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Allergan Finance LLC 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q


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

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

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 001-13305


WATSON PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)

Nevada

 

95-3872914

(State or other jurisdiction of

 

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

incorporation or organization)

 

 

 

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 x   No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x

Accelerated filer o

Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

The number of shares outstanding of the Registrant’s only class of common stock as of November 3, 2006 was approximately 102,468,000.

 




 

WATSON PHARMACEUTICALS, INC.

TABLE OF CONTENTS

FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

Part I. FINANCIAL INFORMATION

 

 

 

 

Item 1.

Condensed Consolidated Financial Statements (Unaudited):

 

 

 

 

 

Condensed Consolidated Balance Sheets as of September 30, 2006 and
December 31, 2005

 

 

 

 

 

Condensed Consolidated Statements of Income for the Three and Nine Months
Ended September 30, 2006 and 2005

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 2006 and 2005

 

 

 

 

 

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 1A.

Risk Factors

 

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

 

 

 

 

Item 6.

Exhibits

 

 

 

 

Signatures

 

 




WATSON PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited; in thousands)

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

735,222

 

$

467,451

 

Marketable securities

 

171,545

 

162,475

 

Accounts receivable, net

 

264,264

 

333,832

 

Inventories

 

318,166

 

278,062

 

Prepaid expenses and other current assets

 

35,018

 

31,014

 

Deferred tax assets

 

98,242

 

87,596

 

Total current assets

 

1,622,457

 

1,360,430

 

 

 

 

 

 

 

Property and equipment, net

 

444,043

 

436,149

 

Investments and other assets

 

66,026

 

50,318

 

Deferred tax assets

 

25,172

 

25,733

 

Product rights and other intangibles, net

 

561,409

 

751,808

 

Goodwill

 

479,926

 

455,595

 

Total assets

 

$

3,199,033

 

$

3,080,033

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable and accrued expenses

 

$

253,864

 

$

211,160

 

Income taxes payable

 

76,972

 

28,789

 

Current portion of long-term debt

 

10,336

 

 

Deferred revenue

 

8,606

 

5,721

 

Total current liabilities

 

349,778

 

245,670

 

 

 

 

 

 

 

Long-term debt

 

574,078

 

587,935

 

Deferred revenue

 

18,812

 

13,891

 

Other long-term liabilities

 

1,853

 

2,504

 

Deferred tax liabilities

 

84,095

 

125,792

 

Total liabilities

 

1,028,616

 

975,792

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock

 

 

 

Common stock

 

368

 

367

 

Additional paid-in capital

 

932,883

 

923,619

 

Unearned compensation

 

 

(9,326

)

Retained earnings

 

1,529,095

 

1,485,100

 

Accumulated other comprehensive income

 

8,071

 

4,481

 

Treasury stock, at cost

 

(300,000

)

(300,000

)

Total stockholders’ equity

 

2,170,417

 

2,104,241

 

Total liabilities and stockholders’ equity

 

$

3,199,033

 

$

3,080,033

 

 

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

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

Restated

 

 

 

Restated

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

$

440,493

 

$

410,296

 

$

1,358,082

 

$

1,227,390

 

Cost of sales (excludes amortization, presented below)

 

257,896

 

210,809

 

823,510

 

628,972

 

Gross profit

 

182,597

 

199,487

 

534,572

 

598,418

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development

 

29,447

 

29,840

 

90,409

 

90,164

 

Selling, general and administrative

 

64,467

 

65,175

 

201,991

 

196,951

 

Amortization

 

39,392

 

41,100

 

121,593

 

122,839

 

Loss on impairment

 

 

 

66,981

 

 

Total operating expenses

 

133,306

 

136,115

 

480,974

 

409,954

 

Operating income

 

49,291

 

63,372

 

53,598

 

188,464

 

 

 

 

 

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

 

 

 

 

Earnings (losses) on equity method investments

 

184

 

(810

)

1,638

 

(1,685

)

Gain on sales of securities

 

 

 

3,695

 

 

Loss on early extinguishment of debt

 

 

 

(525

)

 

Interest income

 

9,601

 

4,928

 

22,766

 

13,580

 

Interest expense

 

(3,814

)

(4,690

)

(10,437

)

(11,604

)

Other expense

 

(428

)

(450

)

(420

)

(489

)

Total other income, net

 

5,543

 

(1,022

)

16,717

 

(198

)

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

54,834

 

62,350

 

70,315

 

188,266

 

Provision for income taxes

 

20,453

 

23,264

 

26,320

 

70,118

 

Net income

 

$

34,381

 

$

39,086

 

$

43,995

 

$

118,148

 

 

 

 

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.34

 

$

0.38

 

$

0.43

 

$

1.11

 

Diluted

 

$

0.31

 

$

0.35

 

$

0.43

 

$

1.02

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

101,865

 

102,966

 

101,760

 

106,131

 

Diluted

 

116,353

 

118,158

 

116,356

 

121,156

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

2




 

WATSON PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited; in thousands)

 

 

Nine Months Ended

 

 

 

September 30,

 

 

 

2006

 

2005

 

 

 

 

 

Restated

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

43,995

 

$

118,148

 

Reconciliation to net cash provided by operating activities:

 

 

 

 

 

Depreciation

 

37,027

 

30,857

 

Amortization

 

121,593

 

122,839

 

Charge for asset impairment

 

66,981

 

 

Deferred income tax (provision) benefit

 

(54,111

)

(10,746

)

Provision for inventory reserve

 

18,126

 

36,607

 

Restricted stock and stock option compensation

 

9,731

 

1,175

 

Losses (earnings) on equity method investments

 

(1,638

)

1,685

 

Gain on sale of securities

 

(3,695

)

 

Loss on early extinguishment of debt

 

525

 

