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FORM 10-Q
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended JUNE 30, 2004
COMMISSION FILE NUMBER 1-6571
SCHERING-PLOUGH CORPORATION
(Exact name of registrant as specified in its charter)
New Jersey 22-1918501
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation) (908) 298-4000
2000 Galloping Hill Road (Registrant's telephone number,
Kenilworth, NJ including area code)
(Address of principal executive
offices)
07033
(Zip 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, and (2) has been subject to such filing requirements
for the past 90 days.
YES [X] NO [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). YES [X] NO [ ]
Common Shares Outstanding as of June 30, 2004: 1,472,377,983
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
STATEMENTS OF CONSOLIDATED OPERATIONS
(UNAUDITED)
(Amounts in millions, except per share figures)
Three Months Six Months
Ended Ended
June 30, June 30,
------------------ ------------------
2004 2003 2004 2003
------- ------- ------- -------
Net sales $ 2,147 $ 2,308 $ 4,110 $ 4,389
------- ------- ------- -------
Cost of sales 790 784 1,530 1,442
Selling, general and administrative 979 938 1,893 1,780
Research and development 451 369 824 691
Other expense (income), net 43 (4) 78 8
Special charges 42 20 112 20
Equity (income)/loss from cholesterol joint venture (77) (26) (154) 4
------- ------- ------- -------
(Loss)/income before income taxes (81) 227 (173) 444
Income taxes benefit/(expense) 16 (45) 35 (89)
------- ------- ------- -------
Net (loss)/income $ (65) $ 182 $ (138) $ 355
======= ======= ======= =======
Diluted (loss)/earnings per common share $ (.04) $ .12 $ (.09) $ .24
======= ======= ======= =======
Basic (loss)/earnings per common share $ (.04) $ .12 $ (.09) $ .24
======= ======= ======= =======
Dividends per common share $ .055 $ .17 $ .11 $ .34
======= ======= ======= =======
See notes to consolidated financial statements.
2
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(Amounts in millions, except per share figures)
June 30, December 31,
2004 2003
-------- ------------
Assets
Cash and cash equivalents $ 4,155 $ 4,218
Short-term investments 832 587
Accounts receivable, net 1,532 1,329
Inventories 1,525 1,651
Deferred income taxes 481 472
Prepaid expenses
and other current assets 536 890
-------- ------------
Total current assets 9,061 9,147
Property, plant and equipment 6,823 6,817
Less accumulated depreciation 2,334 2,290
-------- ------------
Property, net 4,489 4,527
Goodwill 216 218
Other intangible assets, net 368 401
Other assets 756 809
-------- ------------
Total assets $ 14,890 $ 15,102
======== ============
Liabilities and Shareholders' Equity
Accounts payable $ 965 $ 1,030
Short-term borrowings and current
portion of long-term debt 1,305 1,023
Other accrued liabilities 2,521 2,556
-------- ------------
Total current liabilities 4,791 4,609
Long-term debt 2,410 2,410
Other long-term liabilities 695 746
-------- ------------
Total long-term liabilities 3,105 3,156
Shareholders' Equity:
Preferred shares - $1 par value;
issued - none - -
Common shares - $.50 par value;
issued: 2,030 1,015 1,015
Paid-in capital 1,288 1,272
Retained earnings 10,618 10,918
Accumulated other comprehensive income (488) (426)
-------- ------------
Total 12,433 12,779
Less treasury shares: 2004 - 557 shares;
2003 - 559 shares, at cost 5,439 5,442
-------- ------------
Total shareholders' equity 6,994 7,337
-------- ------------
Total liabilities and shareholders' equity $ 14,890 $ 15,102
======== ============
See notes to consolidated financial statements.
3
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
STATEMENTS OF CONSOLIDATED CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30,
(UNAUDITED)
(Amounts in millions)
2004 2003
-------- --------
Operating Activities:
Net (loss)/income $ (138) $ 355
Depreciation and amortization 217 193
Accounts receivable (237) 434
Inventories 84 (141)
Prepaid expenses and other assets (7) 80
Accounts payable and other liabilities (36) (512)
Tax refund from loss carryback 404 -
Special charges 46 20
-------- --------
Net cash provided by operating activities 333 429
-------- --------
Investing Activities:
Capital expenditures (227) (282)
Reduction of investments - 35
Purchases of investments (244) (38)
Other, net 4 2
-------- --------
Net cash used for investing activities (467) (283)
-------- --------
Financing Activities:
Cash dividends paid to common shareholders (162) (500)
Net change in short-term borrowings 284 456
Other, net (48) 8
-------- --------
Net cash provided by (used for) financing activities 74 (36)
-------- --------
Effect of exchange rates on cash and
cash equivalents (3) 1
-------- --------
Net (decrease)/increase in cash and
cash equivalents (63) 111
Cash and cash equivalents, beginning
of period 4,218 3,521
-------- --------
Cash and cash equivalents, end of period $ 4,155 $ 3,632
======== ========
See notes to consolidated financial statements.
4
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Basis of Presentation
The unaudited financial statements included herein have been prepared pursuant
to the rules and regulations of the Securities and Exchange Commission for
reporting on Form 10-Q. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with U.S. generally
accepted accounting principles have been condensed or omitted pursuant to such
rules and regulations. Certain prior year amounts have been reclassified to
conform to the current year presentation. The statements should be read in
conjunction with the accounting policies and notes to consolidated financial
statements included in the Company's 2003 Annual Report on Form 10-K.
In the opinion of management, the financial statements reflect all adjustments
necessary for a fair statement of the operations for the interim periods
presented.
Revenue Recognition
Revenues from the sale of products are recognized when title and risk of loss
passes to customers and reliable estimates of product returns can be made.
Reliable estimates of product returns can be made when business conditions
permit the Company to make reasonable estimates of expected demand.
Following the approval of CLARITIN as an over-the-counter (OTC) product in the
fourth quarter of 2002, revenue from U.S. sales of the prescription form of
CLARITIN was recognized when the product was used to fill patient prescriptions
because reliable estimates of product returns could not be made at the time
title and risk of loss passed to customers. Further, since the expiration of the
initial 180-day period of exclusivity for the first generic competitor of the
OTC form of CLARITIN, the Company has experienced additional private-label
competition. As a result, revenues from the sales of OTC CLARITIN are recognized
at the time title and risk of loss passes to customers, but only to the extent
that the Company can make reasonable estimates of product returns.
Provisions for discounts and rebates are recorded in the same period the related
sales are recorded. For purposes of revenue recognition, at the end of each
quarter the Company estimates the applicable commercial and governmental rebates
that will be paid for products sold and reduces recorded sales by those
estimated amounts. These rebates are estimated based on terms, historical
experience, trend analysis and projected market conditions in the various
markets served.
Recently Issued Accounting Standards
In May 2004, the FASB issued Staff Position No. FAS 106-2, titled "Accounting
and Disclosure Requirements Related to the Medicare Prescription Drug,
Improvement and Modernization Act of 2003", effective in the third quarter of
2004. The act, signed into law in December 2003, introduces a prescription drug
benefit under Medicare as well as a federal subsidy, under certain conditions,
to sponsors of retiree health care benefit plans. Presently, final guidance
under the act on determining eligibility for the federal subsidy has not been
issued, and therefore the impact on the Company's liability for its
post-retirement health care benefits plan has not yet been determined.
5
Special Charges
Special charges for the three months ended June 30, 2004 totaled $42 million
relating to employee termination costs. Special charges for the six months ended
June 30, 2004 totaled $112 million, comprised of $86 million in employee
termination costs and $26 million in asset impairment charges. Special charges
for the three and six month periods ended June 30, 2003 included $20 million of
asset impairment charges.
Employee Termination Costs
In August 2003, the Company announced a global workforce reduction initiative.
The first phase of this initiative was a Voluntary Early Retirement Program in
the United States. Under this program, eligible employees in the United States
had until December 15, 2003, to elect early retirement and receive an enhanced
retirement benefit. Approximately 900 employees elected to retire under the
program, of which approximately 750 employees retired at or near year-end 2003
and approximately 150 employees have staggered retirement dates in the future.
The total cost of this program is estimated to be $191 million, comprised of
increased pension costs of $108 million, increased post-retirement health care
costs of $57 million, vacation payments of $4 million and costs related to
accelerated vesting of stock grants of $22 million. For employees with staggered
retirement dates in the future, these amounts will be recognized as a special
charge over the employees' remaining service periods. This delayed expense
recognition follows the guidance in SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." Amounts recognized, relating to
this program, during the three and six months ended June 30, 2004 were $8
million and $17 million, respectively, with cumulative costs recognized of $181
million as of June 30, 2004. Amounts expected to be recognized during the
remainder of 2004 and 2005 are $3 million and $7 million, respectively.
Also, the Company recognized $34 million and $69 million, respectively, of other
employee severance costs for the three and six months ended June 30, 2004.
Asset Impairment Charges
Asset impairment charges have been recognized in accordance with Statement of
Financial Accounting Standards (SFAS) No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets." For the three months ended June 30, 2004, the
Company did not recognize any asset impairment charges. For the six months ended
June 30, 2004, the Company recognized asset impairment charges of $26 million
based on discounted cash flows. The asset impairments primarily related to the
anticipated exit from a small European research-and-development facility. For
the three and six month periods ended June 30, 2003, the Company recognized
asset impairment charges of $20 million related to manufacturing facility
assets.
6
Summary of Selected Special Charges
The following summarizes the activity in the accounts related to employee
termination costs and asset impairment charges ($ in millions):
Employee Asset
Termination Impairment
Costs Charges
----------- ----------
Special charges accrual balance at Dec. 31, 2003 $ 29 $ -
Special charges incurred during six months ended
June 30, 2004 86 26
Asset impairment charges - (26)
Credit to retirement benefit plan liability (17) -
Cash disbursements (59) -
Special charges accrual balance at June 30, 2004 $ 39 $ -
The balance at June 30, 2004 for employee termination costs represents the value
of stock grants ($22 million) not yet distributed and severance payments
remaining to be paid ($17 million) as of June 30, 2004.
Product License
On June 21, 2004, the Company entered into a collaboration and license agreement
with Toyama Chemical Co., Ltd. ("Toyama"). Under the terms of the agreement, the
Company has acquired the exclusive worldwide rights, excluding Japan, Korea and
China, to develop, use and sell garenoxacin, Toyama's quinolone antibacterial
agent currently in development. In connection with the execution of the
agreement, the Company incurred a charge for an up-front fee of $80 million to
Toyama. This amount has been expensed and reported in "Research and development"
for the three and six months ended June 30, 2004 in the Statements of
Consolidated Operations. Under the terms of the agreement, the Company could
make additional payments up to $245 million to Toyama for milestones relating to
the approval, further development and commercialization of garenoxacin.
Inventories
Inventories consisted of ($ in millions):
June 30, December 31,
2004 2003
-------- ------------
Finished products $ 570 $ 664
Goods in process 640 648
Raw materials and supplies 315 339
-------- ------------
Total inventories $ 1,525 $ 1,651
======== ============
7
Other Intangible Assets
The components of the balance sheet caption "Other intangible assets, net" are
as follows ($ in millions):
June 30, 2004 December 31, 2003
----------------------------------- ------------------------------------
Gross Gross
Carrying Accumulated Carrying Accumulated
Amount Amortization Net Amount Amortization Net
-------- ------------ ------- -------- ------------ --------
Patents and
licenses $ 568 $ 303 $ 265 $ 614 $ 318 $ 296
Trademarks and
other 143 40 103 143 38 105
-------- ------------ ------- -------- ------------ --------
Total other
intangible
assets $ 711 $ 343 $ 368 $ 757 $ 356 $ 401
======== ============ ======= ======== ============ ========
These intangible assets are amortized on the straight-line method over their
respective useful lives. In the six months ended June 30, 2004, the Company did
not make any payments that were capitalized for patent and licensing rights. In
the six months ended June 30, 2003, the Company paid $6 million for patent and
licensing rights; these amounts are being amortized over approximately eight
years. The residual value of intangible assets is estimated to be zero.
Amortization expense related to other intangible assets for the six months ended
June 30, 2004 and 2003 was $21 million and $27 million, respectively. Other
intangible assets are reviewed to determine their recoverability by comparing
their carrying values to their expected undiscounted future cash flows when
events or circumstances warrant such a review. Full year amortization expense in
each of the next five years is estimated to be approximately $45 million per
year based on the intangible assets recorded as of June 30, 2004.
Accounting for Stock-Based Compensation
The following table reconciles net (loss)/income and (loss)/earnings per common
share (EPS), as reported, for the three and six months ended June 30, 2004 and
2003 to pro forma net (loss)/income and EPS, as if the Company had expensed the
grant date fair value of both stock options and deferred stock units as
permitted by SFAS No. 123, "Accounting for Stock-Based Compensation." These pro
forma amounts may not be representative of the initial impact of adopting SFAS
No. 123 since, as amended, it permits alternative methods of adoption.
8
($ in millions, except per share figures):
Three months Six months
ended ended
-------------------- --------------------
June 30, June 30, June 30, June 30,
2004 2003 2004 2003
-------- -------- -------- --------
Net (loss)/income, as reported $ (65) $ 182 $ (138) $ 355
Add back: Expense included in reported net
(loss)/income for deferred stock units, net of tax 8 14 20 24
Deduct: Pro forma expense as if both stock options and
deferred stock units were charged against net
(loss)/income, net of tax (24) (33) (53) (62)
-------- -------- -------- --------
Pro forma net (loss)/income using the fair value method $ (81) $ 163 $ (171) $ 317
-------- -------- -------- --------
Diluted (loss)/earnings per share:
Diluted (loss)/earnings per share, as reported $ (.04) $ .12 $ (.09) $ .24
Pro forma diluted (loss)/earnings per share using the
fair value method (.06) .11 (.12) .22
Basic (loss)/earnings per share:
Basic (loss)/earnings per share, as reported $ (.04) $ .12 $ (.09) $ .24
Pro forma basic (loss)/earnings per share using the
fair value method (.06) .11 (.12) .22
Other expense (income), net
The components of other expense (income), net are as follows ($ in millions):
Three Months Six Months
Ended Ended
June 30, June 30,
2004 2003 2004 2003
-------- -------- -------- --------
Interest cost incurred $ 47 $ 14 $ 100 $ 30
Less: amount capitalized on construction (4) (2) (9) (5)
-------- -------- -------- --------
Interest expense 43 12 91 25
Interest income (15) (15) (29) (28)
Foreign exchange (gains) losses 4 - 4 1
Other, net 11 (1) 12 10
-------- -------- -------- --------
Total $ 43 $ (4) $ 78 $ 8
======== ======== ======== ========
Cash paid for interest, net of amounts capitalized, was $81 million and $23
million, respectively, for the six months ended June 30, 2004 and 2003.
Consent Decree
On May 17, 2002, the Company announced that it had reached an agreement with the
FDA for a consent decree to resolve issues involving the Company's compliance
with current Good Manufacturing
9
Practices (cGMP) at certain manufacturing facilities in New Jersey and Puerto
Rico. The U.S. District Court for the District of New Jersey approved and
entered the consent decree on May 20, 2002.
