousands):

 

 

 

June 30,
2005

 

December 31,
2004

 

Product rights and related intangibles

 

$

1,266,938

 

$

1,266,512

 

Less accumulated amortization

 

(435,504

)

(353,766

)

Total product rights and related intangibles, net

 

$

831,434

 

$

912,746

 

 

The Company’s 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

 

12



 

estimated to be as follows (in thousands):

 

Period ending December 31,

 

2005

 

$

82,201

 

2006

 

164,402

 

2007

 

164,402

 

2008

 

53,452

 

2009

 

52,491

 

Thereafter

 

314,486

 

Total

 

$

831,434

 

 

NOTE 6 – LONG-TERM DEBT

 

Long-term debt consisted of the following (in thousands):

 

 

 

June 30,
2005

 

December 31,
2004

 

 

 

 

 

 

 

CODES, face amount of $575 million, due 2003,
net of unamortized discount

 

$

573,711

 

$

573,573

 

Senior unsecured notes, 7.125%, face amount of $14 million,
due 2008, net of unamortized discount

 

14,045

 

14,036

 

Other notes payable

 

38

 

44

 

Total long-term debt

 

$

587,794

 

$

587,653

 

 

CODES

 

In March 2003, the Company issued $575 million of CODES.  The CODES, which are convertible into shares of Watson’s 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 June 30, 2005 and at December 31, 2004, the unamortized discount for the CODES was $1.3 million and $1.4 million, respectively.

 

The CODES are convertible into Watson’s 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 Watson’s 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 and at June 30, 2005;

 

13



 

                  during any period, following the earlier of (a) the date the CODES are rated by both Standard & Poor’s Rating Services and Moody’s Investor Services, Inc., and (b) April 21, 2003, when the long-term credit rating assigned to the CODES by either Standard & Poor’s or Moody’s (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 and at June 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 Company’s 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 June 30, 2005 and December 31, 2004 the current value of the embedded derivative was $846,000 and $1,687,000, respectively.

 

1998 Senior Notes

 

In May 1998, Watson issued $150 million of its senior unsecured notes (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 June 30, 2005 and December 31, 2004, the unamortized discount for the 1998 Senior Notes was $50,000 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.

 

14



 

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.

 

Credit Facility

 

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. Watson’s 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 June 30, 2005, the Company was in compliance.  As of June 30, 2005, the Company had not drawn any funds from the Credit Facility.

 

NOTE 7 – FINANCIAL INSTRUMENTS

 

Fair value of financial instruments

 

The Company’s 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 Company’s 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 June 30, 2005, no value has been assigned to these instruments.  The contingent interest feature provides unique tax treatment under the Internal Revenue Service’s Contingent Debt Regulations.  In essence, interest accrues, for tax purposes, on the basis of the instrument’s comparable yield (the yield at which the issuer would issue a fixed rate instrument with similar terms). This embedded derivative is reported on the Company’s Condensed Consolidated Balance Sheets at fair value and the changes in the fair value of the embedded derivative are reported as gains or losses in the Company’s Condensed Consolidated Statements of Income.

 

The carrying value of the Company’s derivative financial instruments, which approximates fair value, decreased $841,000 from $1,687,000 at December 31, 2004 to $846,000 at June 30, 2005.  The change in fair value was recorded as an adjustment to interest expense during the respective period.

 

15



 

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 Company’s facilities require the Company to pay property taxes, normal maintenance expenses and maintain minimum insurance coverage.  Total rental expense for operating leases for the six months ended June 30, 2005 and 2004 were $5.5 million and $6.2 million, respectively.

 

Remaining future minimum lease payments under all non-cancelable operating leases are as follows (in thousands):

 

Period ending December 31,

 

2005

 

$

4,586

 

2006

 

7,127

 

2007

 

5,526

 

2008

 

3,355

 

2009

 

2,604

 

Thereafter

 

14,298

 

Total

 

$

37,496

 

 

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.  Watson’s contributions to these retirement plans for the three and six months ended June 30, 2005 were $1.6 million and $3.3 million, respectively.  Watson’s contributions to these retirement plans for the three and six months ended June 30, 2004 were $2.4 million and $3.8 million, respectively.

 

Legal matters

 

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 August 8, 2005, approximately 50 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 Rugby’s 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 May 7, 2005, three groups of plaintiffs from the consolidated action (In re: Ciprofloxacin Hydrochloride Antitrust Litigation, MDL Docket No. 001383), including the direct purchaser plaintiffs, the indirect purchaser plaintiffs, and plaintiffs Rite Aid and CVS, filed Notices of Appeal in the United States Court of Appeals for the Second Circuit, appealing, among other things, the March 31, 2005 Order

 

16



 

by the United States District Court for the Eastern District of New York granting summary judgment in favor of the defendants.