 

Loss on sale of fixed assets

 

329

 

1,607

 

Tax benefits from employee stock plans

 

932

 

3,111

 

Mark to market on derivative

 

(651

)

12

 

Other

 

(3,179

)

(2,389

)

Changes in assets and liabilities (net of acquisition of business):

 

 

 

 

 

Accounts receivable, net

 

69,931

 

(39,189

)

Inventories

 

(53,712

)

12,947

 

Prepaid expenses and other current assets

 

(2,369

)

5,701

 

Accounts payable and accrued expenses

 

40,445

 

1,706

 

Deferred revenue

 

2,796

 

5,723

 

Income taxes payable

 

48,183

 

(11,444

)

Other assets

 

(3,472

)

1,131

 

Total adjustments

 

293,772

 

161,333

 

Net cash provided by operating activities

 

337,767

 

279,481

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Acquisitions of property and equipment

 

(25,468

)

(48,293

)

Acquisition of product rights

 

(440

)

(541

)

Acquisition of business, net of cash acquired

 

(29,574

)

 

Proceeds from sale of marketable equity securities

 

3,693

 

220,083

 

Proceeds from sale of investments

 

4,695

 

 

Additions to marketable securities

 

(5,164

)

(3,809

)

Additions to long-term investments

 

(12,682

)

(1,500

)

Distribution from joint venture

 

5,942

 

2,791

 

Net cash (used in) provided by investing activities

 

(58,998

)

168,731

 

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Payments to repurchase 1998 Senior Notes

 

(14,585

)

 

Repurchase of common stock

 

 

(300,000

)

Payments on term loan, current debt and other long-term liabilities

 

(4,341

)

(7

)

Proceeds from stock plans

 

7,928

 

25,366

 

Net cash used in financing activities

 

(10,998

)

(274,641

)

Net increase in cash and cash equivalents

 

267,771

 

173,571

 

Cash and cash equivalents at beginning of period

 

467,451

 

298,653

 

Cash and cash equivalents at end of period

 

$

735,222

 

$

472,224

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

3




WATSON PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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, 2005.  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.

In the year ended December 31, 2005 the Company acquired additional common shares in Scinopharm Taiwan, Ltd. (“Scinopharm”), previously accounted for under the cost method, to an ownership level in excess of 20%. Accordingly, as required by Accounting Principles Board (“APB”) Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” (“APB 18”), results of operations, earnings per share and cash flows from operating and investing activities have been restated for the three and nine months ended September 30, 2005 to conform to current period presentation.

Acquisition of Andrx Corporation

On November 3, 2006, the Company acquired all the outstanding shares of common stock of Andrx Corporation (“Andrx”) in an all-cash transaction for $25 per share, or total consideration of approximately $1.9 billion (the “Andrx Acquisition”).  Andrx distributes pharmaceutical products primarily to independent and chain pharmacies and physicians’ offices and is considered a leader in formulating and commercializing difficult-to-replicate controlled-release pharmaceutical products and selective immediate-release products.  For additional information on the Andrx Acquisition, refer to NOTE 12 – SUBSEQUENT EVENTS.

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 income (loss) refers to revenues, expenses, gains and losses that, under generally accepted accounting principles, are included in comprehensive income (loss), but excluded from net income as these amounts are recorded directly as an adjustment to stockholders’ equity.  Watson’s 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 and foreign currency translation adjustments.  Other comprehensive income includes unrealized

4




gains on our holdings in shares of Andrx common stock.  For additional information on the impact of the Andrx Acquisition on our accounting for unrealized gains related to Andrx, refer to NOTE 12 – SUBSEQUENT EVENTS.  The components of comprehensive income including attributable income taxes consisted of the following (in thousands):

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

Restated

 

 

 

Restated

 

Net income

 

$

34,381

 

$

39,086

 

$

43,995

 

$

118,148

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Unrealized gain (loss) on securities

 

1,676

 

(2,704

)

6,739

 

(7,997

)

Less related income taxes

 

(601

)

985

 

(2,520

)

2,959

 

Total unrealized gain (loss) on securities, net

 

1,075

 

(1,719

)

4,219

 

(5,038

)

 

 

 

 

 

 

 

 

 

 

Translation loss

 

(199

)

 

(629

)

 

Total other comprehensive income (loss)

 

876

 

(1,719

)

3,590

 

(5,038

)

Total comprehensive income

 

$

35,257

 

$

37,367

 

$

47,585

 

$

113,110

 

 

Preferred and Common Stock

As of September 30, 2006 and December 31, 2005 there were 2,500,000 shares of no par value per share preferred stock authorized, with none issued.  As of September 30, 2006 and December 31, 2005, there were 500,000,000 shares of $0.0033 par value per share common stock authorized, with 111,865,000 and 110,205,000 shares issued, and 102,465,000 and 100,805,000 outstanding, respectively.  Approximately 9,399,800 shares were held as treasury shares as of September 30, 2006 and December 31, 2005, respectively.

Stock Repurchases

During 2005, we repurchased approximately 9.4 million shares of our common stock at an aggregate cost of $300.0 million under the Company’s $300.0 million stock repurchase program approved by the Company’s Board of Directors (“Board”) on February 10, 2005 (the “2005 Repurchase Program”).  This completed our stock repurchase program under the 2005 Repurchase Program.

On February 15, 2006, the Board authorized the expenditure of an additional $300.0 million to repurchase shares of the Company’s outstanding common stock (the “2006 Repurchase Program”).  Repurchases are authorized to be made in open market or privately negotiated transactions from time to time in compliance with the SEC Rule 10b-18, subject to market conditions, applicable legal requirements and other factors. Additionally, the Board has authorized that purchases may be made under Rule 10b5-1 promulgated under the Securities and Exchange Act of 1934, as amended.  A Rule 10b5-1 plan allows Watson to repurchase its shares during periods when it would normally not be active in the market due to its internal trading blackout periods. All such purchases must be made in accordance with a pre-defined plan that is established when the plan administrator is not aware of any material non-public information.  At this time, the Company has no current plans to repurchase common stock under the 2006 Repurchase Program.

