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 MARCH 31, 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
The number of shares outstanding of the Registrants only class of common stock as of May 6, 2005 was approximately 110,168,370.
WATSON PHARMACEUTICALS, INC.
TABLE OF CONTENTS
FORM 10-Q FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005
WATSON PHARMACEUTICALS, INC.
(Unaudited; in thousands, except share amounts)
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 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 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 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 present fairly 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 income refers to revenues, expenses, gains and losses that, under generally accepted accounting principles, are included in comprehensive income, but excluded from net income as these amounts are recorded directly as an adjustment to stockholders equity. Watsons other comprehensive income (loss) is comprised of unrealized gains (losses) on its holdings of publicly traded debt and equity securities, net of realized gains (losses) included in net income. The components of comprehensive income and related income taxes consisted of the following (in thousands):
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 anti-dilutive. In accordance with Emerging Issues Task Force (EITF) Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share, 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. A reconciliation of the numerators and denominators of basic and diluted earnings per share consisted of the following (in thousands, except per share amounts):
Stock options to purchase 6.6 million and 5.5 million common shares for the three month periods ended March 31, 2005 and 2004, respectively, were outstanding but were not included in the computation of diluted earnings per share because the options 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 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):
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 months ended March 31, 2005 and 2004:
The following weighted average assumptions were used for the ESPP during the three months ended March 31, 2005 and 2004:
Under the Companys $300.0 million stock repurchase program approved by the Board of Directors (Board) on February 10, 2005, we repurchased approximately 2.2 million shares of our common stock during the first quarter of 2005 at an aggregate cost of approximately $69.1 million. As of March 31, 2005, the Company had approximately $230.9 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 2006.
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 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 this Statement 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 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 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 significant impact
on our consolidated financial statements, as we will be required to expense the fair value of our employee stock option 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 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 investment and other assets, as appropriate, on the Companys Condensed Consolidated Balance Sheets.
The Companys debt investments in U.S. Treasury securities and auction rate 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 March 31, 2005 and December 31, 2004 (in thousands):
Gross unrealized gains at March 31, 2005 and December 31, 2004 primarily relate to our holdings in shares of Andrx Corporation (Andrx) common stock. The gross unrealized holding loss at March 31, 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 holding gain related to its available-for-sale securities decreased $2.2 million for the three month period ended March 31, 2005. During the three month period ended March 31, 2004, the Companys net unrealized holding gain decreased $0.8 million. These changes in the Companys net unrealized holding gain are included in other comprehensive 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 March 31, 2005 and December 31, 2004.
The Company did not sell any of its shares of Andrx during the three month period ended March 31, 2005. During the three month period ended March 31, 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 Companys investments in U.S. Treasury securities and auction rate securities are classified as a current investment on the Companys Condensed Consolidated Balance Sheet at March 31, 2005 and December 31, 2004.
The contractual maturities of the U.S. Treasury securities at March 31, 2005 are as follows (in thousands):
The Companys investments in the common stock of Genelabs Technologies, Inc. (Genelabs), NovaDel Pharma Inc. and Amarin Corporation plc (Amarin) are classified as non-current investments and are included in Investments and other assets on the Companys Condensed Consolidated Balance Sheets at March 31, 2005 and December 31, 2004.
NOTE 3 OPERATING SEGMENTS
Watson has two operating segments: brand and generic. The brand business segment includes the Companys lines of Specialty Products and Nephrology products. Watson has aggregated its brand product lines in a single segment because of similarities in regulatory environment, manufacturing processes, 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 net revenues and segment 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 other classification for the three month period ended March 31, 2005 and 2004 consists primarily of royalties and revenues from research, development and licensing fees. 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
and segment contribution information for the Companys brand and generic segments, as reclassified, consisted of the following:
NOTE 4 INVENTORIES
Inventories consist of finished goods held for sale and distribution, raw materials and work-in-process. Included in inventory at March 31, 2005 is approximately $9.2 million 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 Companys 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 2004, 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 three months ended March 31, 2005. At March 31, 2005 and December 31, 2004, goodwill for the Companys reporting units consisted of the following (in thousands):
Other intangible assets consist primarily of product rights. The original cost and accumulated amortization of these intangible assets are as follows (in thousands):
Assuming no additions, disposals or adjustments are made to the carrying values and/or useful lives of the assets, annual amortization expense on product rights and related intangibles is estimated to be approximately $165.0 million in 2005, 2006 and 2007 and $53.0 million in 2008 and 2009. The Companys current product rights and related intangibles have a weighted average useful life of approximately thirteen years.