Under terms of the consent decree, the Company agreed to pay a total of $500
million to the U.S. government in two equal installments of $250 million; the
first installment was paid in May 2002, and the second installment was paid in
May 2003. As previously reported, the Company accrued a $500 million provision
for this consent decree in the fourth quarter of 2001.
The consent decree requires the Company to complete a number of actions. In the
event certain actions agreed upon in the consent decree are not satisfactorily
completed on time, the FDA may assess payments for each deadline missed. The
consent decree required the Company to develop and submit for FDA's concurrence
comprehensive cGMP Work Plans for the Company's manufacturing facilities in New
Jersey and Puerto Rico that are covered by the decree. The Company received FDA
concurrence with its proposed cGMP Work Plans on May 14, 2003. The cGMP Work
Plans contain a number of Significant Steps whose timely and satisfactory
completion are subject to payments of $15 thousand per business day for each
deadline missed. These payments may not exceed $25 million for 2002, and $50
million for each of the years 2003, 2004 and 2005. These payments are subject to
an overall cap of $175 million.
In connection with its discussions with FDA regarding the Company's cGMP Work
Plans, and pursuant to the terms of the decree, the Company and FDA entered into
a letter agreement dated April 14, 2003. In the letter agreement, the Company
and FDA agreed to extend by six months the time period during which the Company
may incur payments as described above with respect to certain of the Significant
Steps whose due dates are December 31, 2005. The letter agreement does not
increase the yearly or overall caps on payments described above.
In addition, the decree requires the Company to complete programs of
revalidation of the finished drug products and bulk active pharmaceutical
ingredients manufactured at the covered manufacturing facilities. The Company is
required under the consent decree to complete its revalidation programs for bulk
active pharmaceutical ingredients by September 30, 2005, and for finished drugs
by December 31, 2005. In general, the timely and satisfactory completion of the
revalidations are subject to payments of $15 thousand per business day for each
deadline missed, subject to the caps described above. However, if a product
scheduled for revalidation has not been certified as having been validated by
the last date on the validation schedule, the FDA may assess a payment of 24.6
percent of the net domestic sales of the uncertified product until the
validation is certified. Any such payment would not be subject to the caps
described above. Further, in general, if a product scheduled for revalidation
under the consent decree is not certified within six months of its scheduled
date, the Company must cease production of that product until certification is
obtained. The completion of the Significant Steps in the Work Plans and the
completion of the revalidation programs are subject to third-party expert
certification, which must be accepted by the FDA.
The consent decree provides that if the Company believes that it may not be able
to meet a deadline, the Company has the right, upon the showing of good cause,
to request extensions of deadlines in connection with the cGMP Work Plans and
revalidation programs. However, there is no guarantee that FDA will grant any
such requests.
Although the Company believes it has made significant progress in meeting its
obligations under the consent decree, it is possible that (1) the Company may
fail to complete a Significant Step or a
10
revalidation by the prescribed deadline; (2) the third party expert may not
certify the completion of the Significant Step or revalidation; or (3) the FDA
may disagree with an expert's certification of a Significant Step or
revalidation. In such a case, it is possible that the FDA may assess payments as
described above.
The Company would expense any payments assessed under the decree if and when
incurred.
The consent decree contains a sunset provision that permits the Company to
petition the Court to dissolve the decree if, during any five year period
following the entry of the decree (May 20, 2002), FDA has not notified the
Company that there has been a significant violation of FDA law, regulations, or
the decree. If these conditions are satisfied, the decree states that FDA will
not oppose the Company's petition. The earliest the Company would be in a
position to submit such a petition would be May, 2007 (five years after the
entry of the decree). However, the Company cannot predict at this time when or
how long FDA may take to complete a review of the Company's completion of its
cGMP Work Plans and validation program requirements under the decree.
Also, as noted in the "Legal, Environmental and Regulatory Matters" footnote
below, in April 2003, the Company received notice of a False Claims Act
complaint brought by an individual purporting to act on behalf of the U.S.
government against it and approximately 25 other pharmaceutical companies in the
U.S. District Court for the Northern District of Texas. The complaint alleges
that the pharmaceutical companies, including the Company, have defrauded the
United States by having made sales to various federal governmental agencies of
drugs that were allegedly manufactured in a manner that did not comply with
current Good Manufacturing Practices. The Company and the other defendants filed
a motion to dismiss the second amended complaint in this action on April 12,
2004.
Equity Income from Cholesterol Joint Venture
The Company and Merck & Co., Inc. (Merck) have agreements to jointly develop and
market ZETIA (ezetimibe) as a once-daily monotherapy, as co-administration of
ZETIA with statins, and VYTORIN, a once-daily fixed-combination tablet of
ezetimibe and simvastatin (Zocor), Merck's cholesterol-modifying medicine. The
agreements also involve the development and marketing of a once-daily,
fixed-combination tablet containing CLARITIN and Singulair. Singulair is Merck's
once-daily leukotriene receptor antagonist for the treatment of asthma and
seasonal allergic rhinitis. In January 2002, Schering-Plough/Merck
Pharmaceuticals reported on results of Phase III clinical trials of a
fixed-combination tablet containing CLARITIN and Singulair, which did not
demonstrate sufficient added benefits in the treatment of seasonal allergic
rhinitis.
The agreements generally provide for equal sharing of development costs and for
co-promotion of approved products by each company in the United States and in
most other countries of the world, except Japan. In Japan, no agreement exists.
In general, co-promotion provides that each company will provide equal physician
marketing efforts and that each company will bear the cost of its own sales
force in marketing the products. In general, the agreement provides that the
venture will operate in a "virtual" mode to the maximum degree possible by
relying on the respective infrastructures of the two companies. However, the
companies have agreed to share certain costs, but these costs are limited to a
portion of the costs of manufacturing, the cost of a specialty sales force and
certain specially identified promotion costs. It should be noted that the
Company incurs substantial costs, such as selling costs, that are not reflected
in "Equity (income)/loss from cholesterol joint venture" and are borne entirely
by the overall cost structure of the Company. The agreements do not provide for
any jointly owned facilities and, as
11
such, products resulting from the collaboration will be manufactured in
facilities owned by either Merck or the Company.
During 2003, the Company earned a milestone of $20 million that relates to
certain European approvals of ZETIA, and in the first quarter of 2004 the
Company earned an additional $7 million milestone relating to the approval of
ezetimibe/simvastatin in Mexico.
Under certain other conditions, as specified in the agreements, Merck could pay
additional milestones to the Company totaling $125 million.
To reflect the venture's first full year of commercial operations, the Company
adopted the equity method of accounting effective as of the beginning of 2003.
Under that method, the Company records its share of the operating profits less
its share of the research and development costs in "Equity (income)/loss from
cholesterol joint venture" in the Statements of Consolidated Operations.
"Equity (income)/loss from cholesterol joint venture" totaled $77 million for
the three months ended June 30, 2004. "Equity (income)/loss from cholesterol
joint venture" totaled $154 million for the six months ended June 30, 2004,
which includes the $7 million milestone earned for the Mexico approval. U.S.
ZETIA sales exceeded a pre-defined annual sales level, as stipulated in the
joint venture contract, during the second quarter of 2004. As a result, profit
from the U.S. sales of ZETIA will be split 50/50 for the remainder of the year,
down from a previously higher profit split.
Operating profit in the context of the joint venture represents net sales, less
cost of sales, direct promotion expenses and other costs that the Company and
Merck may agree to share. Operating profit excludes the cost of the Company's
sales forces throughout the world, as well as the many indirect costs incurred
by the Company to support the manufacturing, marketing and management of ZETIA
and VYTORIN. As such, the amount reported as "Equity (income)/loss from
cholesterol joint venture" represents what the Company receives from the joint
venture to fund the costs incurred by the Company that are not shared with
Merck.
Borrowings
On November 26, 2003, the Company issued $1.25 billion aggregate principal
amount of 5.3 percent senior unsecured notes due 2013 and $1.15 billion
aggregate principal amount of 6.5 percent senior unsecured notes due 2033.
Interest is payable semi-annually. The net proceeds from this offering were
$2.37 billion. Upon issuance, the notes were rated A3 by Moody's Investors
Service, Inc. (Moody's), and A+ (on CreditWatch with negative implications) by
Standard & Poor's Rating Services (S&P). The interest rates payable on the notes
are subject to adjustment as follows: If the rating assigned to a particular
series of notes by either Moody's or S&P changes to a rating set forth below,
the interest rate payable on that series of notes will be the initial interest
rate (5.3 percent for the notes due 2013 and 6.5 percent for the notes due 2033)
plus the additional interest rate set forth below for each rating assigned by
Moody's and S&P.
Additional Additional
Moody's Rating Interest Rate S&P Rating Interest Rate
- -------------- ------------- ------------ -------------
Baa 1 0.25% BBB+ 0.25%
Baa2 0.50% BBB 0.50%
Baa3 0.75% BBB- 0.75%
Ba 1 or below 1.00% BB+ or below 1.00%
12
In no event will the interest rate for any of the notes increase by more than 2
percent above the initial coupon rates of 5.3 percent and 6.5 percent,
respectively. If either Moody's or S&P subsequently upgrades its ratings, the
interest rates will be correspondingly reduced, but not below 5.3 percent or 6.5
percent, respectively. Furthermore, the interest rate payable on a particular
series of notes will return to 5.3 percent and 6.5 percent, respectively, and
the rate adjustment provisions will permanently cease to apply if, following a
downgrade by both Moody's and S&P below A3 or A-, respectively, both Moody's and
S&P raise their rating to A3 and A-, respectively, or better.
On July 14, 2004, Moody's lowered its rating of the notes to "Baa1",
accordingly, the interest payable on each note will increase by 25 basis points,
respectively, effective December 1, 2004. Therefore, on December 1, 2004, the
interest rate payable on the notes due 2013 will increase from 5.3% to 5.55%,
and the interest rate payable on the notes due 2033 will increase from 6.5% to
6.75%. This adjustment to the interest rate payable on the notes will increase
the Company's interest expense by $6 million annually.
The notes are redeemable in whole or in part, at the Company's option at any
time, at a redemption price equal to the greater of (1) 100 percent of the
principal amount of such notes and (2) the sum of the present values of the
remaining scheduled payments of principal and interest discounted using the rate
of treasury notes with comparable remaining terms plus 25 basis points for the
2013 notes or 35 basis points for the 2033 notes.
Credit Facilities
The Company has two revolving credit facilities totaling $1.5 billion. Both
facilities are from a syndicate of major financial institutions. The most
recently negotiated facility (May 2004) is a $1.25 billion, five-year credit
facility. This facility matures in May 2009 and requires the Company to maintain
a total debt to total capital ratio of no more than 60 percent. The second
credit facility provides a $250 million line of credit through its maturity date
in May 2006 and requires the Company to maintain a total debt to total capital
ratio of no more than 60 percent anytime the Company is rated at or below Baa3
by Moody's and BBB- by S&P. These facilities are available for general corporate
purposes and are considered as support for the Company's commercial paper
borrowings. These facilities do not require compensating balances; however, a
nominal commitment fee is paid. At June 30, 2004, no funds were drawn under
either of these facilities.
Shelf Registration
On May 11, 2004, the Company's shelf registration, as amended, was declared
effective by the SEC. The shelf registers for issuance up to $2 billion in
various debt and equity securities. As of June 30, 2004, no amounts were issued
under the shelf registration.
Credit Ratings
Changes in Credit Ratings
On February 18, 2004, S&P downgraded the Company's senior unsecured debt ratings
to "A-" from "A." At the same time, S&P also lowered the Company's short-term
corporate credit and commercial paper rating to "A-2" from "A-1." The Company's
S&P rating outlook remains negative.
13
On March 3, 2004, S&P assigned the shelf registration, which was declared
effective on May 11, 2004, a preliminary rating of "A-" for senior unsecured
debt and a preliminary subordinated debt rating of "BBB+". As of June 30, 2004,
no amounts were issued under the shelf registration.
On April 29, 2004, Moody's placed the Company's senior unsecured credit rating
of "A-3" on its Watchlist for possible downgrade based upon concerns related to
market share declines, litigation risks and a high degree of reliance on the
success of VYTORIN. On July 14, 2004, Moody's lowered the Company's senior
unsecured credit rating from "A-3" to "Baa1", lowered the Company's senior
unsecured shelf registration rating from "(P)A3" to "(P)Baa1", lowered the
Company's subordinated shelf registration rating from "(P)Baa1" to "(P)Baa2",
lowered the Company's cumulative and non-cumulative preferred stock shelf
registration rating from "(P)Baa2" to "(P)Baa3", confirmed the Company's "P-2"
commercial paper rating and removed the Company from the Watchlist. Moody's
rating outlook for the Company is negative.
On November 20, 2003, Fitch Ratings (Fitch) downgraded the Company's senior
unsecured and bank loan ratings to "A-" from "A+," and its commercial paper
rating to "F2" from "F1." The Company's rating outlook remained negative. In
announcing the downgrade, Fitch noted that the sales decline in the Company's
leading product franchise, the INTRON franchise, was greater than anticipated,
and that it was concerned that total Company growth is reliant on the
performance of two key growth drivers, ZETIA and REMICADE, in the near term.
Comprehensive (Loss) Income
Total comprehensive (loss) income for the three months ended June 30, 2004 and
2003 was $(86) million and $284 million, respectively. Total comprehensive
(loss) income for the six months ended June 30, 2004 and 2003 was $(200) million
and $473 million, respectively.
Earnings Per Common Share
The shares used to calculate basic and diluted earnings per common share are
reconciled as follows (number of shares in millions):
Three Months Six Months
Ended Ended
June 30, June 30,
2004 2003 2004 2003
-------- -------- -------- --------
Average shares outstanding 1,472 1,469 1,471 1,469
for basic earnings per share
Dilutive effect of options
and deferred stock units - 2 - 2
-------- -------- -------- --------
Average shares outstanding
for diluted earnings per share 1,472 1,471 1,471 1,471
-------- -------- -------- --------
14
As of June 30, 2004, the equivalent of 90 million common shares issuable under
the Company's stock incentive plans were excluded from the computation of
diluted earnings per share because their effect would have been antidilutive.
Retirement Plans and Other Post-Retirement Benefits
The Company has defined benefit pension plans covering eligible employees in the
United States and certain foreign countries, and the Company provides
post-retirement health care benefits to its eligible U.S. retirees and their
dependents.