Provisions for Sales Returns and Allowances

As customary in the pharmaceutical industry, the Company’s gross product sales are subject to a variety of deductions in arriving at reported net product sales.  When the Company recognizes revenue from the sale of its products, an estimate of sales returns and allowances (“SRA”) is recorded which reduces product sales and accounts receivable. These adjustments include estimates for chargebacks, rebates, cash discounts and returns and other allowances.  These provisions are estimated based on historical payment experience, historical relationship to revenues, estimated customer inventory levels and current contract sales terms with direct and

5




indirect customers.  The estimation process used to determine our SRA provision has been applied on a consistent basis and no material adjustments have been necessary to increase or decrease our reserves for SRA as a result of a significant change in underlying estimates.  The Company uses a variety of methods to assess the adequacy of our SRA reserves to ensure that our financial statements are fairly stated.  This includes periodic reviews of customer inventory data, customer contract programs and product pricing trends to analyze and validate the SRA reserves.

The provision for chargebacks is our most significant sales allowance.  A chargeback represents an amount payable in the future to a wholesaler for the difference between the invoice price paid to the Company by our wholesale customer for a particular product and the negotiated contract price that the wholesaler’s customer pays for that product.  The Company’s chargeback provision and related reserve vary with changes in product mix, changes in customer pricing and changes to estimated wholesaler inventory.  The provision for chargebacks also takes into account an estimate of the expected wholesaler sell-through levels to indirect customers at contract prices.  The Company validates the chargeback accrual quarterly through a review of the inventory reports obtained from our largest wholesale customers.  This customer inventory information is used to verify the estimated liability for future chargeback claims based on historical chargeback and contract rates.  These large wholesalers represent 85% - 90% of the Company’s chargeback payments.  The Company continually monitors current pricing trends and wholesaler inventory levels to ensure the liability for future chargebacks is fairly stated.  The following table summarizes the activity in the Company’s major categories of SRA (in thousands):

 

 

Chargebacks

 

Rebates

 

Returns and
Other
Allowances

 

Cash
Discounts

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2004

 

$

129,551

 

$

148,948

 

$

44,483

 

$

10,614

 

$

333,596

 

Provision related to sales in nine months ended September 30, 2005

 

668,145

 

253,964

 

84,154

 

43,647

 

1,049,910

 

Credits and payments

 

(692,243

)

(269,903

)

(91,317

)

(43,672

)

(1,097,135

)

Balance at September 30, 2005

 

105,453

 

133,009

 

37,320

 

10,589

 

286,371

 

Provision related to sales in three months ended December 31, 2005

 

267,679

 

91,906

 

35,719

 

15,853

 

411,157

 

Credits and payments

 

(233,527

)

(96,622

)

(27,746

)

(14,348

)

(372,243

)

Balance at December 31, 2005

 

139,605

 

128,293

 

45,293

 

12,094

 

325,285

 

Provision related to sales in nine months ended September 30, 2006

 

876,450

 

306,016

 

141,136

 

52,224

 

1,375,826

 

Credits and payments

 

(852,695

)

(294,088

)

(132,733

)

(51,762

)

(1,331,278

)

Balance at September 30, 2006

 

$

163,360

 

$

140,221

 

$

53,696

 

$

12,556

 

$

369,833

 

 

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 the dilutive effect of stock options and restricted stock awards outstanding during the period.  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

6




consisted of the following (in thousands, except per share amounts):

 

 

Three months ended

 

Nine months ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

Restated

 

 

 

Restated

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - basic

 

 

 

 

 

 

 

 

 

Net income

 

$

34,381

 

$

39,086

 

$

43,995

 

$

118,148

 

 

 

 

 

 

 

 

 

 

 

Basic weighted average common shares outstanding

 

101,865

 

102,966

 

101,760

 

106,131

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - basic

 

$

0.34

 

$

0.38

 

$

0.43

 

$

1.11

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - assuming dilution

 

 

 

 

 

 

 

 

 

Net income

 

$

34,381

 

$

39,086

 

$

43,995

 

$

118,148

 

Add: Interest expense on CODES, net of tax

 

2,023

 

2,511

 

5,482

 

5,940

 

Net income, adjusted

 

$

36,404

 

$

41,597

 

$

49,477

 

$

124,088

 

 

 

 

 

 

 

 

 

 

 

Basic weighted average common shares outstanding

 

101,865

 

102,966

 

101,760

 

106,131

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Conversion of CODES

 

14,357

 

14,357

 

14,357

 

14,357

 

Dilutive stock options

 

131

 

835

 

239

 

668

 

Diluted weighted average common shares outstanding

 

116,353

 

118,158

 

116,356

 

121,156

 

 

 

 

 

 

 

 

 

 

 

Earnings per share - diluted

 

$

0.31

 

$

0.35

 

$

0.43

 

$

1.02

 

 

Stock awards to purchase 10.8 million and 6.2 million common shares for the three month periods ended September 30, 2006 and 2005, respectively, were outstanding but were not included in the computation of diluted earnings per share because the options were antidilutive.  Stock awards to purchase 10.1 million and 6.3 million common shares for the nine month periods ended September 30, 2006 and 2005, respectively, were outstanding but were not included in the computation of diluted earnings per share because the options were antidilutive.