NOTE 6 LONG-TERM DEBT
Long-term debt consisted of the following (in thousands):
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 at an effective annual rate of 7.2%. At March 31, 2005 and December 31, 2004, the unamortized discount for the 1998 Senior Notes was $54,000 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 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 March 31, 2005 and December 31, 2004, the unamortized discount for the CODES for both periods was $1.4 million.
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 and at March 31, 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 and at March 31, 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. The current value of the embedded derivative was $1.1 million at March 31, 2005.
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. 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 March 31, 2005, the Company was in compliance. As of March 31, 2005, 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, senior subordinated 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 March 31, 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 in the Companys Condensed Consolidated Statements of Income.
The carrying value of the Companys derivative financial instruments, which approximates fair value, decreased $0.6 million from $1.7 million at December 31, 2004 to $1.1 million at March 31, 2005. The change in fair value was recorded as a reduction of 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 three months ended March 31, 2005 and 2004 were $2.9 million and $2.8 million, respectively.
Future minimum lease payments under all non-cancelable operating leases consist of approximately $6.1 million remaining in 2005, $7.0 million in 2006, $5.5 million in 2007, $3.4 million in 2008, $2.6 million in 2009 and $14.4 million thereafter.
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. Watsons contributions to these retirement plans for the three months ended March 31, 2005 and 2004 were $1.8 million and $1.4 million, respectively. The Company does not sponsor any defined benefit retirement plans or postretirement benefit plans.
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 May 6, 2005, approximately 370 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 March 31, 2005, the U.S. District Court for the Eastern District of New York granted summary judgment in the consolidated action (In re: Ciprofloxacin Hydrochloride Antitrust Litigation, MDL Docket No. 001383) in favor of the defendants on all of plaintiffs claims, denied the plaintiffs motions for class certification, and directed the clerk of the court to close the case. The clerk entered judgment on April 5, 2005. Plaintiffs are expected to appeal. In the action pending in the California Superior Court for the County of San Diego (In re: Cipro Cases I & II, JCCP Proceeding Nos. 4154 & 4220), on April 14, 2005, the court granted the parties joint request for a stay of all proceedings, vacated all previously set dates and deadlines in the case, and set a further status conference for October 14, 2005, at which time the parties are to report on the status of the appeal of the consolidated action. In the action pending in the Kansas State Court (Sandhaus v. Bayer, et al., Johnson County Dist. Court Case No. 00CV06193), on April 22, 2005, the court granted the parties joint motion to stay all proceedings pending the outcome of the appeal in the consolidated action, vacated all pending dates and settings, and set a status conference for October 7, 2005, at which time the parties are to report on the status of the appeal in the consolidated action.
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 April and May 2005. As of May 6, 2005, in addition to 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), there were approximately 33 cases pending against the Company or its subsidiaries and other third parties, including actions by seven State Attorneys General, the City of New York, and numerous counties in New York State. Additional actions are anticipated.
These actions, if successful, could adversely affect the Company and may have a material adverse effect on the Companys business, results of operations, financial condition and cash flows.