The components of net pension expense were as follows ($ in millions):
Three months ended Six months ended
June 30, June 30,
-------------------- --------------------
2004 2003 2004 2003
-------- -------- -------- --------
Service cost $ 23 $ 26 $ 49 $ 45
Interest cost 31 33 66 56
Expected return on plan assets (35) (45) (76) (77)
Amortization, net 8 - 16 -
Termination benefits (1) 5 - 11 -
Settlement (1) 2 - 4 -
-------- -------- -------- --------
Net pension expense $ 34 $ 14 $ 70 $ 24
======== ======== ======== ========
The components of other post-retirement benefits expense were as follows ($ in
millions):
Three months ended Six months ended
June 30, June 30,
-------------------- --------------------
2004 2003 2004 2003
-------- -------- -------- --------
Service cost $ 4 $ 3 $ 7 $ 5
Interest cost 7 5 13 8
Expected return on plan assets (4) (5) (8) (8)
Amortization, net 1 - 2 -
Termination benefits (1) 1 - 2 -
Settlement (1) - - - -
-------- -------- -------- --------
Net other post-retirement benefits
expense $ 9 $ 3 $ 16 $ 5
======== ======== ======== ========
(1) Termination benefits and Settlement costs primarily relate to the
matters discussed in the "Special Charges" footnote.
In 2003, the Medicare Prescription Drug, Improvement and Modernization Act (the
"Act") was signed into law in the United States. The benefit obligations
reported herein for the Company's post-retirement benefit plans do not reflect
the impact of the Act, as final guidance on determining eligibility for the
federal subsidy related to the Act has not yet been issued.
15
Segment Data ($ in millions)
The Company has three reportable segments: Prescription Pharmaceuticals,
Consumer Health Care and Animal Health. The segment sales and profit data that
follow are consistent with the Company's current management reporting structure,
established in the second quarter of 2003. The Prescription Pharmaceuticals
segment discovers, develops, manufactures and markets human ethical
pharmaceutical products. The Consumer Health Care segment develops, manufactures
and markets OTC, foot care and sun care products, primarily in the United
States. The Animal Health segment discovers, develops, manufactures and markets
animal health products.
Net sales by segment:
Three months ended Six months ended
June 30, June 30,
-------------------- --------------------
2004 2003 2004 2003
-------- -------- -------- --------
Prescription Pharmaceuticals $ 1,644 $ 1,871 $ 3,125 $ 3,517
Consumer Health Care 317 266 629 559
Animal Health 186 171 356 313
-------- -------- -------- --------
$ 2,147 $ 2,308 $ 4,110 $ 4,389
======== ======== ======== ========
Profit by segment:
Three months ended Six months ended
June 30, June 30,
-------------------- --------------------
2004 2003 2004 2003
-------- -------- -------- --------
Prescription Pharmaceuticals $ 7 $ 232 $ (41) $ 380
Consumer Health Care 46 15 146 104
Animal Health 16 22 21 35
Corporate and other (1) (150) (42) (299) (75)
-------- -------- -------- --------
Consolidated (loss)/profit
before tax $ (81) $ 227 $ (173) $ 444
======== ======== ======== ========
(1) For the three and six months ended June 30, 2004, Corporate and other
included special charges of $42 million and $112 million, respectively, related
to the Voluntary Early Retirement Program, other employee severance costs and
asset impairment charges (see "Special Charges" footnote for additional
information). Special charges for the three months ended June 30, 2004 relate to
the reportable segments as follows: Prescription Pharmaceuticals - $38 million,
Consumer Health Care - $1 million, Animal Health - $1 million and Corporate and
other - $2 million. Special charges for the six months ended June 30, 2004
relate to the reportable segments as follows: Prescription Pharmaceuticals - $96
million, Consumer Health Care - $2 million, Animal Health - $2 million and
Corporate and other - $12 million.
Corporate and other also includes interest income and expense, foreign exchange
gains and losses, headquarters expenses and other miscellaneous items. The
accounting policies used for segment reporting are the same as those described
in the "Summary of Significant Accounting Policies" in the Company's 2003 Annual
Report.
16
Sales of products comprising 10% or more of the Company's U.S. or international
sales in the six months ended June 30, 2004 were as follows ($ in millions):
U.S. International
------- -------------
CLARINEX $ 195 $ 161
NASONEX 167 129
OTC CLARITIN 234 -
REMICADE - 347
The Company does not disaggregate assets on a segment basis for internal
management reporting and, therefore, such information is not presented.
Legal, Environmental and Regulatory Matters
Background
The Company is involved in various claims and legal proceedings of a nature
considered normal to its business, including product liability cases and
Superfund sites discussed below. The Company adjusts its accrued liabilities to
reflect the current best estimate of its probable loss exposure. Where no best
estimate is determinable, the Company accrues the minimum amount within the most
probable range of its liability.
The recorded liabilities for the above matters at June 30, 2004, and the related
expenses incurred during the six months ended June 30, 2004 were not material.
Expected insurance recoveries have not been considered in determining the costs
for environmental-related liabilities.
The Company believes that, except for the matters discussed in the remainder of
this section, it is remote at this time that any material liability in excess of
the amounts accrued will be incurred. With respect to the matters discussed in
the remainder of this section, except where noted, it is not practicable to
estimate a range of reasonably possible loss; where it is, a reserve has been
included in the financial statements. Resolution of any or all of the matters
discussed in the remainder of this section, individually or in the aggregate,
could have a material adverse effect on the Company's results of operations or
financial condition.
The Company reviews the status of the matters discussed in the remainder of this
section on an ongoing basis and from time to time may settle or otherwise
resolve them on such terms and conditions as management believes are in the best
interests of the Company. The Company is aware that settlements of matters of
the types set forth in the remainder of this section, and in particular under
"Investigations," frequently involve fines and/or penalties that are material to
the financial condition and the results of operations of the entity entering
into the settlement. There are no assurances that the Company will prevail in
any of these matters, that settlements can be reached on acceptable terms
(including the scope of release provided) or in amounts that do not exceed the
amounts reserved. Even if an acceptable settlement were to be reached, there can
be no assurance that further investigations or litigations will not be commenced
raising similar type issues, potentially exposing the Company to additional
material liabilities. Further, the Company cannot predict the timing of the
resolution of these matters or their outcomes.
17
Patent Matters
PRIME PAC PRRS Patent. In January 2000, a jury found that the Company's PRIME
PAC PRRS (Porcine Respiratory and Reproductive Syndrome) vaccine infringed a
patent owned by Boehringer Ingelheim Vetmedica, Inc ("Boehringer Ingelheim"). An
injunction was issued in August 2000 barring further sales of the Company's
vaccine. On June 3, 2004, a jury in the United States District Court for the
district of New Jersey awarded Boehringer Ingelheim $6.9 million plus interest
in this matter.
DR. SCHOLL'S FREEZE AWAY Patent. On July 26, 2004, OraSure Technologies filed an
action in the U.S. District Court for the Eastern District of Pennsylvania
alleging patent infringement by Schering-Plough Healthcare Products by its sale
of DR. SCHOLL'S FREEZE AWAY wart removal product. The FREEZE AWAY product was
launched in March 2004. As of June 30, 2004, net sales of this product totaled
$8.4 million.
Investigations
Pennsylvania Investigation. On July 30, 2004, Schering-Plough Corporation, the
U.S. Department of Justice and the U.S. Attorney's Office for the Eastern
District of Pennsylvania announced settlement of the previously disclosed
investigation by that Office.
Under the settlement, Schering Sales Corporation, an indirect wholly owned
subsidiary of Schering-Plough Corporation, will plead guilty to a single federal
criminal charge concerning a payment to a managed care customer. As a result,
Schering Sales Corporation will be excluded from participating in federal
healthcare programs. The settlement will not affect the ability of
Schering-Plough Corporation to participate in those programs.
The aggregate settlement amount is $345.5 million in fines and damages,
comprised of a $52.5 million fine to be paid by Schering Sales Corporation, and
$293 million in civil damages to be paid by Schering-Plough Corporation.
Schering-Plough Corporation will be credited with $53.6 million that was
previously paid in additional Medicaid rebates against the civil damages amount,
leaving a net settlement amount of $291.9 million. Of that amount, $177.5
million of the total settlement will be paid in 2004, and the remaining portion
will be paid by March 4, 2005. Interest will accrue on the unpaid balance at the
rate of 4 percent.
The payments will be funded by cash from operations, borrowings and/or proceeds
from the issuance of securities. There will be no impact on 2004 full year
results related to the Pennsylvania settlement.
Under the settlement, Schering-Plough Corporation also entered into a five year
corporate integrity agreement with the Office of the Inspector General of the
Department of Health and Human Services, under which Schering-Plough Corporation
agreed to implement specific measures to promote compliance with regulations on
issues such as marketing. Failure to comply can result in financial penalties.
Details of the initiation and progress of the investigation can be found in the
Company's prior 10-K and 10-Q reports beginning with the 10-K for 1999.
The Company cannot predict the impact of this settlement, if any, on other
outstanding investigations.
AWP Investigations. The Company is responding to investigations by the
Department of Health and Human Services, the Department of Justice, the
Committee on Energy and Commerce of the U.S. House of Representatives and
certain states into certain industry and Company practices regarding average
wholesale price (AWP). These investigations include a Department of Justice
review of the merits of a federal action filed by a private entity on behalf of
the United States in the U.S. District Court for the
18
Southern District of Florida, as well as an investigation by the U.S. Attorney's
Office for the District of Massachusetts, regarding, inter alia, whether the AWP
set by pharmaceutical companies for certain drugs improperly exceeds the average
prices paid by dispensers and, as a consequence, results in unlawful inflation
of certain government drug reimbursements that are based on AWP. In March 2001,
the Company received a subpoena from the Massachusetts Attorney General's office
seeking documents concerning the use of AWP and other pricing and/or marketing
practices. The Company has also responded to subpoenas from the Attorney General
of California concerning these matters. The Company is cooperating with these
investigations. The outcome of these investigations could include the imposition
of substantial fines, penalties and injunctive or administrative remedies.
Massachusetts Investigation. The U.S. Attorney's Office for the District of
Massachusetts is also investigating whether the Company's sales of a product
manufactured under a private label arrangement with a managed care organization
should have been included in the Company's Medicaid best price calculations. In
early November 2002, the Company was served with two additional grand jury
subpoenas by the U.S. Attorney for the District of Massachusetts. Among other
information, the subpoenas seek a broad range of information concerning the
Company's sales, marketing and clinical trial practices and programs with
respect to INTRON A, REBETRON and TEMODAR; the Company's sales and marketing
contacts with managed care organizations and doctors; and the Company's offering
or provision of grants, honorariums or other items or services of value to
managed care organizations, physician groups, doctors and educational
institutions. The Company understands that this investigation is focused on
whether certain sales, marketing and clinical trial practices and conduct
related thereto, which in certain instances relate to the use of one or more of
the above-mentioned products for indications for which FDA approval had not been
obtained - so-called "off-label" uses - were in violation of federal laws and
regulations with respect to off-label promotional activities. The investigation
also appears to focus on whether drug samples, clinical trial grants and other
items or services of value were given to providers to incentivize them to
prescribe one or more of the above-mentioned products, including for "off-label"
uses, in violation of the federal health care anti-kickback laws. In April 2004,
the Company received an additional grand jury subpoena that requests documents
concerning PROVENTIL, VANCERIL, VANCENASE, NITRO-DUR, IMDUR, K-DUR and CLARITIN.
The subpoena requests (1) documents from certain managed care entities; (2)
documents relating to all contracts where the price of one drug is dependent on
the purchase of another; (3) documents relating to outside audits in the
Medicaid best price area; and (4) documents concerning Warrick, the Company's
generic subsidiary. The Company has implemented certain changes to its sales,
marketing and clinical trial practices and is continuing to review those
practices to ensure compliance with relevant laws and regulations. The Company
is cooperating with these investigations. Future sales of INTRON A, REBETRON and
TEMODAR may be adversely affected, but the Company cannot at this time predict
the ultimate impact, if any, on such sales. The outcome of these investigations
could include the commencement of civil and/or criminal proceedings involving
the imposition of substantial fines, penalties and injunctive or administrative
remedies, including exclusion from government reimbursement programs. During the
2003 third quarter, the Company increased its litigation reserves related to the
investigations by the U.S. Attorney's Office for the District of Massachusetts
described in this paragraph and the investigation described above by the U.S.
Attorney's Office for the Eastern District of Pennsylvania, by $350 million. The
increased litigation reserves reflect an adjustment to the Company's estimate of
its minimum liability relating to those investigations, in compliance with GAAP.
Under GAAP, companies are required to estimate and recognize a minimum liability
when a loss is probable but no better estimate of the loss can be made. In the
fourth quarter of 2002, the Company increased its litigation reserves by $150
million for the same matters. The litigation reserves at June 30, 2004 continue
to reflect a minimum liability for the Massachusetts investigation but as
disclosed in the
19
Pennsylvania Investigation section above, that investigation has been settled
and therefore, the reserves reflect the best estimate for that matter. The
Company notes that its total reserves reflect an estimate and that any final
settlement or adjudication of any of these matters could possibly be less than
or could materially exceed the aggregate liability accrued by the Company and
could have a materially adverse effect on the operations or financial condition
of the Company. The Company cannot predict the timing of resolution of these
matters or their outcomes.
As reported in the 8-K filed May 30, 2003, Schering-Plough has disclosed that,
in connection with the above-described investigations by the U.S. Attorney's
Office for the District of Massachusetts into its sales, marketing and clinical
trial practices, among other matters, on May 28, 2003, Schering Corporation, a
wholly owned and significant operating subsidiary of Schering-Plough, received a
letter (the "Boston Target Letter") from that Office advising that Schering
Corporation (including its subsidiaries and divisions) is a target of a federal
criminal investigation with respect to four areas:
1. Providing remuneration, such as drug samples, clinical trial grants and other
items or services of value, to managed care organizations, physicians and others
to induce the purchase of Schering pharmaceutical products for which payment was
made through federal health care programs;
2. Sale of misbranded or unapproved drugs, which the Company understands to mean
drugs promoted for indications for which approval by the U.S. FDA had not been
obtained (so-called "off-label uses");
3. Submitting false pharmaceutical pricing information to the government for
purposes of calculating rebates required to be paid to the Medicaid program, by
failing to include prices of products under a repackaging arrangement with a
managed care customer as well as the prices of free and nominally priced goods
provided to that customer to induce the purchase of Schering products; and
4. Document destruction and obstruction of justice relating to the government's
investigation.
A "target" is defined in Department of Justice guidelines as a person as to whom
the prosecutor or the grand jury has substantial evidence linking him or her to
the commission of a crime and who, in the judgment of the prosecutor, is a
putative defendant (U.S. Attorney's Manual, Section 9-11.151).
Consumer Products Matter. The U.S. Department of Justice, Antitrust Division, is
investigating whether the Company's Consumer Products Division entered into an
agreement with another company to lower the commission rate of a consumer
products broker. In February 2003, the Antitrust Division served a grand jury
subpoena on the Company seeking documents for the first time. The Company is
cooperating with the investigation.
NITRO-DUR Investigation. In August 2003, the Company received a civil
investigative subpoena issued by the Office of Inspector General of the U.S.
Department of Health and Human Services, seeking documents concerning the
Company's classification of NITRO-DUR for Medicaid rebate purposes, and the
Company's use of nominal pricing and bundling of product sales. The Company is
cooperating with the investigation. It appears that the subpoena is one of a
number addressed to pharmaceutical companies concerning an inquiry into issues
relating to the payment of government rebates.
Securities and Class Action Litigation
On February 15, 2001, the Company stated in a press release that the FDA had
been conducting inspections of the Company's manufacturing facilities in New
Jersey and Puerto Rico and had issued
20
reports citing deficiencies concerning compliance with current Good
Manufacturing Practices, primarily relating to production processes, controls
and procedures. The next day, February 16, 2001, a lawsuit was filed in the U.S.
District Court for the District of New Jersey against the Company and certain
named officers alleging violations of Sections 10(b) and 20(a) of the Securities
Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Additional lawsuits
of the same tenor followed. These complaints were consolidated into one action
in the U.S. District Court for the District of New Jersey, and a lead plaintiff,
the Florida State Board of Administration, was appointed by the Court on July 2,
2001. On October 11, 2001, a consolidated amended complaint was filed, alleging
the same violations described in the second sentence of this paragraph and
purporting to represent a class of shareholders who purchased shares of Company
stock from May 9, 2000, through February 15, 2001. The Company's motion to
dismiss the consolidated amended complaint was denied on May 24, 2002. On
October 10, 2003, the Court certified the shareholder class. Discovery is
ongoing.
In addition to the lawsuits described in the immediately preceding paragraph,
two lawsuits were filed in the U.S. District Court for the District of New
Jersey, and two lawsuits were filed in New Jersey state court against the
Company (as a nominal defendant) and certain officers, directors and a former
director seeking damages on behalf of the Company, including disgorgement of
trading profits made by defendants allegedly obtained on the basis of material
non-public information. The complaints in each of those four lawsuits relate to
the issues described in the Company's February 15, 2001, press release, and
allege a failure to disclose material information and breach of fiduciary duty
by the directors. One of the federal court lawsuits also includes allegations
related to the investigations by the U.S. Attorney's Offices for the Eastern
District of Pennsylvania and the District of Massachusetts, the FTC's
administrative proceeding against the Company, and the lawsuit by the state of
Texas against Warrick Pharmaceuticals (Warrick), the Company's generics
subsidiary, all of which are described herein. Each of these lawsuits is a
shareholder derivative action that purports to assert claims on behalf of the
Company, but as to which no demand was made on the Board of Directors and no
decision has been made on whether the Company can or should pursue such claims.
In August 2001, the plaintiffs in each of the New Jersey state court shareholder
derivative actions moved to dismiss voluntarily the complaints in those actions,
which motions were granted. The two shareholder derivative actions pending in
the U.S. District Court for the District of New Jersey have been consolidated
into one action, which is in its very early stages. On January 2, 2002, the
Company received a demand letter dated December 26, 2001, from a law firm not
involved in the derivative actions described above, on behalf of a shareholder
who also is not involved in the derivative actions, demanding that the Board of
Directors bring claims on behalf of the Company based on allegations
substantially similar to those alleged in the derivative actions. On January 22,
2002, the Board of Directors adopted a Board resolution establishing an
Evaluation Committee, consisting of three directors, to investigate, review and
analyze the facts and circumstances surrounding the allegations made in the
demand letter and the consolidated amended derivative action complaint described
above, but reserving to the full Board authority and discretion to exercise its
business judgment in respect of the proper disposition of the demand. The
Committee engaged independent outside counsel to advise it and issued a report
on the findings of its investigation to the independent directors of the Board
in late October 2002. That report determined that the shareholder demand should
be refused, and finding no liability on the part of any officers or directors.
In November 2002, the full Board adopted the recommendation of the Evaluation
Committee.
The Company is a defendant in a number of purported nationwide or state class
action lawsuits in which plaintiffs seek a refund of the purchase price of
laxatives or phenylpropanolamine-containing cough/cold remedies ("PPA products")
they purchased. Other pharmaceutical manufacturers are co-defendants in some of
these lawsuits. In general, plaintiffs claim that they would not have purchased
or would have
21
paid less for these products had they known of certain defects or medical risks
attendant with their use. In the litigation of the claims relating to the
Company's PPA products, courts in the national class action suit and several
state class action suits have denied certification and dismissed the suits. A
similar application to dismiss in New Jersey, the only remaining statewide class
action suit involving the Company, is pending. Approximately 103 individual
lawsuits relating to the laxative products, PPA products and recalled
albuterol/VANCERIL/VANCENASE inhalers are also pending against the Company
seeking recovery for personal injuries or death. In a number of these lawsuits
punitive damages are claimed.
On March 31, 2003, the Company was served with a putative class action complaint
filed in the U.S. District Court in New Jersey alleging that the Company,
Richard Jay Kogan (who resigned as Chairman of the Board November 13, 2002, and
retired as Chief Executive Officer, President and Director of the Company April
20, 2003) and the Company's Employee Savings Plan (Plan) administrator breached
their fiduciary obligations to certain participants in the Plan. In May 2003,
the Company was served with a second putative class action complaint filed in
the same court with allegations nearly identical to the complaint filed March
31, 2003. On October 6, 2003, a consolidated amended complaint was filed, which
names as additional defendants seven current and former directors and other
corporate officers. The Court dismissed this complaint on June 29, 2004. On July
16, 2004, the plaintiffs filed a Notice of Appeal.
On August 18, 2003, a lawsuit filed in the New Jersey Superior Court, Chancery
Division, Union County, was served on the Company (as a nominal defendant) and
the Company's outside directors, alleging breach of fiduciary duty by the
directors relating to the Company's receipt of the Boston Target Letter
described under the "Investigations" section in this footnote. This action was
temporarily stayed pending adjudication of a separate but related action framed
as a shareholder request for access to the Company's books and records and
seeking documents and other information relating to the Massachusetts
investigation. In March 2004, the Superior Court granted the Company's motion
for summary judgment and dismissed the books and records action. The plaintiffs
have indicated that they intend to amend their complaint in the derivative
action.
Antitrust and FTC Matters
On April 2, 2001, the FTC started an administrative proceeding against the
Company, Upsher-Smith, Inc. (Upsher-Smith) and Lederle. The complaint alleges
anti-competitive effects from the settlement of patent lawsuits between the
Company and Lederle, and the Company and Upsher-Smith. The lawsuits that were
settled related to generic versions of K-DUR, the Company's long-acting
potassium chloride product, which was the subject of ANDAs filed by Lederle and
Upsher-Smith. In June 2002, the administrative law judge overseeing the case
issued a decision that the patent litigation settlements complied with the law
in all respects and dismissed all claims against the Company. An appeal of this
decision to the full Commission was filed by the FTC staff. On December 18,
2003, the full Commission issued an opinion that reversed a 2002 decision of an
Administrative Law Judge who had found no violation of the antitrust laws,
ruling instead that the Company's settlements did in fact violate those laws.
The FTC's decision does not involve a monetary penalty. The Company has appealed
the decision to a federal court of appeals. K-DUR is a potassium chloride
supplement used by cardiac patients.
Following the commencement of the FTC administrative proceeding, alleged class
action suits were filed on behalf of direct and indirect purchasers of K-DUR
against the Company, Upsher-Smith and Lederle in federal and state courts. These
suits all allege essentially the same facts and claim violations
22
of federal and state antitrust laws, as well as other state statutory and/or
common law causes of action. On April 6, 2004, the court overseeing these
actions in federal court remanded 19 of the approximately 40 lawsuits back to
various state courts. A motion to dismiss the remaining actions is pending.
Pricing Matters
During 2000, Warrick Pharmaceuticals (Warrick), the Company's generics
subsidiary, was sued by the state of Texas. In 2002, the Company and its
subsidiary, Schering Corporation, were added as defendants. The lawsuit alleges
that Warrick supplied the state with false reports of wholesale prices, which
caused the state to pay Medicaid claims on prescriptions of Warrick's albuterol
sulfate solution and inhaler at a higher-than-justified level. On May 3, 2004,
the Company announced that it has reached an agreement with the attorney
general's office of the State of Texas to settle the matter for a total of $27
million.
In December 2001, the Prescription Access Litigation project (PAL), a
Boston-based group formed in 2001 to litigate against drug companies, filed a
class action suit in Federal Court in Massachusetts against the Company. In
September 2002, a consolidated complaint was filed in this court as a result of
the coordination by the Multi-District Litigation Panel of all federal court AWP
cases from throughout the country. The consolidated complaint alleges that the
Company and Warrick conspired with providers to defraud consumers by reporting
fraudulently high AWPs for prescription medications reimbursed by Medicare or
third-party payers. The complaint seeks a declaratory judgment and unspecified
damages, including treble damages.
Included in the PAL litigation described in the prior paragraph are lawsuits
that allege that the Company and Warrick reported inflated AWPs for prescription
pharmaceuticals and thereby caused state and federal entities and third-party
payers to make excess reimbursements to providers. Some of these actions also
allege that the Company and Warrick failed to report accurate prices under the
Medicaid Rebate Program and thereby underpaid rebates to some states. These
actions, which began in October 2001, have been brought by state Attorneys
General, private plaintiffs, nonprofit organizations and employee benefit funds.
They allege violations of federal and state law, including fraud, antitrust,
Racketeer Influenced Corrupt Organizations Act (RICO) and other claims. During
the first quarter of 2004, the Company and Warrick were among five groups of
companies put on an accelerated discovery track in the proceeding. In addition,
Warrick and the Company are defendants in a number of such lawsuits in state
courts. The actions are generally brought by states and/or political
subdivisions and seek unspecified damages, including treble and punitive
damages.
SEC Inquiries and Related Litigation
On June 9, 2004, the SEC and the Company announced settlement of the SEC's
enforcement proceeding regarding the books and records and internal controls
provisions of the Foreign Corrupt Practices Act relating to payments of
approximately $76,000 made between February 1999 and March 2002 by one of the
Company's foreign subsidiaries, Schering-Plough Poland, to a charitable
organization called the Chudow Castle Foundation. Without admitting or denying
the allegations in the complaint, the Company paid a $500,000 civil penalty;
consented to the issuance of a Commission Order requiring the Company to cease
and desist from committing or causing violations of Sections 13(b)(2)(A) and
13(b)(2)(B) of the Securities Exchange Act of 1934; and agreed to retain an
independent consultant to review the Company's policies and procedures regarding
compliance with the Foreign Corrupt Practices Act and to implement any changes
recommended by the consultant.
23
On September 9, 2003, the SEC and the Company announced settlement of the SEC
enforcement proceeding against the Company and Richard Jay Kogan, former
Chairman and Chief Executive Officer, regarding meetings held with investors the
week of September 30, 2002, and other communications. Without admitting or
denying the allegations, the Company agreed not to commit future violations of
Regulation FD and related securities laws and paid a civil penalty of $1
million. Mr. Kogan paid a civil penalty of $50 thousand.
The federal putative class actions filed against the Company and Mr. Kogan
regarding the meetings held with investors the week of September 30, 2002, and
other communications were consolidated and, pursuant to that consolidation, an
amended complaint dated March 13, 2003, was filed, alleging violations of
Sections 10(b), 20(a) and 20(A) of the Securities Exchange Act of 1934 relating
to the alleged disclosures made during the meetings mentioned in the paragraph
above. The Company filed a motion to dismiss these class actions May 6, 2003,
and the plaintiffs have sought leave of the court, and thereafter filed a second
amended complaint. On June 29, 2004, the Court dismissed the second amended
complaint.
On September 25, 2003, a lawsuit was filed in New Jersey Superior Court, Union
County, against Richard Jay Kogan and the Company's outside Directors alleging
breach of fiduciary duty, fraud and deceit and negligent misrepresentation, all
relating to the alleged disclosures made during the meetings mentioned above.
The Company removed this case to federal court. A motion to remand to state
court and the Company's motion to dismiss are pending.
Environmental
The Company has responsibilities for environmental cleanup under various state,
local and federal laws, including the Comprehensive Environmental Response,
Compensation and Liability Act, commonly known as Superfund. At several
Superfund sites (or equivalent sites under state law), the Company is alleged to
be a potentially responsible party (PRP). Except where a site is separately
disclosed, the Company believes that it is remote at this time that there is any
material liability in relation to such sites. The Company estimates its
obligations for cleanup costs for Superfund sites based on information obtained
from the federal Environmental Protection Agency (EPA), an equivalent state
agency and/or studies prepared by independent engineers, and on the probable
costs to be paid by other PRPs. The Company records a liability for
environmental assessments and/or cleanup when it is probable a loss has been
incurred and the amount can be reasonably estimated.
Residents in the vicinity of a publicly owned waste-water treatment plant in
Barceloneta, Puerto Rico, have filed two lawsuits against the plant owner and
operator, and numerous companies that discharge into the plant, including a
subsidiary of the Company, for damages and injunctive relief relating to odors
allegedly coming from the plant and connecting sewers. One of these lawsuits is
a class action claiming damages of $600 million. No trial date has been set for
these cases, but the matter has been submitted to mediation.
On November 20, 2003, we received a General Notice of Potential Liability from
EPA addressed to Arno/Scholl's Adhesive Tapes, Inc., a former subsidiary of the
Company, relating to the Lake Culmet Cluster Site in Chicago, Illinois. There
are several hundred other potentially responsible parties for the site. The
Company believes it was named erroneously and that another unrelated company
should be responsible for any cleanup obligations at this site. The Company is
working with the government to have the matter resolved.
24
The New Jersey Department of Environmental Protection sent Schering-Plough a
letter, received September 24, 2003, stating that the Company "may be legally
responsible for damages to natural resources" in the state. The Department has
not adopted regulations covering how such liability is to be calculated, making
it difficult to accurately predict the ultimate extent of the Company's
exposure.
Other Matters
The Company is subject to pharmacovigilance reporting requirements in many
countries and other jurisdictions, including the United States, the European
Union (EU) and the EU member states. The requirements differ from jurisdiction
to jurisdiction, but all include requirements for reporting adverse events that
occur while a patient is using a particular drug in order to alert the
manufacturer of the drug and the governmental agency to potential problems.
During pharmacovigilance inspections by officials of the British and French
medicines agencies conducted at the request of the European Agency for the
Evaluation of Medicinal Products (EMEA), serious deficiencies in reporting
processes were identified. The Company is taking urgent actions to rectify these
deficiencies as quickly as possible. The Company does not know what action, if
any, the EMEA or national authorities will take in response to these findings.
Possible actions include further inspections, demands for improvements in
reporting systems, criminal sanctions against the Company and/or responsible
individuals and changes in the conditions of marketing authorizations for the
Company's products.
In April 2003, the Company received notice of a False Claims Act complaint
brought by an individual purporting to act on behalf of the U.S. government
against it and approximately 25 other pharmaceutical companies in the U.S.
District Court for the Northern District of Texas. The complaint alleges that
the pharmaceutical companies, including the Company, have defrauded the United
States by having made sales to various federal governmental agencies of drugs
that were allegedly manufactured in a manner that did not comply with current
Good Manufacturing Practices. The Company and the other defendants filed a
motion to dismiss the second amended complaint in this action on April 12, 2004.