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 clarifies that items such as abnormal freight, handling costs, and wasted materials (spoilage) be recognized as current period charges rather than as a portion of the inventory cost.  Unallocated overheads are to be recognized as an expense in the period in which they are incurred.  In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities.  This Statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005.  The provision of this Statement shall be applied prospectively.  The adoption of SFAS 151 on January 1, 2006, did 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 No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) as well as SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”), supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and amends SFAS No. 95, “Statement of Cash Flows” (“SFAS 95”). SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The intrinsic value method as permitted under APB 25 together with the

7




pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. Under SFAS 123R, the Company must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for attributing compensation cost to reporting periods 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 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 beginning with the first period restated.  SFAS 123R also requires any previously recorded unearned or deferred compensation accounts (i.e. contra-equity accounts) within stockholders’ equity be recorded as a reduction to additional paid-in capital balances rather than shown as contra equity accounts as was permitted prior to January 1, 2006.  SFAS 95 is amended to require excess tax benefits be reported as a financing cash flow rather than as a reduction in taxes paid within the Consolidated Statement of Cash Flows.  On January 1, 2006, the Company adopted SFAS 123R using the modified prospective method option.

In March 2005, the SEC issued SEC Staff Bulletin No. 107 (“SAB 107”) which describes the SEC staff position as well as supplemental implementation guidance on the application  and adoption of SFAS 123R.  The Company has applied the provisions of SAB 107 and its guidance in our adoption of SFAS 123R on January 1, 2006 (Refer to NOTE 2 – SHARE-BASED COMPENSATION).

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”), which replaces APB Opinion No. 20, “Accounting Changes” (“APB 20”) and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements” (“SFAS 3”). SFAS 154 applies to all voluntary changes in accounting principle and changes the requirements for the accounting for and reporting of a change in accounting principle.  SFAS 154 also requires retrospective application to prior period financial statements involving changes in accounting principle unless it is impracticable to determine either the period-specific or cumulative effect of the change.  This statement also requires that a change in the method of depreciation, amortization or depletion of long-lived assets be accounted for as a change in accounting estimate that is accounted for prospectively.  SFAS 154 also retains many provisions of APB 20 including those related to reporting a change in accounting estimate, a change in the reporting entity and a correction of an error and also carries forward provisions of SFAS 3 governing the reporting of accounting changes in interim financial statements.  SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005.  The adoption of SFAS 154 on January 1, 2006, did not have a material effect on our Consolidated Financial Statements.

In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – An Interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 clarifies the accounting for the uncertainty in recognizing income taxes in an organization in accordance with FASB Statement No. 109 by providing detailed guidance for financial statement recognition, measurement and disclosure involving uncertain tax positions.  FIN 48 requires an uncertain tax position to meet a more-likely-than-not recognition threshold at the effective date to be recognized both upon the adoption of FIN 48 and in subsequent periods.  FIN 48 is effective for fiscal years beginning after December 15, 2006.  As the provisions of FIN 48 will be applied to all tax positions upon initial adoption, the cumulative effect of applying the provisions of FIN 48 will be reported as an adjustment to the opening balance of retained earnings for that fiscal year.  The Company is currently evaluating FIN 48 and the effect, if any, on our Condensed Consolidated Financial Statements.

8




NOTE 2 – SHARE-BASED COMPENSATION

As indicated above, effective January 1, 2006, the Company adopted the modified prospective method of SFAS 123R which requires the measurement and recognition of compensation expense for all share-based compensation awards made to employees and directors based on estimated fair values.  SFAS 123R eliminates previously available alternatives to account for share-based compensation transactions, as the Company formerly did, using the recognition and measurement principles of APB 25 and related interpretations.  Under the intrinsic value method of APB 25, no stock-based employee compensation expense had been recognized for employee options in the Company’s Condensed Consolidated Statements of Income, as all employee options granted under the Company’s stock option plans or employee stock purchase plan (“ESPP”) either had an exercise price equal to the market value of the underlying common stock on the date of grant or were deemed non-compensatory under APB 25 for common stock issued under our ESPP.  In accordance with the modified prospective method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the share-based compensation impact of FAS 123R.

Stock Option Plans

The Company has adopted several stock option plans, all of which have been approved by the Company’s shareholders, that authorize the granting of options to purchase the Company’s common shares subject to certain conditions.  At September 30, 2006, the Company had reserved 14.6 million of its common shares for issuance of share-based compensation awards under the Company’s stock option and restricted stock plans.  Options are granted at the fair value of the shares underlying the options at the date of the grant and generally become exercisable over periods ranging from three to five years and expire in ten years.  In conjunction with certain of the Company’s acquisitions, Watson assumed stock option and warrant plans from the acquired companies.  The options and warrants in these plans were adjusted by the individual exchange ratios specified in each transaction.  No additional options or warrants have been granted under any of the assumed plans.  In connection with the Andrx Acquisition, the Company assumed the Andrx Corporation 2000 Stock Option Plan, as amended and restated (the "Andrx Plan"), and converted the shares remaining available for future grants thereunder into shares available for future grants under the Amendment and Restatement of the 2001 Incentive Award Plan of Watson Pharmaceuticals, Inc. (the "Watson Plan").  The shares available for future awards under the Watson Plan will not be used for grants to individuals who, as of immediately prior to the effective time of the Andrx Acquisition, were providing services (whether as an employee, director or consultant) to the Company or any entity that was a subsidiary of the Company immediately prior to the effective time of the Andrx Acquisition.  As of September 30, 2006, approximately 6.1 million shares of common stock remain available for future grants under the Andrx Plan, of which no more than approximately 0.3 million shares are available for award grants other than stock options.