FDA Matters. In May 2002, Watson reached an agreement with the FDA on the terms of a consent decree with respect to its Corona, California manufacturing facility. The court approved the consent decree on May 13, 2002 (United States of America v. Watson Laboratories, Inc., and Allen Y. Chao, United States District Court for the Central District of California, EDCV-02-412-VAP). From April 5, 2005 through April 13, 2005, the FDA conducted an inspection of the Companys Corona, California facility. At the conclusion of the inspection no formal observations were made and no FDA Form 483 was issued. However, if, in the future, the FDA determines that, with respect to its Corona facility, Watson has failed to comply with the consent decree or FDA regulations, including current Good Manufacturing Practices (cGMPs), the consent decree allows the FDA to order Watson to take a variety of actions to remedy the deficiencies. These actions could include ceasing manufacturing and related operations at the Corona facility, and recalling affected products. Such actions, if taken by the FDA, could adversely affect the Company, its results of operations, financial position and/or cash flows.
Securities Litigation. On March 14, 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 opening brief. The defendants filed their answering brief on April 27, 2005, and the appellants are required to file their reply brief, if any, on or before May 11, 2005.
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.
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.
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. As of March 31, 2005, we marketed more than 130 generic pharmaceutical products and more than 20 brand pharmaceutical products.
Results of Operations
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 exclusivity 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.
The $12.9 million or 4% decrease in sales from our generic segment for the first quarter of 2005 was primarily due to the following:
1. A decrease in sales of bupropion hydrochloride sustained-release tablets. Bupropion hydrochloride sustained-release tablets are a distributed product and was launched during the first quarter of 2004.
2. Price reductions on select generic products, particularly nicotine gum, as a competitor entered the nicotine gum business in December 2004.
The decrease in sales from the aforementioned products was partially offset by higher sales of our oral contraceptive products. Sales of oral contraceptive products represented 28% and 23% of total generic sales for the three months ended March 31, 2005 and 2004, respectively. Sales of oral contraceptive products for the three months ended March 31, 2005 increased approximately $11.0 million to $81.3 million, compared to $70.3 million in the prior year period.
We expect sales of generic pharmaceutical products to increase slightly in 2005 as a result of new product launches and a full year of sales for the products launched in the third and fourth quarters of 2004.
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 portfolio also includes: (i) anti-hypertensive, psychiatry, pain management and dermatology products, (ii) 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 key 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 18% increase in sales from our brand segment for the three months ended March 31, 2005, as compared to the same prior year period, was primarily attributable to an increase in sales within our Specialty Products group. During the first quarter of 2004, we experienced a decline in sales of our Androderm® product due to customer stocking in the fourth quarter of 2003 in advance of a price increase. The increase in sales of Androderm® in 2005 represents a return to normal levels. We also experienced higher sales for Oxytrol® in the first quarter of 2005 compared to the same prior year period, due to an increase in total prescription volume which occurred as a result of the impact of physician detailing and managed care accessibility.
Sales from our Nephrology business declined $2.9 million or 7% due to slight reductions in sales of our Ferrlecit® product.
We expect our Specialty Products group sales to increase during 2005 as a result of the launch of our Trelstar® Depot and Trelstar® LA (collectively Trelstar) products for the palliative treatment of advanced prostate cancer in the first half of 2005 and price increases in certain products. Product sales from our Nephrology group are expected to remain at 2004 levels.
Other revenues include royalties and revenues earned under research and development agreements. 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 March 31, 2005 was primarily related to the absence of royalty payments from Aventis Pharmaceuticals (Aventis) in connection with Barr Laboratories, Inc.s sales of ciprofloxacin tablets.
Gross Profit Margin (Gross Margin)
The decrease in gross margin from our generic segment for the three months ended March 31, 2005 was primarily due to price reductions on select generic products (particularly nicotine gum, as a competitor entered the nicotine gum business in December 2004).
Gross margin from our brand segment decreased as we decreased production levels at certain manufacturing facilities resulting in higher unit overhead absorption during the three months ended March 31, 2005 as compared to the same period of the prior year.
The $12.1 million decrease in other revenues during the three months ended March 31, 2005 was a significant factor in the reduction of our overall consolidated gross margin as compared to prior periods.