Tax Matters
In October of 2001, the IRS auditors asserted, in reports, that the Company is
liable for additional tax for the 1990 through 1992 tax years. The reports
allege that two interest rate swaps that the Company entered into with an
unrelated party should be recharacterized as loans from affiliated companies,
resulting in approximately $195 million of tax, plus interest. The Company
estimates the interest to be approximately $280 million. In April of 2004, the
Company received a formal Notice of Deficiency (Statutory Notice) from the IRS
asserting additional federal income tax due of $195 million. The statutory
ninety-day notice period expired on July 7, 2004, and the Company expects to
receive a bill from the IRS for additional tax of $195 million plus interest of
$280 million. The Company believes it has complied with all applicable rules and
regulations related to the tax treatment of interest rate swaps. Thus, the
Company intends to pay the tax and the interest and file suit for refund. It is
likely that this payment will be made in the third quarter of this year. The
Company's tax reserves are adequate to cover the payment of these amounts.
25
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and Board of Directors of
Schering-Plough Corporation:
We have reviewed the accompanying consolidated balance sheet of Schering-Plough
Corporation and subsidiaries (the "Corporation") as of June 30, 2004, and the
related statements of consolidated operations for the three-month and six-month
periods ended June 30, 2004 and 2003 and the statements of consolidated cash
flows for the six-month periods ended June 30, 2004 and 2003. These interim
financial statements are the responsibility of the Corporation's management.
We conducted our reviews in accordance with standards of the Public Company
Accounting Oversight Board (United States). A review of interim financial
information consists principally of applying analytical procedures and making
inquiries of persons responsible for financial and accounting matters. It is
substantially less in scope than an audit conducted in accordance with standards
of the Public Company Accounting Oversight Board (United States), the objective
of which is the expression of an opinion regarding the financial statements
taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should
be made to such consolidated interim financial statements for them to be in
conformity with accounting principles generally accepted in the United States of
America.
We have previously audited, in accordance with standards of the Public Company
Accounting Oversight Board (United States), the consolidated balance sheet of
Schering-Plough Corporation and subsidiaries as of December 31, 2003, and the
related statements of consolidated operations, shareholders' equity, and cash
flows for the year then ended (not presented herein); and in our report dated
February 19, 2004, we expressed an unqualified opinion on those consolidated
financial statements. In our opinion, the information set forth in the
accompanying consolidated balance sheet as of December 31, 2003 is fairly
stated, in all material respects, in relation to the consolidated balance sheet
from which it has been derived.
/s/ Deloitte & Touche LLP
Parsippany, New Jersey
July 30, 2004
26
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Executive Summary
About the Company:
Schering-Plough is a research-based pharmaceutical company committed to
discovering, developing, manufacturing and marketing new therapies and
treatments to enhance human health.
As a research-based pharmaceutical company, Schering-Plough invests substantial
amounts of funds in scientific research with the goal of creating important
medical and commercial value. There is a high rate of failure inherent in
scientific research and, as a result, there is a high risk that the funds
invested will not generate financial returns. Further compounding this risk
profile is the fact that research has a long investment cycle. To bring a
pharmaceutical compound from discovery phase to commercial phase may take a
decade or more. Because of the high risk nature of research investments,
financial resources typically must come from internal sources (operations and
cash reserves) or from equity-type capital.
The current state of the Company:
During the past three years, the Company experienced a confluence of negative
events that have strained and continue to strain the Company's financial
resources. These negative events have converged almost simultaneously and in
large part caused a rapid, sharp and material decline in sales, a material
increase in costs and material amounts of actual and potential payments for
fines, settlements and penalties. These events have had a severe, negative
impact on the Company. If this situation were to continue unmitigated, it may
impair the Company's ability to invest in research at historical levels.
Throughout this period of time, the Company has held to its core strategy and
continued to invest in scientific research at historical levels. However, this
level of investment is not sustainable without a dramatic change in the current
financial situation. If cash flow from operations does not increase materially,
the Company would likely consider changing its current business model.
Unfortunately, increased sales of existing products and cost reductions alone
cannot be expected to increase cash flow from operations sufficiently to offset
the negative events. In order to maintain its current business model, the
Company must introduce new products in the near term.
There are two sources of new products: products acquired through acquisition and
licensing arrangements, and products in the Company's late-stage research
pipeline. With respect to acquisitions and licensing, there are limited
opportunities for critical late-stage products, and these limited opportunities
typically require substantial amounts of funding. The Company competes for these
products against companies often with far greater financial resources than that
of the Company. Due to the present financial situation, it will be challenging
for the Company to acquire or license critical late-stage products.
27
With respect to products in the Company's late-stage research pipeline, there is
only one product that was recently approved by the FDA, which could materially
increase cash flow from operations. That product is VYTORIN, the combination of
ZETIA, the Company's cholesterol absorption inhibitor, and Zocor, Merck & Co.,
Inc.'s (Merck) statin medication. The U.S. approval of VYTORIN enables the
Company to expand its position in the approximately $25 billion
cholesterol-reduction market, the single largest pharmaceutical market in the
world. However, VYTORIN competes against other, well-established
cholesterol-management products marketed by companies with financial resources
much greater than that of the Company. The financial commitment to compete in
this marketplace is shared with Merck; however, profits from VYTORIN are also
shared with Merck.
Regardless of the success of VYTORIN, during 2004, the Company currently
anticipates seeking access to the capital markets to obtain additional
financing. It is expected that the financing would be used for general corporate
purposes, which may include, among other things, refinancing of short-term debt
or commercial paper, the funding of operating expenses, shareholder dividends,
capital expenditures, business development activities, licensing fees and
milestone payments and the payment of settlement amounts, fines, penalties and
other investigatory and litigation costs and expenses.
The Company's credit rating could decline further. The impact of such decline
could be reduced availability of commercial paper borrowing and would increase
the interest rate on the Company's long-term debt. If this were to occur, the
Company may be forced to seek short-term financing from other sources at higher
interest rates than that of commercial paper, or to repatriate additional funds
currently held by foreign affiliates that would incur additional U.S. income
tax.
Further, if VYTORIN does not provide a material amount of cash flow from
operations, the Company would likely evaluate the need to examine strategic
alternatives. With regard to an examination of strategic alternatives, the
contracts with Merck for ZETIA and VYTORIN and the contract with Centocor, Inc.
for REMICADE (exhibits 10 (r) and 10 (u), respectively, to the Company's 2003
Form 10-K) contain provisions dealing with a change of control, as defined in
those contracts. These provisions could result in the aforementioned products
being acquired by Merck or reverting back to Centocor, Inc., as the case may be.
The negative events that have converged to strain financial resources during the
past three years are summarized as follows:
- Since 2001, the Company has been working with the FDA to resolve
issues involving the Company's compliance with current Good
Manufacturing Practices (cGMP) at certain of its manufacturing sites
in New Jersey and Puerto Rico. In 2002, the Company reached a formal
agreement with the FDA for a consent decree. Under the terms of the
consent decree, the Company has made payments totaling $500 million
and agreed to revalidate the manufacturing processes at these sites.
These manufacturing sites have remained opened throughout this period;
however, the consent decree has placed significant additional controls
on production and release of products from these sites, including
review and third-party certification of production variances, and, for
some products, review and third-party certification of batch
production records. The third-party certifications and other cGMP
improvement projects have resulted in higher costs as well as reduced
output at these facilities. In addition, the Company has found it
necessary to discontinue certain older products. The Company's
research and development operations have also been negatively impacted
by the decree because these operations share common facilities with
the manufacturing operations. The Company's
28
commitments under the GMP Work Plan and Validation Program required by
the consent decree are scheduled for completion by December 31, 2005.
However, the consent decree will not be lifted at that point. The
decree will remain in place until the Company successfully petitions
the court to have it lifted. Under the terms of the decree, the
Company is allowed to petition the court to lift the decree if, after
any five year period following the decree's entry in May 2002, the
Company has not been notified by FDA of a significant violation of FDA
law, regulation, or the decree. Thus, the earliest date by which the
Company could petition the court to lift the decree is May 2007 (five
years after the decree's entry). The Company has no assurance that the
decree will be lifted at that time. The impact of the consent decree
is discussed in more detail in the sections that follow.
- Certain of the Company's sales and marketing practices are under
investigation by the U.S. Attorney's Office in Massachusetts. This
investigation poses significant financial and commercial risks to the
Company. The Company announced settlement with the U.S. Attorney's
Office for the Eastern District of Pennsylvania regarding that
Office's investigation into the Company's sales and marketing
practices. The settlement requires payments by the Company totaling
$345.5 million, of which $53.6 million was previously paid in 2003 as
additional Medicaid rebates against the damages amount, leaving net
payments of $291.9 million. These matters are discussed in further
detail in the "Legal, Environmental and Regulatory Matters" footnote
included in the financial statements to this report.
- In December 2002, the Company switched all formulations of CLARITIN in
the United States from prescription to over-the-counter (OTC) status.
This switch followed the loss of marketing exclusivity for the
product. The average unit selling price for an OTC product is much
lower than the price in the prescription market. Further, with the
loss of marketing exclusivity, the Company faces additional
competition from comparable brands and generics in the OTC
marketplace.
CLARITIN in the United States had been the Company's leading product
in terms of sales, and even more so in terms of profit. As a result,
the Company has experienced a rapid, sharp and material decline in
earnings and cash flow beginning in 2003.
- The Company's other leading franchise is the combination of pegylated
interferon (PEG-INTRON) and ribavirin (REBETOL) to treat hepatitis C.
In late 2002, a competitor entered the hepatitis C marketplace with
its own versions of pegylated interferon and ribavirin, and pursued
aggressive pricing and marketing practices. Prior to the introduction
of these competing products, the Company held a leading position in
the hepatitis C market. With the introduction of this competitor in a
market that has been contracting, the Company's market shares and
sales levels have fallen significantly. In addition, generic forms of
REBETOL have been approved in the important U.S. market. As a result
of the introduction of a competitor for pegylated interferon and the
introduction of generic ribavirin, the value of the Company's second
most important product franchise has been and will continue to be
severely diminished, and earnings and cash flow have been and will
continue to be materially and negatively impacted.
29
- Sales of other important products have been negatively impacted by
overall market conditions. For example, CLARINEX competes in a
declining prescription antihistamine market and NASONEX competes in a
market with little to no growth.
- The Company's manufacturing sites operate well below optimum levels
due to the sales declines and the reduction in output related to the
consent decree. At the same time, overall costs of operating the
manufacturing sites have increased due to the consent decree
activities. The impact of this is a material increase in costs. At
this time, the major investments in manufacturing capacity are not
impaired; however, the Company continues to review the carrying value
of these assets for indications of impairment. Future events and
decisions may lead to asset impairment losses and accelerated
depreciation due to shortened asset lives.
In response to the above, a new management team was appointed during 2003. A
program was initiated to reduce costs and to reinvest the savings into the
business to stabilize market shares of key products and to help ensure the
successful launch of VYTORIN. Due to the need to reinvest, the overall cost
structure of the Company has not declined. In spite of the additional
investment, the market shares of the Company's existing products have not yet
responded in a meaningful way due to the need to realign the sales force to
prepare for the launch of VYTORIN. In the first quarter of 2004, the Company
incurred a net loss of $73 million, which included pre-tax special charges of
$70 million. In the second quarter of 2004, the Company incurred a net loss of
$65 million, which included a pre-tax research and development charge of $80
million for a product licensing fee as well as pre-tax special charges of $42
million. Second quarter operations were benefited by the seasonal nature of the
Company's allergy products. Subsequent quarters in 2004 will not include this
benefit. The Company's ability to generate profits is dependent upon growing
sales of existing products, successfully launching VYTORIN and controlling
expenses. Management cannot give assurance that operations will generate profits
in the near term, especially if VYTORIN is not a commercial success.
Net Sales
Consolidated net sales for the second quarter totaled $2.1 billion, a decrease
of $161 million or 7 percent compared with the same period in 2003. Consolidated
net sales for the second quarter reflected a volume decline of 12 percent and a
favorable foreign exchange rate impact of 3 percent. For the six months,
consolidated net sales decreased $279 million or 6 percent versus 2003.
Consolidated net sales for the first six months reflected a volume decline of 12
percent and a favorable foreign exchange rate impact of 5 percent. Net sales in
the United States decreased 21 percent versus the second quarter of 2003 and 22
percent for the six-month period. International sales advanced 5 percent for the
second quarter and 7 percent for the first half of the year compared with the
same periods in 2003. International sales included a favorable foreign exchange
rate impact of 6 percent for the quarter and 9 percent for the first six months.
30
Net sales for the second quarter and six months ended June 30, were as follows:
(Dollars in millions)
Second Quarter Six Months
-------------------------------- --------------------------------
2004 2003 % 2004 2003 %
-------- -------- -------- -------- -------- --------
GLOBAL PHARMACEUTICALS $ 1,644 $ 1,871 (12) $ 3,125 $ 3,517 (11)
Clarinex / Aerius 226 219 3 356 392 (9)
Remicade 182 126 44 347 240 45
Nasonex 156 175 (11) 296 254 17
PEG-Intron 144 247 (42) 293 469 (38)
Temodar 102 87 17 188 146 28
Intron A 89 125 (29) 158 199 (21)
Rebetol 88 196 (55) 187 415 (55)
Claritin Rx * 82 90 (9) 173 179 (3)
Integrilin 78 92 (15) 151 181 (16)
Subutex 47 36 31 91 66 37
Elocon 46 41 13 84 80 6
Caelyx 35 26 34 70 49 43
CONSUMER HEALTH CARE 317 266 19 629 559 12
OTC 150 135 11 306 291 5
OTC Claritin 117 97 22 234 225 4
Foot Care 89 83 7 166 145 14
Sun Care 78 48 60 157 123 28
ANIMAL HEALTH 186 171 9 356 313 14
-------- -------- -------- -------- -------- --------
CONSOLIDATED NET SALES $ 2,147 $ 2,308 (7) $ 4,110 $ 4,389 (6)
-------- -------- -------- -------- -------- --------
* Includes international sales of CLARITIN Rx only. Canadian sales of CLARITIN
are now reported in the OTC line within Consumer Health Care. The prior period
has been reclassified accordingly.
Certain prior period amounts have been reclassified to conform to the current
year presentation.
Global net sales of CLARINEX (marketed as AERIUS in many countries outside the
U.S.) for the treatment of seasonal outdoor allergies and year-round indoor
allergies were $226 million in the second quarter of 2004, an increase of 3
percent versus the second quarter of 2003. Sales outside the U.S. climbed 34
percent to $100 million in the second quarter due to market share gains and
continued conversion from prescription CLARITIN. U.S. sales declined 13 percent
to $126 million due to the continued contraction in the U.S. prescription
antihistamine market following the launch of OTC CLARITIN and other branded and
non-branded nonsedating antihistamines coupled with market share declines.
Global net sales of CLARINEX decreased 9 percent to $356 million for the
six-month period.
International net sales of REMICADE, for the treatment of rheumatoid arthritis,
Crohn's disease and ankylosing spondylitis, were up $56 million or 44 percent to
$182 million in the second quarter and were up $107 million or 45 percent to
$347 million for the first six months. The increase was primarily in Europe due
to increased patient utilization and expanded indications.
Global net sales of NASONEX Nasal Spray, a once-daily corticosteroid nasal spray
for allergies, decreased 11 percent to $156 million in the second quarter
primarily due to trade buying patterns in the U.S. coupled with a decline in
U.S. market share. Global net sales increased 17 percent to $296 million for the
first six months primarily due to trade buying patterns in the U.S. coupled with
international sales
31
growth, tempered by a decline in U.S. market share. International sales of
NASONEX grew 18 percent to $71 million for the quarter and 23 percent to $129
million for the six-month period due to market share gains and market growth.
Global net sales of PEG-INTRON Powder for Injection, a pegylated interferon
product for treating hepatitis C, decreased 42 percent to $144 million in the
second quarter and decreased 38 percent to $293 million year-to-date due to
ongoing market competition in a contracting market. Market share of PEG-INTRON
has been declining, reflecting the entrance of a competitor's new products in
the hepatitis C market in 2003.
Global net sales of TEMODAR Capsules, for treating certain types of brain
tumors, increased 17 percent to $102 million for the second quarter and
increased 28 percent to $188 million year-to-date due to increased market
penetration.
Global net sales of INTRON A Injection, for chronic hepatitis B and C and other
antiviral and anticancer indications, decreased 29 percent to $89 million for
the second quarter and 21 percent to $158 million year-to-date due to lower
demand coupled with unfavorable trade inventory fluctuations in the U.S.
In the second quarter and first six months of 2004, global net sales of REBETOL
Capsules for use in combination with INTRON or PEG-INTRON for treating hepatitis
C, decreased 55 percent to $88 million and 55 percent to $187 million,
respectively, due to ongoing competition including the launch of generic
versions of REBETOL in the United States in April 2004.
International net sales of prescription CLARITIN decreased 9 percent to $82
million in the second quarter and decreased 3 percent to $173 million for the
six month period of 2004 due to the continued conversion to CLARINEX.
In the second quarter and first six months of 2004, global net sales of
INTEGRILIN Injection, a glycoprotein platelet aggregation inhibitor for the
treatment of patients with acute coronary syndromes, decreased 15 percent to $78
million and 16 percent to $151 million, respectively, due to changes in U.S.
trade inventory levels tempered by increased patient utilization in the United
States. Sales in the United States of INTEGRILIN decreased 17 percent to $72
million for the quarter and decreased 18% to $139 million for the six months of
2004.
International sales of SUBUTEX, for the treatment of opiate addiction, increased
31 percent to $47 million in the second quarter and 37 percent to $91 million
for the six-month period due to increased market penetration.
International net sales of CAELYX, for the treatment of ovarian cancer,
metastatic breast cancer and Kaposi's sarcoma, increased 34 percent to $35
million for the second quarter and 43 percent to $70 million for the first six
months of 2004. The increase reflects the launch of expanded indications
including the treatment of metastatic breast cancer in patients who are at
increased cardiac risk.
Contributing to the decline in global sales in the second quarter and first six
months of 2004 was the absence of LOSEC revenues in Europe, as the Company's
agreement with AstraZeneca ended in the 2003 third quarter. LOSEC revenues were
$39 million in the second quarter of 2003 and $78 million for the first six
months of 2003.
32
Net sales of consumer health care products, which include OTC, foot care and sun
care products, increased $51 million or 19 percent in the second quarter and $70
million or 12 percent year-to-date. Sales of OTC CLARITIN for the second quarter
of 2004 were $117 million, up 22 percent from $97 million in 2003. The increase
in sales was due to trade inventory adjustments in the second quarter of 2003.
Net sales of sun care products increased $30 million or 60 percent in the second
quarter and $34 million or 28 percent year-to-date due to the timing of orders
and shipments coupled with favorable weather conditions. Sales of foot care
products increased 7 percent to $89 million in the second quarter and 14 percent
to $166 million year-to-date due to the successful launch of FREEZE AWAY, a
wart-remover product.
Global net sales of animal health products increased 9 percent in the second
quarter of 2004 to $186 million and 14 percent to $356 million for the six-month
period. Sales were favorably impacted by foreign exchange of 6 percent and 8
percent for the quarter and six-month period, respectively.
Cost, Expenses and Equity Income
Cost of sales as a percentage of net sales increased to 36.8 and 37.2 percent
for the second quarter and first six months of 2004, respectively, versus 34.0
and 32.9 percent in the second quarter and six-month period of 2003. The
increase was primarily due to lower production volumes coupled with increased
spending related to the FDA consent decree and efforts to upgrade the Company's
global infrastructure and an unfavorable change in product sales mix (primarily
higher sales of lower margin products). The absence of European LOSEC revenues
in both the second quarter and six months of 2004 contributed to the unfavorable
comparison as well.
Selling, general and administrative expenses increased 4 percent to $979 million
in the second quarter and 6 percent to $1.9 billion year-to-date versus $938
million and $1.8 billion for the second quarter and first six months of 2003,
respectively. The increase was primarily due to higher sales force and marketing
related costs associated with the previously reported expansion of the field
force to prepare for the VYTORIN launch and continued investment to support key
brands coupled with the unfavorable impact of foreign exchange. The second
quarter and year-to-date ratios to net sales of 45.6 and 46.1 percent,
respectively, are higher than the 40.6 percent ratio in the respective prior
year periods, primarily due to lower overall sales reported in the 2004 periods.
Research and development spending increased 22 percent to $451 million in the
second quarter and 19 percent to $824 million year-to-date, representing 21.0
and 20.0 percent of net sales, respectively. Research and development spending
for the second quarter and six-month period of 2004 includes an $80 million
charge in conjunction with the license from Toyama Chemical Company Ltd. for
garenoxacin, a quinolone antibiotic currently in development.
In the second quarter and first six months of 2004, Other expense (income), net
reflects higher net interest expense. Interest expense increased primarily
because the Company changed the composition of its debt portfolio. Prior to this
change, the Company was financed entirely with short-term debt (primarily
commercial paper). In the fourth quarter of 2003, the Company issued $2.4
billion of fixed-rate, long-term debt. Although the interest rate on the
long-term debt is higher than the rate on short-term debt, this change in
composition of the debt portfolio decreased the inherent risk associated with
reliance on short-term financing. Interest expense also increased because
overall borrowings have increased over the prior year.
33
Special Charges
Special charges for the second quarter ended June 30, 2004 included $42 million
of employee termination costs. Special charges for the six months ended June 30,
2004 included $86 million of employee termination costs and $26 million of asset
impairment charges. Special charges for 2003 included $20 million of asset
impairment charges.
Employee Termination Costs
In August 2003, the Company announced a global workforce reduction initiative.
The first phase of this initiative was a Voluntary Early Retirement Program
(VERP) in the United States. The total cost of this program is estimated to be
$191 million, comprised of increased pension costs of $108 million, increased
post-retirement health care costs of $57 million, vacation payments of $4
million and costs related to accelerated vesting of stock grants of $22 million.
Amounts recognized relating to this program during the second quarter and first
six months of 2004 were $8 million and $17 million, respectively, with
cumulative costs of $181 million recognized as of June 30, 2004. Amounts
expected to be recognized during the remainder of 2004 and 2005 are $3 million
and $7 million, respectively.
The Company also recognized $34 million and $69 million of other employee
severance costs in the second quarter and six-month period of 2004,
respectively, primarily outside the United States.
Asset Impairment Charges
The Company recognized $26 million of asset impairment charges for the
year-to-date related to the anticipated exit from a small European
research-and-development facility. The Company recognized $20 million of asset
impairment charges in the first six months of 2003 related to manufacturing
facility assets.
Equity (Income)/Loss from Cholesterol Joint Venture
Global cholesterol franchise sales, which include ZETIA and VYTORIN, totaled
$247 million in the 2004 second quarter and $436 million year-to-date compared
with sales of $123 million and $170 million in the second quarter and first six
months of 2003, respectively. ZETIA has now been approved in 65 countries. In
the United States, more than 9 million prescriptions have been written for the
product since its U.S. launch in November 2002, according to IMS Health. The
Company utilizes the equity method of accounting for its cholesterol joint
venture with Merck. Under that method, the Company records its share of the
operating profits less its share of the research and development costs in
"Equity (income)/loss from cholesterol joint venture." Operating profit in the
context of the joint venture represents net sales, less cost of sales, direct
promotion expenses and other costs that the Company and Merck may agree to
share. Operating profit excludes the cost of the Company's sales forces
throughout the world, as well as the many indirect costs incurred by the Company
to support the manufacturing, marketing and management of ZETIA and VYTORIN. As
such, the amount reported as "Equity (income)/loss from cholesterol joint
venture" represents what the Company receives from the joint venture to fund the
costs incurred by the Company that are not shared with Merck. "Equity income
from cholesterol joint venture," as defined, totaled $77 million in the second
quarter of 2004 versus $26 million in the second quarter of 2003. For 2004
year-to-date, equity income from cholesterol joint venture totaled $154 million
including a $7 million milestone earned as a result of the approval in Mexico of
the ezetimibe/simvastatin product, versus a loss of ($4) million for the first
six months of 2003. U.S. ZETIA sales exceeded a pre-defined annual sales level,
as stipulated in the joint venture
34
contract, during the second quarter of 2004. As a result, profit from the U.S.
sales of ZETIA will be split 50/50 for the remainder of the year, down from a
previously higher profit split.
Net (loss)/income
Net (loss)/income was a loss of ($65) million for the second quarter versus
income of $182 million in 2003. Net loss in the second quarter of 2004 includes
a pre-tax research and development charge of $80 million for a product licensing
fee as well as pre-tax special charges of $42 million, as described above. Net
income in the second quarter of 2003 includes pre-tax special charges of $20
million.
Net (loss)/income was a loss of ($138) million for the first six months of 2004
versus income of $355 million in 2003. Net loss for year-to-date 2004 includes a
pre-tax research and development charge of $80 million for a product licensing
fee as well as pre-tax special charges of $112 million, as described above. Net
income for the first six months of 2003 includes pre-tax special charges of $20
million.
Effective Tax Rate
The effective tax rate was 20.0 percent in the second quarters and first six
months of 2004 and 2003.
Liquidity and Financial Resources - six months ended June 30, 2004
Background
The following background information may be useful to the reader in
understanding the current state of the Company's liquidity and financial
resources.
At June 30, 2004, substantially all cash and cash equivalents and short-term
investments shown in the accompanying balance sheet were held by wholly-owned,
foreign-based subsidiaries. At the same time, substantially all of the debt
shown in the accompanying balance sheet was owed by the parent company.
In the past, this geographic disparity between the location of funds and the
location of debt was not a pivotal issue for the Company. However, with the
material decline in earnings following the loss of marketing exclusivity of
CLARITIN in the United States, this geographic disparity has taken on more
importance.
On a consolidated basis, dividends and capital expenditures exceed cash
generated from operations. This excess becomes particularly pronounced when
disaggregated on a geographic basis. Foreign operations generate cash in excess
of cash needs. However, U.S. operations have cash needs well in excess of cash
generated in the U.S.
The U.S. operations fund dividend payments, the vast majority of research and
development costs and approximately half of the worldwide capital expenditures.
In the past, these cash needs were funded primarily through operations. However,
following the loss of marketing exclusivity of CLARITIN, U.S. profits declined
materially and U.S. cash needs now exceed U.S. cash generation.
Cash and cash equivalents, plus short-term investments, exceeded total debt at
June 30, 2004 by $1.3 billion. However, as discussed above, the funds are held
by foreign-based subsidiaries, and the U.S. operations have cash needs and carry
substantially all the debt. Using the funds held by the foreign-based
subsidiaries for the cash needs of the U.S.-based subsidiaries may result in
U.S. income tax payments. The amount
35
of any U.S. income tax payments would depend upon a number of factors, including
the amount of the funds used and whether the U.S. operations were generating
taxable profits or losses.
In 2003, the U.S. operations generated tax losses, primarily due to the decline
of CLARITIN sales and the continued investment in research and development. For
2003, the entire amount of the U.S. tax losses was used to recoup taxes paid in
previous years (carryback benefit).
In 2004, management expects the U.S. operations to again generate tax losses.
However, only a portion of these losses is expected to be used to recoup taxes
paid in previous years because, under current law, the carryback benefit will be
exhausted. The amount of the expected 2004 loss in excess of that used to recoup
taxes paid in previous years becomes available to reduce taxable income in the
future (carryforward benefit).
When the U.S. operations generate losses that cannot be used to recoup taxes
paid in previous years, the Company has a choice. It can either use the
carryforward benefits in future years, or utilize some or all of those losses to
absorb taxable distributions to the U.S. of cash or other assets held by the
foreign-based subsidiaries. Absorbing the U.S. operating losses in this manner
allows a portion of the assets held by the foreign-based subsidiaries to become
available for use in the U.S. operations without having to make U.S. income tax
payments.
As discussed below, the Company expects to finance a portion of its cash needs
in 2004 and possibly beyond by accessing some of the funds held by the
foreign-based subsidiaries. The funds that the Company expects to access
represent foreign earnings to be generated in 2004 and beyond. The Company does
not expect to incur additional U.S. income taxes when accessing these funds
because these taxable distributions will be absorbed by the expected U.S.
operating losses. However, the Company could owe additional U.S. taxes on
additional foreign distributions, were it to be unable to finance any U.S. cash
requirements which exceed the expected U.S. operating losses. Currently, the
Company believes it can finance any such requirements.
Federal tax legislation passed by both the House of Representatives and the U.S.
Senate contain provisions which, if enacted, will have a positive impact on the
Company's ability to access the funds held by its foreign-based subsidiaries.
Both the American Jobs Creation Act of 2004, as passed by the U.S. House of
Representatives, and the Jumpstart Our Business Strength (JOBS) Act, as passed
by the U.S. Senate, contain provisions that would permit the Company to remit
funds held by its foreign-based subsidiaries to the U.S. operations at a reduced
tax rate. These two legislative proposals will be considered by a committee of
both the House and the Senate, and a single bill will emerge which must be
approved by both Houses of Congress; and if approved, signed by the President to
become law. If legislation is enacted into law and the provision to remit such
funds at reduced rates is part of the legislation, the Company intends to remit
some or all of the amounts finally permitted to be remitted and to pay tax on
such amounts at the reduced rate.
Discussion of Cash Flow
Cash provided by operating activities totaled $333 million for the first six
months of 2004. This amount includes the receipt of $404 million for a U.S. tax
refund relating to the 2003 "carryback benefit" described above. However, the
benefit of this tax refund is most likely temporary because the Company expects
to pay approximately $475 million to the U.S. government for a tax deficiency
related to certain transactions entered into in 1991 and 1992. It is likely that
this payment will be made in the third quarter
36
of this year. (See the "Legal, Environmental and Regulatory Matters" footnote
included in the financial statements to this report.) For this reason,
management believes that as of June 30, 2004 it is more meaningful to discuss
cash flow without the benefit of the tax refund.
Absent the benefit of the tax refund, consolidated cash from operating
activities for the first six months of 2004 was a negative amount; meaning that
operations resulted in a net use of cash. Capital expenditures and dividend
payments added to the use of cash during the first six months of 2004.
As discussed above, this net use of cash occurred entirely in the U.S.
operations. Foreign operations generated net cash of approximately $400 million
through the first six months, but the net use of cash in the U.S. totaled
approximately $900 million during this same period of time, excluding the tax
refund. Through the first six months of 2004, the cash shortfall in the U.S. was
funded with the receipt of the tax refund discussed above, as well as with cash
that was available in the U.S. at the beginning of the year. Funds held by the
foreign-based subsidiaries have not been used to fund the U.S. cash needs
through June 30, 2004.
For the second half of 2004, the cash needs of the U.S. operations are expected
to increase further due to continuing U.S. operating losses and due to the
payment of the first installment under the settlement agreement with the U.S.
Attorney's Office for the Eastern District of Pennsylvania. The aggregate
settlement amount is $345.5 million in fines and damages. The Company will be
credited with $53.6 million that was previously paid, leaving a net settlement
amount of $291.9 million. Of that amount, $177.5 million of the total settlement
will be paid in 2004, and the remaining portion will be paid by March 4, 2005.
Interest will accrue on the unpaid balance at the rate of 4 percent. (See the
"Legal, Environmental and Regulatory Matters" footnote included in the financial
statements to this report.) In addition, the cash needs of the U.S. operations
could increase further as a result of any potential payments arising from other
matters described in the "Legal, Environmental and Regulatory Matters" footnote
included in the financial statements to this report. The cash shortfall in the
U.S. for the second half of 2004 is expected to be funded through a combination
of accessing the capital markets and accessing earnings generated in 2004 by the
foreign-based subsidiaries.
As discussed above, the Company does not expect to incur additional U.S. income
taxes when accessing the funds held by its foreign-based subsidiaries because of
the expected U.S. operating losses. Alternatively, if the proposed U.S. income
tax legislation discussed above becomes law, the funds held by the foreign-based
subsidiaries can be remitted to the U.S. at a reduced tax rate. If this were to
be the case, the U.S. operating losses would not have to be used to absorb
otherwise taxable distributions, in which case the Company would be able to
carry forward its U.S. operating losses to offset future earnings.
The Company currently anticipates seeking access to the capital markets to
obtain additional financing. It is expected that the financing would be used for
general corporate purposes, which may include, among other things, refinancing
of short-term debt or commercial paper, the funding of operating expenses,
shareholder dividends,capital expenditures, business development activities,
licensing fees and milestone payments and the payment of settlement amounts,
fines, penalties and other investigatory and litigation costs and expenses. On
May 11, 2004, the shelf registration, as amended, that allows the Company to
issue up to $2 billion in various debt and equity securities, was declared
effective by the SEC. As of June 30, 2004, no amounts were issued under the
shelf registration.
37
The Company's credit rating could decline further. The impact of such decline
could be reduced availability of commercial paper borrowing and would increase
the interest rate on the Company's long-term debt. If this were to occur, the
Company may have to seek short-term financing from other sources at higher
interest rates than that of commercial paper, or to repatriate additional funds
currently held by foreign affiliates that would incur additional U.S. income
tax.
Borrowings and Credit Facilities
On November 26, 2003, the Company issued $1.25 billion aggregate principal
amount of 5.3 percent senior unsecured notes due 2013 and $1.15 billion
aggregate principal amount of 6.5 percent senior unsecured notes due 2033.
Proceeds from this offering of $2.4 billion were used for general corporate
purposes, including to repay commercial paper outstanding in the United States.
Upon issuance, the notes were rated A3 by Moody's Investors' Service (Moody's)
and A+ (on CreditWatch with negative implications) by Standard & Poor's (S&P).
The interest rates payable on the notes are subject to adjustment. If the rating
assigned to the notes by either Moody's or S&P is downgraded below "A3" or "A-,"
respectively, the interest rate payable on that series of notes will increase.
See the "Borrowings" footnote included in the financial statements to this
report for additional information.
On July 14, 2004, Moody's lowered its rating on the notes to "Baa1", accordingly
the interest payable on each note will increase 25 basis points, respectively,
effective December 1, 2004. Therefore, on December 1, 2004, the interest rate
payable on the notes due 2013 will increase from 5.3% to 5.55%, and the interest
rate payable on the notes due 2033 will increase from 6.5% to 6.75%. This
adjustment to the interest rate payable on the notes will increase the Company's
interest expense by $6 million annually.
The Company has two revolving credit facilities totaling $1.5 billion. Both
facilities are from a syndicate of major financial institutions. The most
recently negotiated facility (May 2004) is a $1.25 billion, five-year credit
facility. This facility matures in May 2009 and requires the Company to maintain
a total debt to total capital ratio of no more than 60 percent. The second
credit facility provides a $250 million line of credit through its maturity date
in May 2006 and requires the Company to maintain a total debt to total capital
ratio of no more than 60 percent anytime the Company is rated at or below Baa3
by Moody's and BBB- by S&P. These facilities are available for general corporate
purposes and are considered as support for the Company's commercial paper
borrowings. These facilities do not require compensating balances; however, a
nominal commitment fee is paid. At June 30, 2004, no funds were drawn under
either of these facilities.
At June 30, 2004, short-term borrowings totaled $1.305 billion. Approximately 94
percent of this was outstanding commercial paper. The commercial paper ratings
discussed below have not significantly affected the Company's ability to issue
or roll over its outstanding commercial paper borrowings at this time. However,
the Company believes the ability of commercial paper issuers, such as the
Company, with one or more short-term credit ratings of "P-2" from Moody's, "A-2"
from S&P and/or "F2" from Fitch Ratings (Fitch) to issue or roll over
outstanding commercial paper can, at times, be less than that of companies with
higher short-term credit ratings. In addition, the total amount of commercial
paper capacity available to such issuers is typically less than that of higher
rated companies. The Company maintains sizable lines of credit with commercial
banks, as well as cash and short-term investments held by foreign-based
subsidiaries, to serve as alternative sources of liquidity and to support its
commercial paper program.
38
Credit Ratings
On February 18, 2004, S&P downgraded the Company's senior unsecured debt ratings
to "A-" from "A." At the same time, S&P also lowered the Company's short-term
corporate credit and commercial paper rating to "A-2" from "A-1." The Company's
S&P rating outlook remains negative.
On May 11, 2004 the shelf registration, as amended, that allows the Company to
issue up to $2 billion in various debt and equity securities was declared
effective by the SEC. On March 3, 2004, S&P assigned the shelf registration a
preliminary rating of "A-" for senior unsecured debt and a preliminary
subordinated debt rating of "BBB+". As of June 30, 2004, no amounts were issued
under the shelf registration.
On April 29, 2004, Moody's placed the Company's senior unsecured credit rating
of "A-3" on its Watchlist for possible downgrade based upon concerns related to
market share declines, litigation risks and a high degree of reliance on the
success of VYTORIN. On July 14, 2004, Moody's lowered the Company's senior
unsecured credit rating from "A-3" to "Baa1", lowered the Company's senior
unsecured shelf registration rating from "(P)A3" to "(P)Baa1", lowered the
Company's subordinated shelf registration rating from "(P)Baa1" to "(P)Baa2",
lowered the Company's cumulative and non-cumulative preferred stock shelf
registration rating from "(P)Baa2" to "(P)Baa3", confirmed the Company's "P-2"
commercial paper rating and removed the Company from the Watchlist. Moody's
rating outlook for the Company is negative. See the "Borrowings and Credit
Facilities" section above for a discussion of the impact of Moody's rating
downgrade on the interest rates paid on the Company's long-term debt.
On November 20, 2003, Fitch downgraded the Company's senior unsecured and bank
loan ratings to "A-" from "A+," and its commercial paper rating to "F2" from
"F1." The Company's rating outlook remained negative. In announcing the
downgrade, Fitch noted that the sales decline in the Company's leading product
franchise, the INTRON franchise, was greater than anticipated, and that it was
concerned that total Company growth is reliant on the performance of two key
growth drivers, ZETIA and REMICADE, in the near term.
Financial Arrangements Containing Credit Rating Downgrade Triggers
The Company previously had two separate arrangements that enable it to manage
cash flows between its U.S. subsidiaries and its foreign-based subsidiaries. One
of these arrangements has been terminated as described below. The other
arrangement remains in effect. Both of these arrangements employ interest rate
swaps, and both of these arrangements have similar credit rating downgrade
triggers which allow the counterparty to call for early termination. The credit
rating downgrade triggers require the Company to maintain a long-term debt
rating of at least "A2" by Moody's or "A" by S&P. Both S&P's and Moody's current
credit ratings are below this specified minimum. As a result, the counterparties
to the interest rate swaps can elect early termination following a specified
period, as described below.
The one arrangement still in effect utilizes two long-term interest rate swap
contracts, one between a foreign-based subsidiary and a bank and the other
between a U.S. subsidiary and the same bank. The two contracts have equal and
offsetting terms and are covered by a master netting arrangement. The contract
involving the foreign-based subsidiary permits the subsidiary to prepay a
portion of its future obligation to the bank, and the contract involving the
U.S. subsidiary permits the bank to prepay a portion of its future obligation to
the U.S. subsidiary. Interest is paid on the prepaid balances by both
39
parties at market rates. Prepayments totaling $1.9 billion have been made under
both contracts as of June 30, 2004 and 2003. The prepaid amounts have been
netted in the preparation of the consolidated balance sheet in accordance with
Financial Accounting Standards Board (FASB) Interpretation No. 39, "Offsetting
of Amounts Related to Certain Contracts."
This arrangement provides that in the event the Company fails to maintain the
required minimum credit ratings, the counterparty may terminate the transaction
by designating an early termination date not earlier than 36 months following
the date of such notice to terminate. However, if such notice is given, the
early termination consequences discussed below would not be required to occur
until the end of the three-year period. As of this date, the counterparty has
not given the Company notice to terminate.
Early termination requires repayment of all prepaid amounts, and repayment must
occur in the original tax jurisdiction in which the prepaid amounts were made.
Accordingly, early termination would require the Company's U.S. subsidiary to
repay $1.9 billion to the bank and for the bank to repay $1.9 billion to the
Company's foreign-based subsidiary.
The financial impact of early termination depends on the manner and extent to
which the Company decides to finance its U.S. repayment obligation. The Company
could finance its entire obligation by obtaining short- or long-term financing
in the United States. (In this case, cash and debt would increase by equal
amounts in the consolidated balance sheet.) However, the Company's ability to
finance its obligation under the swaps will depend on the Company's credit
ratings and business operations, as well as market conditions, at the time such
financing is contemplated. Alternatively, the Company could repatriate to the
United States some or all of the funds received by the foreign-based subsidiary.
Repatriating funds could have U.S. income tax consequences depending primarily
on profitability of the U.S. operations. Any such tax would be accrued against
future earnings, and may result in the Company reporting a higher effective tax
rate. Currently, the U.S. operations are generating tax losses. However, future
tax losses may be insufficient to absorb any or all of the potential tax should
the Company repatriate some or all of the funds received by the foreign-based
subsidiary. If the proposed U.S. tax law previously discussed in this "Liquidity
and Financial Resources" section becomes law, the Company may be able to finance
its U.S. repayment obligation by repatriating the funds received by the
foreign-based subsidiary at a significantly reduced tax cost.
As stated above, both S&P's and Moody's current credit ratings are below the
specified minimum, however, termination of the transaction is not required to
occur earlier than 36 months following the date on which the Company receives a
termination notice from the counterparty. As of this date, the Company has not
received a termination notice from the counterparty. Accordingly, early
termination is not imminent. Due to this fact, as well as the alternative
courses of action available to the Company in the event of early termination,
the potential of early termination does not impact current liquidity and
financial resources.
The second arrangement, which is no longer in effect, utilized long-term
interest rate swap contracts, one entered into in 1991 with a notional principal
of $650 million and a second entered into in 1992 with a notional principal of
$950 million. The terms of these contracts enabled the Company to sell the right
to receive payments while retaining the obligation to make payments. In 1991 and
1992, the U.S. parent company sold the rights to receive payments under both
contracts to two foreign-based subsidiaries in return for approximately $700
million (fair value). This intercompany transaction was eliminated in the
preparation of the consolidated financial statements. (The Internal Revenue
Service has asserted that these transactions were not a sale but a loan on which
additional U.S. income taxes are due. The
40
Company expects to litigate this matter as described in the "Legal,
Environmental and Regulatory Matters" footnote to the financial statements.)
Under this second arrangement, the swap contracts allowed the counterparty to
effectively terminate the transaction if the Company failed to maintain the
required minimum credit ratings and within 60 days does not restore at least one
of the required minimum credit ratings. The Company's credit rating fell below
the required minimum credit rating on February 18, 2004. The Company was unable
to restore at least one of its credit ratings in the allotted time and as a
result, an early termination event occurred. On April 1, 2004, the U.S. parent
reacquired from the foreign based subsidiaries the right to receive payments
under both contracts from the counterparty at its fair market value. On May 10,
2004, all of the interest rate swaps related to the $650 million and $950
million swap arrangements were terminated, and the impact on the Company's
Statements of Consolidated Operations was not material.
Additional Factors Influencing Operations
In the United States, many of the Company's pharmaceutical products are subject
to increasingly competitive pricing as managed care groups, institutions,
government agencies and other groups seek price discounts. In most international
markets, the Company operates in an environment of government-mandated
cost-containment programs. In the U.S. market, the Company and other
pharmaceutical manufacturers are required to provide statutorily defined rebates
to various government agencies in order to participate in Medicaid, the veterans
health care program and other government-funded programs. Several governments
have placed restrictions on physician prescription levels and patient
reimbursements, emphasized greater use of generic drugs and enacted
across-the-board price cuts as methods to control costs.
Since the Company is unable to predict the final form and timing of any future
domestic or international governmental or other health care initiatives,
including the passage of laws permitting the importation of pharmaceuticals into
the United States, their effect on operations and cash flows cannot be
reasonably estimated. Similarly, the effect on operations and cash flows of
decisions of government entities, managed care groups and other groups
concerning formularies and pharmaceutical reimbursement policies cannot be
reasonably estimated.
The Company cannot predict what net effect the Medicare prescription drug
benefit will have on markets and sales. The program does not go into effect
until 2006 and many of the Company's leading drugs are already covered under
Medicare Part B (e.g., TEMODAR, INTEGRILIN and INTRON A). Others have a
relatively small portion of their sales to the Medicare population (e.g.,
CLARINEX, the hepatitis C franchise). The Company could experience expanded
utilization of ZETIA and VYTORIN and new drugs in the Company's R&D pipeline. Of
greater consequence for the Company may be the legislation's impact on pricing,
rebates and discounts.
A significant portion of net sales are made to major pharmaceutical and health
care products distributors and major retail chains in the United States.