The Company estimates the fair value of its stock option plans and the ESPP using the Black-Scholes option pricing model (the “Option Model”).  The Option Model requires the use of subjective and complex assumptions, including the option’s expected term and the estimated future price volatility of the underlying stock, which determine the fair value of the share-based awards.  The Company’s estimate of expected term in 2006 was determined based on the weighted average period of time that options granted are expected to be outstanding considering current vesting schedules and the historical exercise patterns of existing option plans.  Beginning in 2005, the expected volatility assumption used in the Option Model changed from being based on historical volatility to implied volatility based on traded options on the Company’s stock in accordance with guidance provided in SFAS 123R and SAB 107.  Prior to 2005, the Company’s measurement of expected volatility was based on the historical volatility of its stock.  The risk-free interest rate used in the Option Model is based on the yield of U.S. Treasuries with a maturity closest to the expected term of the Company’s stock options.

9




The following weighted average assumptions were used for stock options granted during the three and nine months ended September 30, 2006 and 2005:

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

 

 

 

 

 

 

 

 

Dividend yield

 

None

 

None

 

None

 

None

 

Expected volatility

 

26

%

22

%

26

%

23

%

Risk-free interest rate

 

4.70

%

4.18

%

4.78

%

4.15

%

Expected term

 

5.4

 

4.8

 

5.4

 

5.0

 

 

 

 

 

 

 

 

 

 

 

Weighted average fair value per share at grant date

 

$

8.67

 

$

9.56

 

$

8.87

 

$

9.25

 

 

Effective January 1, 2006, in accordance with the provisions of SFAS 123R, share-based compensation expense recognized during a period is based on the value of the portion of share-based awards that are expected to vest with employees.  Accordingly, the recognition of share-based compensation expense beginning January 1, 2006 has been reduced for estimated future forfeitures.  SFAS 123R requires forfeitures to be estimated at the time of grant with adjustments recorded in subsequent period compensation expense if actual forfeitures differ from those estimates.  Prior to 2006, we accounted for forfeitures as they occurred for the disclosure of pro forma information presented in our Notes to Condensed Consolidated Financial Statements for prior periods.  Share-based compensation expense recognized under SFAS 123R includes share-based awards granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R as well as share-based awards granted prior to, but not yet vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123.  In conjunction with the adoption of SFAS 123R, we changed the method of recognizing share-based compensation expense from the accelerated multiple-option approach to the ratable single-option approach.

As a result of adopting SFAS 123R on January 1, 2006, the Company’s operating income and net income before income tax was reduced by $1.6 million and $6.1 million, and net income was reduced by $1.0 million ($0.01 per basic and diluted share) and $3.8 million ($0.04 per basic and $0.03 per diluted share) for the three and nine months ended September 30, 2006, related to the Company’s employee stock option plans, respectively.  There was no employee stock option compensation related expense recognized in the three and nine months ended September 30, 2005.  Total stock option cost capitalized as part of inventory was $0.2 million and $0.9 million for three and nine months ended September 30, 2006, respectively. There was no stock option cost capitalized as part of inventory in the three and nine months ended September 30, 2005.

On December 15, 2005 the Compensation Committee of the Board approved the accelerated vesting of certain unvested, out-of-the-money stock options having an exercise price of $38.00 or greater.  The acceleration of vesting was effective December 15, 2005, for stock options previously awarded to the Company’s employees, including its executive officers under the Company’s equity compensation plans.  In connection with the acceleration of vesting terms of these options, the Company recognized an additional $6.9 million, pre-tax non-cash compensation expense on a pro forma basis in accordance with SFAS 123 in the three months ended December 31, 2005.  The acceleration action was taken in order to reduce the impact on future compensation expense of recognizing share based payment transactions within future periods’ consolidated statements of income upon adoption of SFAS 123R on January 1, 2006.

10




A summary of the changes in the Company’s stock option plans during the nine months ended September 30, 2006 is presented below (in thousands, except per share amounts):

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Weighted

 

Average

 

 

 

 

 

 

 

Average

 

Remaining

 

Aggregate

 

 

 

 

 

Exercise

 

Contractual

 

Intrinsic

 

 

 

Shares

 

Price

 

Term (Years)

 

Value

 

 

 

 

 

 

 

 

 

 

 

Outstanding at December 31, 2005

 

11,194

 

$

36.76

 

 

 

 

 

Granted

 

840

 

26.46

 

 

 

 

 

Exercised

 

(303

)

18.67

 

 

 

 

 

Cancelled

 

(503

)

39.42

 

 

 

 

 

Outstanding at September 30, 2006

 

11,228

 

$

36.36

 

6.0

 

$

1,551

 

 

 

 

 

 

 

 

 

 

 

Vested and expected to vest at September 30, 2006

 

10,598

 

$

36.82

 

6.0

 

$

1,438

 

 

 

 

 

 

 

 

 

 

 

Options exercisable at September 30, 2006

 

8,290

 

$

39.07

 

5.1

 

$

1,023

 

 

As of September 30, 2006, the Company had $11.7 million of total unrecognized compensation expense, net of estimated forfeitures, related to stock option grants, which will be recognized over the remaining weighted average period of 1.8 years.

Restricted Stock

During 2005, the Compensation Committee of the Board authorized and issued restricted stock to the Company’s employees, including its executive officers and certain non-employee directors (the “Participants”) under the Company’s equity compensation plans.  The restricted stock award program offers Participants the opportunity to earn shares of our common stock over time, rather than options that give Participants the right to purchase stock at a set price. Restricted stock awards are grants that entitle the holder to shares of common stock subject to certain terms. Restricted stock awards generally have restrictions eliminated over a one to four year period.  Restrictions generally lapse for non-employee directors after one year.  Restrictions generally lapse for employees over a two to four year period.  The fair value of restricted stock grants is based on the fair market value of our common stock on the respective grant dates.  Restricted stock compensation is being amortized and charged to operations over the same period as the restrictions are eliminated for the Participants.

The Company’s operating income and net income before income tax provision was reduced by $1.4 and $2.6 million and net income was reduced by $0.9 million ($0.01 per basic and diluted share) and $1.6 million ($0.02 per basic and $0.01 per diluted share) for the three and nine months ended September 30, 2006, related to the Company’s restricted stock plans, respectively.  For the three and nine months ended September 30, 2005 the Company’s operating income and net income before income tax provision was reduced by $0.4 million and net income was reduced by $0.2 million ($0.00 per basic and diluted share) related to the Company’s restricted stock plans, respectively.  Total restricted stock cost capitalized as part of inventory was $0.4 million and $0.8 for the three and nine months ended September 30, 2006, respectively. Restricted stock cost capitalized as part of inventory in the three and nine months ended September 30, 2005 was $0.2 million.

11




A summary of the changes in restricted stock grants during the nine months ended September 30, 2006 is presented below (in thousands, except per share amounts):

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Weighted

 

Average

 

 

 

 

 

 

 

Average

 

Remaining

 

Aggregate

 

 

 

 

 

Grant Date

 

Contractual

 

Intrinsic

 

 

 

Shares

 

Fair Value

 

Term (Years)

 

Value

 

 

 

 

 

 

 

 

 

 

 

Restricted shares outstanding at December 31, 2005

 

315.5

 

$

34.43

 

2.3

 

$

10,863

 

Granted

 

296.3

 

26.62

 

 

 

7,894

 

Vested

 

(5.0

)

30.04

 

 

 

(150

)

Cancelled

 

(30.4

)

35.00

 

 

 

(1,063

)

Restricted shares outstanding at September 30, 2006

 

576.4

 

$

30.44

 

2.2

 

$

17,544

 

 

 

 

 

 

 

 

 

 

 

Restricted shares net of estimated forfeitures at September 30, 2006

 

410.5

 

$

31.09

 

2.2

 

$

12,760

 

 

As of September 30, 2006, the Company had $8.5 million of total unrecognized compensation expense, net of estimated forfeitures, related to restricted stock grants, which will be recognized over the remaining weighted average period of 2.2 years.

ESPP

An ESPP was established for eligible employees to purchase shares of the Company’s common stock at 85% of the lower of the fair market value of Watson common stock on the effective date of subscription or the date of purchase.  Under the ESPP, employees could authorize the Company to withhold up to 15% of their compensation during any offering period for common stock purchases, subject to certain limitations.  The ESPP was implemented on January 1, 2002 and was qualified under Section 423 of the Internal Revenue Code.  The Board authorized an aggregate of 700,000 shares of the Company’s common stock for issuance under the ESPP.  As of December 31, 2005, a total of 471,307 shares were issued under the ESPP.  On June 29, 2005 the Compensation Committee of the Board terminated the ESPP effective January 1, 2006.

The following weighted average assumptions were used for the ESPP during the three and nine months ended September 30, 2005:

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30, 2005

 

September 30, 2005

 

 

 

 

 

 

 

Dividend yield

 

None

 

None

 

Expected volatility

 

22

%

24

%

Risk-free interest rate

 

3.80

%

3.90

%

Expected term

 

6 months

 

6 months

 

 

 

 

 

 

 

Weighted average fair value per share at grant date

 

$

6.45

 

$

6.87

 

 

Pro Forma Information for Periods Prior to the Adoption of FAS 123R

Prior to 2006, the Company determined stock-based compensation expense using the intrinsic value method of APB 25 and we provided the disclosures required by SFAS 123, as amended by SFAS 148.  The following table provides the pro forma effects on net income and earnings per share for the three and nine months ended September 30, 2005 as if the fair value recognition provisions of SFAS 123R had been applied to options and ESPP

12




grants under the Company’s employee compensation plans (in thousands, except per share amounts):

 

 

Three Months

 

Nine Months

 

 

 

Ended

 

Ended

 

 

 

September 30, 2005

 

September 30, 2005

 

 

 

Restated

 

Restated

 

Net income, as reported

 

$

39,086

 

$

118,148

 

Add: Stock-based employee compensation expense included in reported net income, net of related tax effects

 

356

 

356

 

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

 

(2,935

)

(8,881

)

Pro forma net income

 

36,507

 

109,623

 

Add: Interest expense on CODES, net of related tax effects

 

2,510

 

5,940

 

Pro forma net income, adjusted

 

$

39,017

 

$

115,563

 

Earnings per share:

 

 

 

 

 

Basic - as reported

 

$

0.38

 

$

1.11

 

Basic - pro forma

 

$

0.35

 

$

1.03

 

 

 

 

 

 

 

Diluted - as reported

 

$

0.35

 

$

1.02

 

Diluted - pro forma

 

$

0.33

 

$

0.95

 

 

NOTE 3 – ACQUISITIONS

Acquisition of Andrx Corporation

On November 3, 2006, the Company completed the Andrx Acquisition.  Accordingly, the Company’s Condensed Consolidated Financial Statements for the nine months ended September 30, 2006 do not include the results of operations, cash flows or financial position of Andrx.  For additional information on the Andrx Acquisition, refer to NOTE 12 – SUBSEQUENT EVENTS.

Acquisition of Sekhsaria Chemicals Ltd.

On March 16, 2006, the Company acquired Sekhsaria Chemicals Ltd. (“Sekhsaria”), a private company located in Mumbai, India that provides active pharmaceutical ingredient and finished dosage formulation expertise to the global pharmaceutical industry.  The Company acquired all the outstanding shares of Sekhsaria for approximately $29.5 million plus acquisition costs.  The transaction was accounted for as a purchase in accordance with SFAS No. 141, “Business Combinations” “SFAS 141” and accordingly, the tangible assets acquired were recorded at fair value on acquisition date based on reasonable assumptions.

The results of operations of Sekhsaria have been included in the Company’s Condensed Consolidated Financial Statements subsequent to the date of acquisition.  Pro forma results of operations have not been presented because the effect of the acquisition was not material.

13




Additional Investment in Scinopharm

The Company holds an equity interest in Scinopharm.  In January 2006, we made an additional investment in Scinopharm of approximately $12.0 million which increased our ownership share to approximately 31%.  Additionally, we have an option to acquire an additional 44% interest in Scinopharm at a cost of approximately $80 million which expires in October 2007.

Acquisition of Manufacturing Facility in Goa, India

In October 2005, the Company entered into an asset purchase agreement to purchase a manufacturing facility located in Goa, India from Dr. Reddy’s Laboratories, Ltd. for total cash consideration of approximately $16.4 million plus acquisition costs.  The transaction included a manufacturing facility, machinery and equipment.

NOTE 4 – INVESTMENTS

The Company’s equity investments in publicly traded securities 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 Company’s Condensed Consolidated Balance Sheets.

The Company’s debt investments in U.S. Treasury and agency 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 (in thousands):

 

 

Cost, Including

 

Gross Unrealized

 

Gross Unrealized

 

 

 

At September 30, 2006

 

Accrued Interest

 

Gains

 

Losses

 

Fair Value

 

Available-for-sale:

 

 

 

 

 

 

 

 

 

U.S. Treasury and agency securities

 

$

157,100

 

$

 

$

(393

)

$

156,707

 

Equity securities - current

 

1,575

 

13,263

 

 

14,838

 

Current

 

158,675

 

13,263

 

(393

)

171,545

 

Equity securities - non-current

 

232

 

832

 

 

1,064

 

Total

 

$

158,907

 

$

14,095

 

$

(393

)

$

172,609

 

 

 

 

Cost, Including

 

Gross Unrealized

 

Gross Unrealized

 

 

 

At December 31, 2005

 

Accrued Interest

 

Gains

 

Losses

 

Fair Value

 

Available-for-sale:

 

 

 

 

 

 

 

 

 

U.S. Treasury and agency securities

 

$

154,302

 

$

 

$

(1,835

)

$

152,467

 

Equity securities - current

 

1,572

 

8,436

 

 

10,008

 

Current

 

155,874

 

8,436

 

(1,835

)

162,475

 

Equity securities - non-current

 

232

 

707

 

 

939

 

Total

 

$

156,106

 

$

9,143

 

$

(1,835

)

$

163,414

 

 

Gross unrealized gains at September 30, 2006 and December 31, 2005 primarily relate to our holdings in shares of Andrx common stock.  The gross unrealized holding loss at September 30, 2006 and December 31, 2005 is attributable to adjustments, included in other comprehensive income, for the decline in fair value in the Company’s investment in U.S. Treasury and agency securities.  For additional information on the impact of the Andrx Acquisition on our accounting for unrealized gains related to Andrx, refer to NOTE 12 – SUBSEQUENT EVENTS.

14




The Company’s net unrealized gain related to its available-for-sale securities increased $4.2 million for the nine month period ended September 30, 2006.  During the nine month period ended September 30, 2005, the Company’s net unrealized holding gain decreased $5.0 million.  These changes in the Company’s net unrealized holding gain are included in other comprehensive income.

Current Investments

The Company’s investment in the common stock of Andrx is classified as a current investment on the Company’s Condensed Consolidated Balance Sheets at September 30, 2006 and December 31, 2005.  The Company did not sell any of its shares of Andrx during the nine month periods ended September 30, 2005 and 2006.  (Refer to NOTE 1 – GENERAL.)

The Company’s investments in U.S. Treasury and agency securities are classified as a current investment on the Company’s Condensed Consolidated Balance Sheet at September 30, 2006 and December 31, 2005.

The contractual maturities of the U.S. Treasury and agency securities at September 30, 2006 are as follows (in thousands):

 

Fair value

 

 

 

 

 

Mature within one year

 

$

154,247

 

Mature within two years

 

2,460

 

 

 

$

156,707

 

 

For additional information on the impact of the Andrx Acquisition on our accounting for current marketable securities, refer to NOTE 12 – SUBSEQUENT EVENTS.

Non-current Investments

The Company’s investments in the common stock of NovaDel Pharma Inc. and Amarin Corporation plc (“Amarin”) are classified as non-current investments and are included in investments and other assets on the Company’s Condensed Consolidated Balance Sheets at September 30, 2006 and December 31, 2005.

NOTE 5 – SEGMENTS

Watson has two reportable 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 reportable 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.

The Company evaluates segment performance based on segment net revenues, gross profit and contribution. Segment contribution represents segment gross profit less direct research and development expenses and selling and marketing expenses.  The Company does not report depreciation expense, total assets, and capital expenditures by segment as such information is not used by management, or has not been accounted for at the segment level.

The “other” revenue classification for the three month period ended September 30, 2006 and 2005 consists primarily of royalties and revenues from research, development and licensing fees and, beginning in 2006,

15




commission revenue earned as a sales agent of Cephalon, Inc. from the launch of Fentanyl Citrate.  Net revenues and segment contribution information for the Company’s Brand and Generic segments, consisted of the following:

 

Three Months Ended September 30, 2006

 

Three Months Ended September 30, 2005

 

 

 

Generic

 

Brand

 

Total

 

Generic

 

Brand

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product sales

 

$

347,635

 

$

85,543

 

$

433,178

 

$

315,234

 

$

91,554

 

$

406,788

 

Other

 

5,436

 

1,879

 

7,315

 

1,137

 

2,371

 

3,508

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

353,071

 

87,422

 

440,493

 

316,371

 

93,925

 

410,296

 

Cost of revenue (excludes amortization, presented below)

 