Overall gross margins are expected to be between 48.5% and 50% for the full year of 2005.
Research and Development Expenses
Research and development expenses consist predominantly of personnel costs, contract research, development and facilities costs associated with the development of our products.
Research and development expenses within our generic segment increased during the three months ended March 31, 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.
Research and development expenses within our brand segment decreased during the three months ended March 31, 2005, as compared to the same period of the prior year, primarily due to the timing of the commencement of development programs and clinical studies between the two periods.
We expect research and development expenses to increase slightly in the second quarter of 2005. Research and development spending will continue to fluctuate during the remaining quarters of 2005 in tandem with the timing of clinical study costs associated with (i) the Companys generic product pipeline, (ii) the initiation of Phase III studies on the silodosin product for benign prostatic hyperplasia, as well as (iii) studies on the next generation formulation of oxybutynin for overactive bladder.
Selling, General and Administrative Expenses
Selling, general and administrative expenses consist mainly of personnel costs, facilities costs, insurance and professional services costs, which support our sales, marketing, human resources, finance and administration functions.
Brand segment selling and marketing expenses decreased during the three months ended March 31, 2005 as compared to the same period of the prior year due to cost reductions realized from the termination of a long-term contract sales force agreement during the third quarter of 2004 and the workforce reduction resulting from the realignment of our business strategy announced in June 2004.
We expect our brand segment selling and marketing and selling, general and administrative expenses overall to increase during the second quarter of 2005 due to product launch costs associated with the April 2005 launch of our Trelstar products.
The Companys amortizable 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 changes in the markets for our products. As a result of our review, we accelerated the amortization of several product rights including the Ferrlecit® product rights. The increase in amortization expense in the first quarter of 2005 was primarily due to higher amortization associated with the Ferrlecit® product rights.
We expect amortization expense in 2005 to increase over 2004 amounts due to the accelerated amortization of the Ferrlecit® product rights and amortization related to the Trelstar product rights.
Equity in Earnings (Losses) of Joint Ventures
The Companys equity investments are accounted for under the equity-method when the Companys ownership does not exceed 50% and when the Company can exert significant influence over the management of the investee. The loss recorded during the three months ended March 31, 2004 represents our equity in losses incurred by Somerset Pharmaceuticals, Inc. (Somerset), our joint venture with Mylan Laboratories, Inc., due to expenses associated with ongoing trials, operational costs and the remaining U.S. Food and Drug Administration (FDA) requirements relating to Emsam, a selegeline patch for the treatment of depression.
Gain on Sale of Securities
The 2004 gain on sale of securities primarily resulted from the sale of a portion of our investment in the common stock of Andrx Corporation (Andrx). We sold 150,000 shares of Andrx common stock for proceeds of $4.3 million. We did not sell any securities during the three months ended March 31, 2005. At March 31, 2005, we held approximately 607,000 shares of Andrx common stock at a fair value of $13.8 million with a gross unrealized holding gain of $12.2 million.
Loss on Early Extinguishment of Debt
In February 2004, we repurchased $101.6 million of our 1998 Senior Notes for total consideration of $115.1 million, or a 13% premium over each notes face value. As a result of the repurchase, we incurred charges of $14.0 million related to fees, expenses, and the premium paid.
Interest expense decreased for the three month period ended March 31, 2005 due to the repurchase of a portion of our 1998 Senior Notes in February 2004 and a decrease in the fair value of the derivative (as described in Note 7 in the accompanying Notes to Condensed Consolidated Financial Statements in this Quarterly Report).
Liquidity and Capital Resources
Cash from Operations
Watsons primary source of liquidity is cash from operations. Net working capital at March 31, 2005 was $1.13 billion compared to $1.11 billion at December 31, 2004 and $963.2 million at March 31, 2004.
We expect that 2005 cash flows from operating activities will continue to exceed net income. In addition, management expects that 2005 cash flows from operating activities and available cash balances will be sufficient to fund our operating liquidity needs.