 

Governmental Reimbursement Investigations and Drug Pricing Litigation. With respect to the Drug Pricing Litigation pending against the Company and certain subsidiaries, additional actions raising similar allegations were filed in June and July of 2005, including actions by six counties in New York State (County of Columbia v. Abbott Laboratories, Inc., et al., United States District Court for the Northern District of New York, Case No. 05-CV-0867-GLS/RFTl; County of Cortland v. Abbott Laboratories, Inc., et al., United States District Court for the Northern District of New York, Case No. 05-CV-0881-NAM/GJD; County of Dutchess v. Abbott Laboratories, Inc., et al., United States District Court for the Southern District of New York, Case No. 05-CV-06458-ESJ/KNF; Essex County v. Abbott Laboratories, Inc., et al., United States District Court for the Northern District of New York, Case No. 05-CV-0878-TJM/DRH; County of Lewis v. Abbott Laboratories, Inc., et al., United States District Court for the Northern District of New York, Case No. 05-CV-0839-DNH/GHL; and County of Orleans v. Abbott Laboratories, Inc., et al., United States District Court for the Western District of New York, Case No. 05-CV-06371-MAT).  In 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), on June 15, 2005, a separate consolidated complaint was filed that adds six other New York counties (County of Jefferson, County of Madison, County of Niagra, County of Putnam, County of Steuben, and County of Suffolk) to those that had earlier sued the Company and certain subsidiaries.  On July 20, 2005, an action was filed against the Company and a subsidiary by the Attorney General for the State of Florida (The State of Florida ex rel. Ven-A-Care of the Florida Keys, Inc. et al. v. Mylan Laboratories, Inc. et al., Civil Action No. 98-3032G, Florida Leon County Court).  As of August 8, 2005, in addition to the Consolidated Action pending in the United States District Court for the District of Massachusetts, there were approximately 45 plaintiffs in 40 cases pending against the Company or its subsidiaries and other third parties, including actions by eight State Attorneys General, the City of New York, and 36 counties in New York State. The defendants have removed several of these actions (originally filed in state court) to federal court, and are seeking eventual transfer of these cases into the Consolidated Action.  However, the plaintiffs have filed motions to remand several of the cases back to state court. The Company has been served in several of the actions filed by New York counties. 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 Company’s business, results of operations, financial condition and cash flows.

 

Securities Litigation.  On May 31, 2005, the appellants in the action pending in the U.S. Court of Appeals for the Ninth Circuit (Pension Fund v. Watson Pharmaceuticals, Inc., USCA Docket No. 04-56791) filed their reply brief.  The appellate court has not yet scheduled a hearing on the appeal.

 

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 August 8, 2005, there were approximately 90 cases pending against the Company and its affiliates in various state and federal courts, representing claims by approximately 800 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 Company’s 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.

 

17



 

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

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.  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.

 

Overview

 

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 June 30, 2005 Compared to the Three Months Ended June 30, 2004

 

Net Revenues

 

 

 

Three Months Ended June 30,

 

Change

 

($ in thousands):

 

2005

 

2004

 

Dollars

 

%

 

 

 

 

 

 

 

 

 

 

 

Generic product sales

 

$

312,453

 

$

305,566

 

$

6,887

 

2.3

%

% of product net sales

 

76

%

78

%

 

 

 

 

Brand product sales

 

 

 

 

 

 

 

 

 

Specialty Products

 

54,710

 

43,075

 

11,635

 

27.0

%

Nephrology

 

46,036

 

41,435

 

4,601

 

11.1

%

Total brand product sales

 

100,746

 

84,510

 

16,236

 

19.2

%

% of product net sales

 

24

%

22

%

 

 

 

 

Total product net sales

 

413,199

 

390,076

 

23,123

 

5.9

%

Other

 

3,067

 

9,292

 

(6,225

)

-67.0

%

Total net revenues

 

$

416,266

 

$

399,368

 

$

16,898

 

4.2

%

 

Generic Products

 

Our generic pharmaceutical business 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

 

18



 

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 June 30, 2005 increased 2.3% over sales from the same period of the prior year.   Increased sales of oral contraceptives and bupropion sustained release were partially offset by a decrease in sales of nicotine gum due to the entry of a competitor in that product line in December 2004 and selective price declines in certain other products.

 

Sales of oral contraceptive products represented 25% and 22% of total generic sales for the three months ended June 30, 2005 and 2004, respectively.  Generic oral contraceptive product sales were lower during the prior year period due to wholesaler destocking.