234,973

 

22,923

 

257,896

 

187,326

 

23,483

 

210,809

 

Gross profit

 

118,098

 

64,499

 

182,597

 

129,045

 

70,442

 

199,487

 

Gross margin

 

33

%

74

%

41

%

41

%

75

%

49

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

18,339

 

11,108

 

29,447

 

18,493

 

11,347

 

29,840

 

Selling and marketing

 

12,656

 

26,447

 

39,103

 

12,800

 

28,867

 

41,667

 

Contribution

 

$

87,103

 

$

26,944

 

114,047

 

$

97,752

 

$

30,228

 

127,980

 

Contibution margin

 

25

%

31

%

26

%

31

%

32

%

31

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

General and administrative

 

 

 

 

 

25,364

 

 

 

 

 

23,508

 

Amortization

 

 

 

 

 

39,392

 

 

 

 

 

41,100

 

Loss on impairment

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

 

 

 

 

$

49,291

 

 

 

 

 

$

63,372

 

Operating margin

 

 

 

 

 

11

%

 

 

 

 

15

%

 

 

 

Nine Months Ended September 30, 2006

 

Nine Months Ended September 30, 2005

 

 

 

Generic

 

Brand

 

Total

 

Generic

 

Brand

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product sales

 

$

1,088,491

 

$

256,831

 

$

1,345,322

 

$

920,850

 

$

296,826

 

$

1,217,676

 

Other

 

7,101

 

5,659

 

12,760

 

3,372

 

6,342

 

9,714

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net revenues

 

1,095,592

 

262,490

 

1,358,082

 

924,222

 

303,168

 

1,227,390

 

Cost of revenue (excludes amortization, presented below)

 

758,921

 

64,589

 

823,510

 

558,657

 

70,315

 

628,972

 

Gross profit

 

336,671

 

197,901

 

534,572

 

365,565

 

232,853

 

598,418

 

Gross margin

 

31

%

75

%

39

%

40

%

77

%

49

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

56,958

 

33,451

 

90,409

 

59,455

 

30,709

 

90,164

 

Selling and marketing

 

39,120

 

85,187

 

124,307

 

35,748

 

86,867

 

122,615

 

Contribution

 

$

240,593

 

$

79,263

 

319,856

 

$

270,362

 

$

115,277

 

385,639

 

Contibution margin

 

22

%

30

%

24

%

29

%

38

%

31

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

General and administrative

 

 

 

 

 

77,684

 

 

 

 

 

74,336

 

Amortization

 

 

 

 

 

121,593

 

 

 

 

 

122,839

 

Loss on impairment

 

 

 

 

 

66,981

 

 

 

 

 

 

Operating income

 

 

 

 

 

$

53,598

 

 

 

 

 

$

188,464

 

Operating margin

 

 

 

 

 

4

%

 

 

 

 

15

%

 

For additional information on the impact of the Andrx Acquisition on our operating segments related to Andrx, refer to NOTE 12 – SUBSEQUENT EVENTS.

16




NOTE 6 – INVENTORIES

Inventories consist of finished goods held for sale and distribution, raw materials and work-in-process. Included in inventory at September 30, 2006 and December 31, 2005 is approximately $11.3 and $6.0 million, respectively, of inventory that is pending approval by the U.S. Food and Drug Administration (“FDA”) or has not been launched due to contractual restrictions.  This inventory consists of generic pharmaceutical products that are capitalized only when the bioequivalence of the product is demonstrated or the product is already FDA approved and is awaiting a contractual triggering event to enter the marketplace.

Inventories are stated at the lower of cost (first-in, first-out method) or market (net realizable value) and consisted of the following (in thousands):

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Raw materials

 

$

94,673

 

$

85,983

 

Work-in-process

 

57,121

 

67,173

 

Finished goods

 

166,372

 

124,906

 

Total inventories

 

$

318,166

 

$

278,062

 

 

NOTE 7 – ASSET IMPAIRMENT CHARGES

In Accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), Watson reevaluates the carrying value of identifiable intangible and long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable.  SFAS 144 defines impairment as the condition that exists when the carrying amount of a long-lived asset exceeds its fair value.  An impairment loss is recognized only if the carrying amount of a long-lived asset is not recoverable and exceeds its fair value.

In the quarter ended June 30, 2006, revisions to the Company’s long range product sales forecast were deemed necessary as a result of a detailed analysis of prescription trends and a review of sales and inventory data provided by our largest customers.  As a result of these downward revisions to our long range product sales forecast, the Company conducted a product right impairment review.  Results of our impairment review indicated future undiscounted cash flows for four product rights were less than their respective carrying values.  An analysis was undertaken to determine the fair values for the four product rights and an impairment of approximately $67.0 million was recognized predominantly relating to Alora® (purchased in 1999) and Actigall® (purchased in 2002).

NOTE 8 – 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 employed in, and liabilities relating to, to those reporting units, including the existing goodwill and intangible assets.  Goodwill is considered impaired if the carrying amount exceeds the fair value of the reporting unit.  During the second quarter of 2006, Watson performed its annual assessment for the impairment of goodwill and determined there was no indication of impairment.

During the nine months ended September 30, 2006, in conjunction with the acquisition of Sekhsaria, the total purchase price in excess of the fair value of net assets acquired amounted to $24.3 million (See Note 3 –

17




ACQUISITIONS).  This entire amount was recorded as an addition to goodwill under the Generic pharmaceutical product segment.  Goodwill for the Company’s reporting units consisted of the following (in thousands):

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

 

 

 

 

 

 

Brand pharmaceutical products

 

$

368,105

 

$

368,105

 

Generic pharmaceutical products

 

111,821

 

87,490

 

Total goodwill

 

$

479,926

 

$

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):

 

September 30,

 

December 31,