Summarized cash flow information is as follows:
Net cash provided by operating activities increased during the three month period ended March 31, 2005, as compared to the same period of the prior year, due primarily to a decrease in accounts receivable and the timing of annual tax payments in 2004.
Cash flows from operations is expected to exceed $320 million in 2005.
Changes in Working Capital
Working capital at March 31, 2005 and December 31, 2004 is summarized as follows:
The decrease in accounts receivable at March 31, 2005 was due to higher mix of our brand versus generic receivables. Brand products are typically sold with shorter collection terms than generic products.
Our capital expenditures are summarized as follows:
Capital expenditures for the first quarter of 2005 included costs to support the manufacture of transdermal products in Salt Lake City, various additions to machinery and equipment at our Watson locations and on-going construction of a new distribution facility in Gurnee, Illinois. We expect to spend approximately between $75 and $100 million in property and equipment additions in 2005. Most of the expected additions in 2005 will be related to our new distribution facility. Our new facility will replace an existing facility and should allow us to consolidate a portion of our existing operations upon expiration of our current lease obligations.
Debt and Borrowing Capacity
Our debt and borrowing capacity at March 31, 2005 and December 31, 2004 is summarized as follows:
In March 2003, we issued $575 million of convertible contingent senior debentures due in 2023 (CODES). As of March 31, 2005, the entire amount of the CODES remained outstanding at an effective annual interest rate of approximately 2.1%.
Between February and May 2004, we repurchased $135.9 million of our 1998 Senior Notes for total consideration of $152.5 million, or a 12% premium over each notes face value. We recorded charges of $17.8 million in 2004, related to fees, expenses, unamortized discount, and premiums paid. Interest expense in 2005 will decline as a result of the repurchase.
In May 2003, we 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. As of March 31, 2005, the total $300 million under the Credit Facility was available to us. Under the terms of the Credit Facility, each of our subsidiaries, other than minor subsidiaries, entered into a full and unconditional guarantee on a joint and several basis. In order to provide subsidiary guarantees in connection with the Credit Facility, we were required to issue similar guarantees to the 1998 Senior Note holders. We are subject to, and, as of March 31, 2005, were in compliance with financial and operation covenants under the terms of the Credit Facility. The agreement currently contains the following financial covenants:
maintenance of a minimum net worth of at least $1.6 billion at March 31, 2005 (the sum of $1.44 billion plus an amount equal to the sum of 50% of net income for each fiscal quarter after December 31, 2002);
maintenance of a maximum leverage ratio not greater than 2.25 to 1.0; and
maintenance of a minimum interest coverage ratio of at least 7.0 to 1.0.
At March 31, 2005, our net worth was $2.2 billion and our leverage ratio was 1.43 to 1.0. Our interest coverage ratio for the three months ended March 31, 2005 was 32.2 to 1.0.
Under the Credit Facility, interest coverage ratio, with respect to any financial covenant period, is defined as the ratio of EBITDA for such period to interest expense for such period. The leverage ratio, for any financial covenant period, is defined as the ratio of the outstanding principal amount of funded debt for the borrower and its subsidiaries at the end of such period, to EBITDA for such period. EBITDA under the Credit Facility, for any covenant period, is defined as net income plus (1) depreciation and amortization, (2) interest expense, (3) provision for income taxes, (4) extraordinary or unusual losses, (5) non-cash portion of nonrecurring losses and charges, (6) other non-operating, non-cash losses and (7) minority interest expense in respect of equity holdings in affiliates; minus (1) extraordinary gains, (2) interest income and (3) other non-operating, non-cash income.
The following table lists our enforceable and legally binding obligations as of March 31, 2005. Some of the amounts included herein are based on managements estimates and assumptions about these obligations, including their duration, the possibility of renewal, anticipated actions by third parties, and other factors. Because these estimates and assumptions are necessarily subjective, the enforceable and legally binding obligation we will actually pay in future periods may vary from those reflected in the table: