Allergan Finance LLC 10-Q 2006
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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 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):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý
The number of shares outstanding of the Registrants only class of common stock as of May 4, 2006 was approximately 111,410,000.
WATSON PHARMACEUTICALS, INC.
TABLE OF CONTENTS
FORM 10-Q FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2006
WATSON PHARMACEUTICALS, INC.
(Unaudited; in thousands)
See accompanying Notes to Condensed Consolidated Financial Statements.
WATSON PHARMACEUTICALS, INC.
(Unaudited; in thousands, except per share amounts)
See accompanying Notes to Condensed Consolidated Financial Statements.
WATSON PHARMACEUTICALS, INC.
(Unaudited; in thousands)
See accompanying Notes to Condensed Consolidated Financial Statements.
WATSON PHARMACEUTICALS, INC.
NOTE 1 GENERAL
Watson Pharmaceuticals, Inc. (Watson 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, 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 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.
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 months ended March 31, 2005 to conform to current period presentation.
Merger Agreement with Andrx Corporation
On March 13, 2006, the Company announced a definitive merger agreement to acquire all the outstanding shares of common stock of Andrx Corporation (Nasdaq: ADRX) (Andrx) in an all-cash transaction for $25 per share, or total consideration of approximately $1.9 billion. 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.
The consummation of the merger is subject to customary closing conditions, including approval of the transaction by Andrx stockholders and the receipt of applicable U.S. regulatory approvals. On May 3, 2006, the Company and Andrx announced they had each received a request from the Federal Trade Commission (FTC) for additional information under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (HSR Act), in connection with Watsons pending acquisition of Andrx. The effect of this second request by the FTC is to extend the waiting period imposed by the HSR Act until 30 days after both Watson and Andrx have substantially complied with the request. For additional information on Andrx, see the U.S. Securities and Exchange Commissions (SEC) website at www.sec.gov.
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 (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. 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 and foreign currency translation adjustments. The components of comprehensive income including attributable income taxes consisted of the following (in thousands):
Preferred and Common Stock
As of March 31, 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 March 31, 2006 and December 31, 2005, there were 500,000,000 shares of $0.0033 par value per share common stock authorized, with 111,356,000 and 110,205,000 shares issued, respectively. Of the issued shares, 9,399,800 shares were held as treasury shares as of March 31, 2006 and December 31, 2005, respectively.
During 2005, we repurchased approximately 9.4 million shares of our common stock at an aggregate cost of $300.0 million under the Companys $300.0 million stock repurchase program approved by the Board of Directors of Watson (Board) on February 10, 2005 (the 2005 Repurchase Program). This completed our stock repurchase 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 Companys 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 does not intend to repurchase common stock under the 2006 Repurchase Program as a result of its pending acquisition of Andrx.
Provisions for Sales Returns and Allowances
As customary in the pharmaceutical industry, the Companys 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 various sales returns and allowances is recorded which reduces product sales and accounts receivable. These adjustments include estimates for chargebacks, rebates, returns, and other sales allowances. These provisions are estimated based on historical payment experience, historical relationship to revenues, estimated customer inventory levels and current contract sales terms with wholesale and indirect customers.
The Companys provision for chargebacks is the most significant and complex estimated 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 wholesalers customer pays for that product. The Companys chargeback estimates take into consideration the current average chargeback rates by product and estimated wholesaler inventory levels. Watson continually monitors the assumptions giving consideration to current pricing trends and estimated wholesaler inventory levels and make adjustments to these estimates when the Company believes that the actual chargeback amounts payable in the future will differ from original estimates. The following table summarizes the activity in the Companys major categories of sales returns and allowances (in thousands):
The balance of the Companys allowances for rebates has declined due to efficiencies in processing as well as an acceleration in the frequency of payments. The increase in the balance of the Companys chargeback allowances is the result of changes in our customer inventory mix.
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
consisted of the following (in thousands, except per share amounts):
Stock awards to purchase 7.9 million and 6.6 million common shares for the three month periods ended March 31, 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 Accounting Principles Board (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 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 its 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.
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 Companys Condensed Consolidated Statements of Income, as all employee options granted under the Companys 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 Companys shareholders, that authorize the granting of options to purchase the Companys common shares subject to certain conditions. At March 31, 2006, the Company had reserved 15.3 million of its common shares for issuance of
share-based compensation awards under the Companys 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 Companys 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.
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 options expected term and the estimated future price volatility of the underlying stock, which determine the fair value of the share-based awards. The Companys 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 Companys stock in accordance with guidance provided in SFAS 123R and SAB 107. Prior to 2005, the Companys 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 Companys stock options.
The following weighted average assumptions were used for stock options granted during the three months ended March 31, 2006 and 2005:
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 Companys operating income and net income before income tax provision was reduced by $1.8 million and net income was reduced by $1.1 million ($0.02 per
basic share, $0.01 per diluted share) for the three months ended March 31, 2006, related to the Companys employee stock option plans. There was no share-based employee compensation related expense recognized in the three months ended March 31, 2005. Total stock option cost capitalized as part of inventory was $0.3 million and $0 for three months ended March 31, 2006 and 2005, respectively.
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 Companys employees, including its executive officers under the Companys 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.
A summary of the changes in the Companys stock option plans during the three months ended March 31, 2006 is presented below (in thousands, except per share amounts):
As of March 31, 2006, the Company had $9.7 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 1.7 years.
During 2005, the Compensation Committee of the Board authorized and issued restricted stock to the Companys employees, including its executive officers and certain non-employee directors (the Participants) under the Companys 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 Companys operating income and net income before income tax provision was reduced by $0.5 million and net income was reduced by $0.3 million ($0.00 per basic share, $0.00 per diluted share) for the three months ended March 31, 2006, related to the Companys restricted stock plans. There was no restricted stock expense
recognized in the three months ended March 31, 2005. Total restricted stock cost capitalized as part of inventory was $0.2 million and $0 for three months ended March 31, 2006 and 2005, respectively.
A summary of the changes in restricted stock grants during the three months ended March 31, 2006 is presented below (in thousands, except per share amounts):
As of March 31, 2006, the Company had $5.0 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 2.1 years.
An ESPP was established for eligible employees to purchase shares of the Companys 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 can 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 Companys 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 months ended March 31, 2005:
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 months ended March 31, 2005 as if the fair value recognition provisions of SFAS 123R had been applied to options and ESPP grants
under the Companys employee compensation plans (in thousands, except per share amounts):
NOTE 3 ACQUISITIONS
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 initial purchase price was allocated as follows (in thousands):
The results of operations of Sekhsaria have been included in the Companys 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. The Company is planning an additional investment in Sekhsaria in order to repay existing debt.
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 within the next 21 months.
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 (Goa) from Dr. Reddys Laboratories, Ltd. (Dr. Reddy) 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 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 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 Watsons available-for-sale securities (in thousands):
Gross unrealized gains at March 31, 2006 and December 31, 2005 primarily relate to our holdings in shares of Andrx Corporation (Andrx) common stock. The gross unrealized holding loss at March 31, 2006 and December 31, 2005 is attributable to adjustments, included in other comprehensive income, for the decline in fair value in the Companys investment in U.S. Treasury and agency securities.
The Companys net unrealized gain related to its available-for-sale securities increased $3.4 million for the three month period ended March 31, 2006. During the three month period ended March 31, 2005, the Companys net unrealized holding gain decreased $2.2 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, 2006 and December 31, 2005. The Company did not sell any of its shares of Andrx during the three month periods ended March 31, 2005 and 2006. (Refer to NOTE 1 GENERAL.)
The Companys investments in U.S. Treasury and agency securities are classified as a current investment on the Companys Condensed Consolidated Balance Sheet at March 31, 2006 and December 31, 2005.
The contractual maturities of the U.S. Treasury and agency securities at March 31, 2006 are as follows (in thousands):
The Companys 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 Companys Condensed Consolidated Balance Sheets at March 31, 2006 and December 31, 2005.
NOTE 5 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, 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. Amortization of acquired product rights is not included in the calculation of segment gross profit or 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 March 31, 2006 and 2005 consists primarily of royalties and revenues from research, development and licensing fees. Net revenues and segment
contribution information for the Companys Brand and Generic segments, consisted of the following:
NOTE 6 INVENTORIES
Inventories consist of finished goods held for sale and distribution, raw materials and work-in-process. Included in inventory at March 31, 2006 and December 31, 2005 is approximately $8.2 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):
NOTE 7 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 2005, Watson performed its annual assessment for the impairment of goodwill and determined there was no indication of impairment.
During the three months ended March 31, 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 ACQUISITIONS). This entire amount was recorded as an addition to goodwill under the Generic pharmaceutical product segment. 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 $164.0 million in each of 2006 and 2007 and $53.0 million in each of 2008 and 2009 and $45.0 million in 2010. The Companys current product rights and related intangibles have a weighted average useful life of approximately fourteen years.
NOTE 8 LONG-TERM DEBT
Long-term debt consisted of the following (in thousands):
In March 2003, the Company issued $575 million of CODES. The CODES, which are convertible into shares of Watsons common stock upon the occurrence of certain events, are due in March 2023, with interest payments due semi-annually in March and September at an effective annual interest rate of 2.1%, excluding changes in fair value of the contingent interest derivative. At March 31, 2006 and December 31, 2005, the unamortized discount for the CODES for both periods was $1.1 and 1.2 million, respectively.
The CODES are convertible into Watsons common stock at a conversion price of approximately $40.05 per share (subject to certain adjustments upon certain events such as (i) stock splits or dividends, (ii) material stock distributions or reclassifications, (iii) distribution of stock purchase rights at less than current market rates or (iv) a distribution of assets or common stock to our shareholders or subsidiaries). The CODES may be converted, at the option of the holders, prior to maturity under any of the following circumstances:
during any quarterly conversion period (period from and including the thirtieth trading day in a fiscal quarter to, but not including, the thirtieth trading day in the immediately following fiscal quarter) if the closing sale price per share of Watsons common stock for a period of at least 20 trading days during the 30 consecutive trading-day period ending on the first day of such conversion period is more than 125% ($50.06) of the conversion price in effect on that thirtieth day;
on or before March 15, 2018, during the five business-day period following any 10 consecutive trading-day period in which the daily average trading price for the CODES for such ten-day period was less than 105% of the average conversion value for the debentures during that period. This conversion feature represents an embedded derivative. However, based on the de minimis value associated with this feature, no value has been assigned at issuance 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 $ 0.5 and $0.9 million at March 31, 2006 and December 31, 2005, respectively.
1998 Senior Notes
In May 1998, Watson issued $150 million of its 1998 Senior Notes. The Company is required to make interest only payments due semi-annually in May and November at an effective annual rate of 7.2%. 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. In May 2004, the Company acquired an additional $34.3 million of its outstanding 1998 Senior Notes in an open market transaction. On March 31, 2006, the Company initiated a redemption notice to the holders of all of its outstanding 1998 Senior Notes. As a result, the Company has reclassified the remaining 1998 Senior Notes as current liabilities in the accompanying Condensed Consolidated Financial Statements as at March 31, 2006.
In May 2003, the Company entered into an agreement with a syndicate of lenders for a five-year, $300 million senior, unsecured revolving credit facility (the Credit Facility) for working capital and other general corporate purposes. On September 8, 2005, the Company entered into a Second Amendment to the Credit Facility on substantially the same terms and conditions except the fee structure was reduced and certain defined terms were added or amended. On March 6, 2006, the Company entered into a Third Amendment to the Credit Facility which, among other things, permits the Company to repurchase up to $300.0 million of its common stock. As of December 31, 2005, the total $300 million under the Credit Facility was available to the Company. 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. 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, the Company was required to issue similar guarantees to 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. As of March 31, 2006 and December 31, 2005, the Company had not drawn any funds from the Credit Facility. Watson is subject to certain financial and operational covenants, all of which, as of March 31, 2006, the Company was in compliance.
NOTE 9 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 8 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, 2006, 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 $0.4 million from $0.9 million at December 31, 2005 to $0.5 million at March 31, 2006. The change in fair value was recorded as a reduction of interest expense during the respective period.
NOTE 10 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, 2006 and 2005 were $2.1 million and $2.9 million, respectively.
Future minimum lease payments under all non-cancelable operating leases consist of approximately $6.2 million remaining in 2006, $6.7 million in 2007, $4.7 million in 2008, $3.7 million in 2009, $2.4 million in 2010 and $13.8 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, 2006 and 2005 were $1.9 million and $1.8 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, 2005. 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.
Cipro Litigation. In the action pending in the Wisconsin Court of Appeals (Barbara A. Meyers, et. Al. v. Bayer AG, et. al., Appeal No. 2003AP2840), on May 9, 2006, the appellate court reversed the circuit courts order granting the defendants Motion to Dismiss and remanded the case to the circuit court for further proceedings.
Governmental Reimbursement Investigations And Drug Pricing Litigation. With respect to the Drug Pricing Litigation pending against the Company and certain subsidiaries, an additional action raising similar allegations was filed by the Attorney General of the State of Hawaii on April 27, 2006. (State of Hawaii v. Abbott Laboratories, Inc., et al, Civil Action No. 06-1-0720-04 EEH, Circuit Court of the First Circuit, State of Hawaii,). In the action filed
by Erie County, New York (County of Erie v. Abbott Laboratories, Inc., et al., Index Number 2005-2439, New York Supreme Court for Erie County,) the Company filed a Motion to Dismiss the complaint on March 10, 2006. Additional actions in other states 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.
Hormone Replacement Therapy Litigation. With respect to the hormone replacement therapy product liability lawsuits pending against the Company, certain of its subsidiaries, and others, additional actions raising similar issues have been filed, and some actions or claims have been dismissed. As of May 8, 2006, approximately 107 cases were pending against Watson and/or its affiliates in state and federal courts, representing claims by approximately 307 plaintiffs. Discovery is ongoing. 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.
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 operations should be read in conjunction with the Condensed Consolidated Financial Statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q (Quarterly Report). This discussion contains forward-looking statements that are subject to known and unknown risks, uncertainties and other factors that may cause our actual results to differ materially from those expressed or implied by such forward-looking statements. These risks, uncertainties and other factors include, among others, those identified under Cautionary Note Regarding Forward-Looking Statements and elsewhere in this Quarterly Report and under Risks Related to our Business in our Annual Report on Form 10-K for the year ended December 31, 2005.
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 currently operate and manage our business as two segments: Generic and Brand.
During the fourth quarter of 2005, the Company announced a plan to close its solid dosage manufacturing facility in Puerto Rico as part of an ongoing effort to optimize the capacity utilization of the Companys manufacturing operations. The Company plans to transfer product manufacturing from its Humacao, Puerto Rico facility to its Carmel, New York. and Corona, California sites and discontinue manufacturing operations at the Puerto Rico facility over the next 12 to 18 months. Under SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, costs associated with exit or disposal activities will be recognized when the liability is incurred rather than at the date of a commitment to an exit or disposal plan. Accordingly, additional cash costs will be recognized in future periods as we transition production to other sites and we incur product transfer, severance and decommissioning costs.
On March 13, 2006, the Company announced a definitive merger agreement to acquire all the outstanding shares of common stock of Andrx Corporation (Nasdaq: ADRX) (Andrx) in an all-cash transaction for $25 per share, or total consideration of approximately $1.9 billion. 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. The consummation of the merger is subject to customary closing conditions, including approval of the transaction by Andrx stockholders and the receipt of applicable U.S. regulatory approvals. Following the close of the merger, Watson will have three operating segments: Generic, Brand and Distribution. The following discussion does not include or incorporate the anticipated impact of Andrx on our business, results of operations, financial condition, cash flows or expectations for 2006.
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.
Other revenues include royalties and revenues earned under research and development agreements, other agreements and royalties. Revenues recognized from research, development and licensing agreements (including milestone payments) are deferred and recognized over the entire contract performance period, starting with the contracts commencement, but not prior to the removal of any contingencies for each individual milestone. We recognize this revenue based upon the pattern in which the revenue is earned or the obligation is fulfilled.
Our Generic segment develops, manufactures, markets, sells and distributes products within two product lines: Generics and Generic Oral Contraceptives (Generic OCs).
Our Generics product line includes oral dosage, transdermal, injectable and transmucosal products used for a variety of indications including pain management, depression, hypertension and smoking cessation.
Sales from our Generics product line for the three months ended March 31, 2006 increased $33.9 million or 16% over sales from the prior year period. This increase in sales was mainly attributable to the Companys launch of an authorized generic version of oxycodone extended-release tablets during the fourth quarter of 2005 which was partially offset by price erosion within our Generics product line.
Sales from our Generic OC product line for the three months ended March 31, 2006 decreased $5.7 million or 7% from the prior year period. The reduction in sales was caused by price erosion in oral contraceptive products since the first quarter of 2005.