 

Brand Products

 

Our brand pharmaceutical business develops, manufactures, markets, sells and distributes products within two sales and marketing groups: Specialty Products and Nephrology.

 

Our Specialty Products product line consists primarily of products for the treatment of urologic disorders.  Our Specialty Product portfolio also includes: (i) anti-hypertensive, psychiatry, pain management and dermatology products, (ii) a genital warts treatment, and (iii) a visual cervical screening device.

 

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 of the Nephrology group is Ferrlecit®, which is used to treat low iron levels in patients undergoing hemodialysis in conjunction with erythropoietin therapy.

 

The $16.2 million or 19% increase in sales from our brand segment for the three months ended June 30, 2005, as compared to the same prior year period, was primarily attributable to an increase in sales within our Specialty Products group.  The increase in sales of Specialty Products resulted primarily from the launch of our Trelstar® Depot and Trelstar® LA (collectively “Trelstar®”) products for the palliative treatment of advanced prostate cancer and higher sales of our Oxytrol® product.

 

Sales from our Nephrology business increased $4.6 million or 11.1% due to an increase in sales of our Ferrlecit® product.  Ferrlecit® represented approximately 79% of sales from our Nephrology business.

 

Other

 

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 contract’s 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 June 30, 2005 was primarily related to the absence of royalty payments from Aventis Pharmaceuticals (Aventis, formerly known as Hoechst Marion Roussel, Inc., and now known as Sanofi-Aventis) in connection with Barr Laboratories, Inc.’s sales of ciprofloxacin tablets.  Several companies launched competitive products into the ciprofloxacin market during the second half of 2004.

 

19



 

Gross Profit Margin (Gross Margin)

 

 

 

Three Months Ended
June 30,

 

 

 

2005

 

2004

 

Change

 

 

 

 

 

 

 

 

 

Overall Consolidated Gross Margin

 

49.3

%

50.2

%

-0.9

%

 

 

 

 

 

 

 

 

Generic product sales

 

39.8

%

41.3

%

-1.5

%

Brand product sales

 

77.1

%

76.8

%

0.3

%

Gross margin on product net sales

 

48.9

%

49.0

%

-0.1

%

 

Gross profit increased by $4.6 million to $205.1 million during the three months ended June 30, 2005 from $200.5 million during same period of 2004.  The primary contributors to the gross profit improvement were improved efficiencies and cost reductions.  However, such improvements were offset by price erosion within certain products in our generic segment.

 

The $6.2 million decrease in other revenues during the three months ended June 30, 2005 was a significant factor in the reduction of our overall consolidated gross margin as compared to the same period of the prior year.

 

Research and Development Expenses

 

 

 

Three Months Ended June 30,

 

Change

 

($ in thousands):

 

2005

 

2004

 

Dollars

 

%

 

 

 

 

 

 

 

 

 

 

 

Research and development expenses by segment:

 

 

 

 

 

 

 

 

 

Generic

 

$

21,818

 

$

17,050

 

$

4,768

 

28.0

%

Brand

 

9,668

 

25,479

 

(15,811

)

-62.1

%

Total research and development expenses

 

$

31,486

 

$

42,529

 

$

(11,043

)

-26.0

%

as % of net revenues

 

7.6

%

10.6

%

 

 

 

 

 

Research and development expenses consist predominantly of personnel costs, contract research, development and facilities costs associated with the development of our products.

 

Generic research and development expenses increased during the three months ended June 30, 2005, as compared to the same period of the prior year, due to an increase in the number of generic products being developed in conjunction with our development partners. Our Abbreviated New Drug Application (ANDA) count at June 30, 2005 was 40, which is up from the 33 ANDAs, on file as of December 31, 2004.

 

Brand research and development expenses for 2004 included a $10 million milestone payment to Kissei Pharmaceutical Co., Ltd., related to silodosin, Watson’s investigational drug to treat the signs and symptoms of Benign Prostatic Hyperplasia (BPH).   In addition, research and development expenses within our brand segment decreased due to the timing of the commencement of development programs and clinical studies.

 

20



 

Selling, General and Administrative Expenses

 

 

 

Three Months Ended June 30,

 

Change

 

($ in thousands):

 

2005

 

2004

 

Dollars

 

%

 

 

 

 

 

 

 

 

 

 

 

Selling and marketing expenses by segment:

 

 

 

 

 

 

 

 

 

Generic

 

$

11,688

 

$

11,156

 

$

532

 

4.8

%

Brand

 

30,532

 

42,066

 

(11,534

)

-27.4

%

Total segment selling and marketing expenses

 

42,220

 

53,222

 

(11,002

)

-20.7

%

Corporate general and administrative

 

25,905

 

25,947

 

(42

)

-0.2

%