The decrease in other revenues in the three months ended March 31, 2006 for the Generic segment was primarily related to a decline in the amount of deferred revenue recognized in the quarter.
We expect total net revenues in the Generic segment in 2006 to range between $1.4 and $1.5 billion as a result of new product launches, including the introduction of pravastatin sodium tablets through a distribution agreement with Bristol-Myers Squibb Company.
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 includes urology and a number of other non-promoted products.
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 $24.4 million or 38% decrease in sales from our Specialty Products group for the three months ended March 31, 2006, as compared to the same prior year period, was attributable to a decrease in prescription volumes and a reduction in wholesaler inventory levels resulting from our entry into inventory management agreements with some of our larger customers during 2005. The reduction in sales for the period was partially offset by sales of our Trelstar® Depot and Trelstar® LA products for the palliative treatment of advanced prostate cancer launched in the second quarter of 2005. Sales levels in the prior year period were impacted by wholesaler buying in anticipation of price increases.
Sales from our Nephrology business increased $3.1 million or 8% due to slight increases in sales of our Ferrlecit® product.
The decrease in other revenues in the three months ended March 31, 2006 for the Brand segment was primarily related to a decline in the amount of deferred revenue recognized in the quarter.
We expect total net revenues in the Brand segment in 2006 to range between $350 and $360 million.
Gross Profit (Gross Margin)
Gross profit represents net revenues less cost of sales. Cost of sales includes the cost of manufacturing and packaging for the products we manufacture, the cost of products we purchase from third parties, our profit-sharing or royalty payments made to third parties, changes to our inventory reserves and excess capacity
utilization charges, where applicable. Amortization of acquired product rights is included in operating expenses.
The decrease in gross margin from our Generic segment for the three months ended March 31, 2006 was primarily due to price erosion, the introduction of a third party manufactured product (Authorized Generic) during the fourth quarter of 2005 with lower margins and excess capacity utilization charges as a result of the anticipated closure of our Puerto Rico facility.
Gross margin from our Brand segment increased as we increased production levels at certain manufacturing facilities resulting in more efficient unit overhead absorption during the three months ended March 31, 2006 as compared to the same period of the prior year.
Overall consolidated gross margins are expected to be 41% for the remainder of 2006.
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, 2006, as compared to the same period of the prior year, due to increased activity in the number of generic products being developed.
Research and development expenses within our Brand segment decreased during the three months ended March 31, 2006, 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.
Research and development investment for 2006 is estimated to range between 6.5% and 7% of expected total net revenue. Research and development spending is expected to fluctuate during the remaining quarters of 2006 in tandem with the timing of clinical study costs associated with (i) the Companys generic product pipeline, (ii) the continuation of Phase III studies on the silodosin product for benign prostatic hyperplasia, as well as (iii) the initiation of Phase 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.
Generic and Brand segment selling and marketing expenses increased during the three months ended March 31, 2006, as compared to the same period of the prior year, due to higher personnel costs related to commissions, stock option and restricted stock expense as well as increased facility charges related to the opening of our Gurnee, Illinois distribution facility in the third quarter of 2005.
Selling, general and administrative expenses for 2006 are estimated to range between 14.5% and 15% of expected total net revenue.
The Companys amortizable assets consist primarily of acquired product rights.
We expect amortization expense in 2006 to approximate 2005 levels.
(Losses) Earnings on Equity Method Investments
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. 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 of approximately 24%. Accordingly, as required by Accounting Principles Board (APB) Opinion No. 18,
The Equity Method of Accounting for Investments in Common Stock (APB 18), loss on equity method investments has been restated for all periods presented to conform to current period presentation. In January 2006, we made an additional $12.0 million investment in Scinopharm which increased our ownership share to approximately 31%.
The loss recorded during the three months ended March 31, 2006 represents our equity in losses incurred by Somerset Pharmaceuticals, Inc., our joint venture with Mylan Laboratories, Inc. Somerset has developed Emsam®, a selegeline patch for the treatment of depression. On February 28, 2006, the U.S. Food and Drug Administration (FDA) granted Somerset final approval for Emsam®. As a result of this approval, the Company expects Somerset to be profitable for the remainder of 2006.
Gain on Sale of Securities