Consequently, net sales and quarterly growth comparisons may be affected by
fluctuations in the buying patterns of major distributors, retail chains and
other trade buyers. These fluctuations may result from seasonality, pricing,
wholesaler buying decisions or other factors.
The market for pharmaceutical products is competitive. The Company's operations
may be affected by technological advances of competitors, industry
consolidation, patents granted to competitors, new
41
products of competitors and generic competition as the Company's products
mature. In addition, patent positions are increasingly being challenged by
competitors, and the outcome can be highly uncertain. An adverse result in a
patent dispute can preclude commercialization of products or negatively affect
sales of existing products. The effect on operations of competitive factors and
patent disputes cannot be predicted.
On November 27, 2002, the Company announced that all five formulations of the
CLARITIN brand of non-drowsy allergy products had been approved at their
original prescription strengths by the FDA as OTC medicines for the treatment of
allergies. The Company also has been informed by the FDA that the New Drug
Applications (NDAs) for these CLARITIN formulations, as well as for all
indications (allergies and hives), will be transferred from the FDA's Pulmonary
Division Office of Drug Evaluation II to the Division of Over-the-Counter Drug
Products Office of Drug Evaluation V. The Company launched OTC CLARITIN in the
United States in December 2002. Also in December 2002, a competing OTC
loratadine product was launched in the United States. In the third quarter of
2003, the Company began to face additional private-label competition for its OTC
CLARITIN line of nonsedating antihistamines, as the initial 180-day period of
exclusivity expired for the first OTC generic competitor. In November 2003, the
FDA approved CLARITIN for the over-the-counter relief of hives.
The Company continues to market CLARINEX (desloratadine) 5 mg Tablets for the
treatment of allergic rhinitis, which combines the indication of seasonal
allergic rhinitis with the indication of perennial allergic rhinitis, as well as
the treatment of chronic idiopathic urticaria, or hives of unknown cause. The
ability of the Company to capture and maintain market share for CLARINEX and OTC
CLARITIN in the U.S. market will depend on a number of factors, including:
additional entrants in the market for allergy treatments; clinical
differentiation of CLARINEX from other allergy treatments and the perception of
the extent of such differentiation in the marketplace; the pricing differentials
among OTC CLARITIN, CLARINEX, other allergy treatments and generic OTC
loratadine; the erosion rate of OTC CLARITIN and CLARINEX sales upon the entry
of additional generic OTC loratadine products; and whether or not one or both of
the other branded second-generation antihistamines are switched from
prescription to OTC status. CLARINEX is experiencing intense competition in the
prescription U.S. allergy market. The prescription allergy market has been
shrinking since the OTC switch of CLARITIN in December 2002. The Company is
implementing new marketing efforts to address market share performance for
CLARINEX.
The switch of CLARITIN to OTC status and the introduction of competing OTC
loratadine has resulted in a rapid, sharp and material decline in CLARITIN sales
in the United States and the Company's results of operations. U.S. sales of
prescription CLARITIN products were $25 million or 0.3 percent of the Company's
consolidated global sales in 2003 and $1.4 billion or 14 percent in 2002. Sales
of CLARINEX in the United States and abroad have also been materially adversely
affected by the presence of generic OTC loratadine and OTC CLARITIN. In light of
the factors described above, management believes that the Company's December
2002 introduction of OTC CLARITIN, as well as the introduction of a competing
OTC loratadine product in December 2002 and additional entrants of generic OTC
loratadine products in the market, have had a rapid, sharp and material adverse
effect on the Company's results of operations and will likely continue for an
indeterminate period of time.
Following settlement in 2003 of patent litigation by the Company involving three
drug manufacturers, and dismissal of patent litigation relating to ribavirin
patents that did not involve the Company, generic forms of ribavirin entered the
U.S. market in April 2004. The generic forms of ribavirin compete with the
Company's REBETOL (ribavirin) Capsules in the United States. The REBETOL patents
are
42
material to the Company's business. U.S. sales of REBETOL in 2003 were $306
million. For the six months ended June 30, 2004, U.S. sales of REBETOL were $53
million.
PEG-INTRON and REBETOL combination therapy for hepatitis C contributed
substantially to sales in 2003 and 2002. During the fourth quarter of 2002, a
competing pegylated interferon-based combination product, including a brand of
ribavirin, received regulatory approval in most major markets, including the
United States. The overall market share of the hepatitis C franchise has
declined sharply, reflecting this new market competition. Management believes
that the ability of PEG-INTRON and REBETOL combination therapy to maintain
market share will continue to be adversely affected by new competition in the
hepatitis C marketplace.
As a result of the introduction of a competitor for pegylated interferon and the
introduction of generic ribavirin, the value of the Company's second most
important product franchise has been and will continue to be severely diminished
and earnings and cash flow have been and will continue to be materially and
negatively impacted.
In October 2002, Merck/Schering-Plough Pharmaceuticals announced that the FDA
approved ZETIA (ezetimibe) 10 mg for use either by itself or together with
statins for the treatment of elevated cholesterol levels. In March 2003, the
Company announced that ezetimibe (EZETROL, as marketed in Europe) had
successfully completed the European Union (EU) mutual recognition procedure
(MRP). With the completion of the MRP process, the 15 EU member states as well
as Iceland and Norway can grant national marketing authorization with unified
labeling for EZETROL. EZETROL has been launched in many international markets.
The Merck/Schering-Plough partnership also developed a once-daily tablet
combining ezetimibe with simvastatin (Zocor), Merck's cholesterol-modifying
medicine. Ezetimibe/simvastatin has been approved for marketing in several
countries, including Germany in April of 2004 and in Mexico in March of 2004. On
July 23, 2004, Merck/Schering-Plough Pharmaceuticals announced that the FDA had
approved VYTORIN.
Uncertainties inherent in government regulatory approval processes, including,
among other things, delays in approval of new products, formulations or
indications, may also affect the Company's operations. The effect of regulatory
approval processes on operations cannot be predicted.
The Company is subject to the jurisdiction of various national, state and local
regulatory agencies and is, therefore, subject to potential administrative
actions. Of particular importance is the FDA in the United States. It has
jurisdiction over all the Company's businesses and administers requirements
covering the testing, safety, effectiveness, approval, manufacturing, labeling
and marketing of the Company's products. From time to time, agencies, including
the FDA, may require the Company to address various manufacturing, advertising,
labeling or other regulatory issues, such as those noted below relating to the
Company's current manufacturing issues. Failure to comply with governmental
regulations can result in delays in the release of products, seizure or recall
of products, suspension or revocation of the authority necessary for the
production and sale of products, discontinuance of products, fines and other
civil or criminal sanctions. Any such result could have a material adverse
effect on the Company's financial position and its results of operations.
Additional information regarding government regulation that may affect future
results is provided in Part I, Item I, "Business," in the Company's annual
report on Form 10-K for the fiscal year ended December 31, 2003. Additional
information about cautionary factors that may affect future results is provided
under the caption "Cautionary Factors That May Affect Future Results (Cautionary
Statements Under the Private Securities Litigation Reform Act of 1995)" in this
Management's Discussion and Analysis of Operations and Financial Condition.
43
As noted in the "Consent Decree" footnote included in the financial statements
to this report, on May 17, 2002, the Company announced that it had reached an
agreement with the FDA for a consent decree to resolve issues involving the
Company's compliance with current Good Manufacturing Practices at certain
manufacturing facilities in New Jersey and Puerto Rico. The U.S. District Court
for the District of New Jersey approved and entered the consent decree on May
20, 2002.
Under terms of the consent decree, the Company agreed to pay a total of $500
million to the U.S. government in two equal installments of $250 million; the
first installment was paid in May 2002 and the second installment was paid in
the second quarter of 2003. As previously reported, the Company accrued a $500
million provision for this consent decree in the fourth quarter of 2001.
The consent decree requires the Company to complete a number of actions. In the
event certain actions agreed upon in the consent decree are not satisfactorily
completed on time, the FDA may assess payments for each deadline missed. The
consent decree required the Company to develop and submit for FDA's concurrence
comprehensive cGMP Work Plans for the Company's manufacturing facilities in New
Jersey and Puerto Rico that are covered by the decree. The Company received FDA
concurrence with its proposed cGMP Work Plans on May 14, 2003. The cGMP Work
Plans contain a number of Significant Steps whose timely and satisfactory
completion are subject to payments of $15,000 per business day for each deadline
missed. These payments may not exceed $25 million for 2002, and $50 million for
each of the years 2003, 2004 and 2005. These payments are subject to an overall
cap of $175 million.
In connection with its discussions with FDA regarding the Company's cGMP Work
Plans, and pursuant to the terms of the decree, the Company and the FDA entered
into a letter agreement dated April 14, 2003. In the letter agreement the
Company and the FDA agreed to extend by six months the time period during which
the Company may incur payments as described above with respect to certain of the
Significant Steps whose due dates are December 31, 2005. The letter agreement
does not increase the yearly or overall caps on payments described above.
In addition, the decree requires the Company to complete programs of
revalidation of the finished drug products and bulk active pharmaceutical
ingredients manufactured at the covered manufacturing facilities. The Company is
required under the consent decree to complete its revalidation programs for bulk
active pharmaceutical ingredients by September 30, 2005, and for finished drugs
by December 31, 2005. In general, the timely and satisfactory completion of the
revalidations are subject to payments of $15,000 per business day for each
deadline missed, subject to the caps described above. However, if a product
scheduled for revalidation has not been certified as having been validated by
the last date on the validation schedule, the FDA may assess a payment of 24.6
percent of the net domestic sales of the uncertified product until the
validation is certified. Any such payment would not be subject to the caps
described above. Further, in general, if a product scheduled for revalidation
under the consent decree is not certified within six months of its scheduled
date, the Company must cease production of that product until certification is
obtained. The completion of the Significant Steps in the Work Plans and the
completion of the revalidation programs are subject to third-party expert
certification, which must be accepted by the FDA.
The consent decree provides that if the Company believes that it may not be able
to meet a deadline, the Company has the right, upon the showing of good cause,
to request extensions of deadlines in
44
connection with the cGMP Work Plans and revalidation programs. However, there is
no guarantee that FDA will grant any such requests.
Although the Company believes it has made significant progress in meeting its
obligations under the consent decree, it is possible that (1) the Company may
fail to complete a Significant Step or a revalidation by the prescribed
deadline; (2) the third party expert may not certify the completion of the
Significant Step or revalidation; or (3) the FDA may disagree with an expert's
certification of a Significant Step or revalidation. In such a case, it is
possible that the FDA may assess payments as described above.
The Company would expense any payments assessed under the decree if and when
incurred.
In addition, the failure to meet the terms of the consent decree could result in
delays in approval of new products, seizure or recall of products, suspension or
revocation of the authority necessary for the production and sale of products,
fines and other civil or criminal sanctions.
In April 2003, the Company received notice of a False Claims Act complaint
brought by an individual purporting to act on behalf of the U.S. government
against it and approximately 25 other pharmaceutical companies in the U.S.
District Court for the Northern District of Texas. The complaint alleges that
the pharmaceutical companies, including the Company, have defrauded the United
States by having made sales to various federal governmental agencies of drugs
that were allegedly manufactured in a manner that did not comply with current
Good Manufacturing Practices. The Company and the other defendants filed a
motion to dismiss the second amended complaint in this action on April 12, 2004.
The Company is subject to pharmacovigilance reporting requirements in many
countries and other jurisdictions, including the United States, the European
Union (EU) and the EU member states. The requirements differ from jurisdiction
to jurisdiction, but all include requirements for reporting adverse events that
occur while a patient is using a particular drug in order to alert the
manufacturer of the drug and the governmental agency to potential problems.
During pharmacovigilance inspections by officials of the British and French
medicines agencies conducted at the request of the European Agency for the
Evaluation of Medicinal Products (EMEA), serious deficiencies in reporting
processes were identified. The Company is taking urgent actions to rectify these
deficiencies as quickly as possible. The Company does not know what action, if
any, the EMEA or national authorities will take in response to these findings.
Possible actions include further inspections, demands for improvements in
reporting systems, criminal sanctions against the Company and/or responsible
individuals and changes in the conditions of marketing authorizations for the
Company's products.
As described more specifically in the "Legal, Environmental and Regulatory
Matters" footnote included in the financial statements to this report, to which
the reader of this report is directed, the pricing, sales and marketing programs
and arrangements, and related business practices of the Company and other
participants in the health care industry are under increasing scrutiny from
federal and state regulatory, investigative, prosecutorial and administrative
entities. These entities include the Department of Justice and its U.S.
Attorney's Offices, the Office of Inspector General of the Department of Health
and Human Services, the FDA, the Federal Trade Commission (FTC) and various
state Attorneys General offices. Many of the health care laws under which
certain of these governmental entities operate, including the federal and state
"anti-kickback" statutes and statutory and common law "false claims" laws, have
been
45
construed broadly by the courts and permit the government entities to exercise
significant discretion. In the event that any of those governmental entities
believes that wrongdoing has occurred, one or more of them could institute civil
or criminal proceedings, which, if instituted and resolved unfavorably, could
subject the Company to substantial fines, penalties and injunctive or
administrative remedies, including exclusion from government reimbursement
programs, and the Company also cannot predict whether any investigations will
affect its marketing practices or sales. Any such result could have a material
adverse effect on the Company, its financial condition or its results of
operations.
Critical Accounting Policies
Refer to "Management's Discussion and Analysis of Operations and Financial
Condition" in the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 2003 for disclosures regarding the Company's critical accounting
policies.
Disclosure Notice
Cautionary Factors That May Affect Future Results (Cautionary Statements Under
the Private Securities Litigation Reform Act of 1995)
Management's Discussion and Analysis of Financial Condition and Results of
Operations and other sections of this report and other written reports and oral
statements made from time to time by the Company may contain "forward-looking
statements" within the meaning of the Securities Litigation Reform Act of 1995.
Forward-looking statements relate to expectations or forecasts of future events.
They use words such as "anticipate," "believe," "could," "estimate," "expect,"
"forecast," "project," "intend," "plan," "potential," "will," and other words
and terms of similar meaning in connection with a discussion of potential future
events, circumstances or future operating or financial performance. You can also
identify forward-looking statements by the fact that they do not relate strictly
to historical or current facts.
In particular, forward-looking statements include statements relating to future
actions, ability to access the capital markets, prospective products, the status
of product approvals, future performance or results of current and anticipated
products, sales efforts, development programs, expenses and programs to reduce
expenses, the cost of and savings from reductions in work force, the outcome of
contingencies such as litigation and investigations, growth strategy and
financial results.
Any or all forward-looking statements here or in other publications may turn out
to be wrong. Actual results may vary materially, and there are no guarantees
about Schering-Plough's financial and operational performance or the performance
of Schering-Plough stock. Schering-Plough does not assume the obligation to
update any forward-looking statement.
Many factors could cause actual results to differ from Schering-Plough's
forward-looking statements. These factors include inaccurate assumptions and a
broad variety of other risks and uncertainties, including some that are known
and some that are not. Although it is not possible to predict or identify all
such factors, they may include the following:
- - A significant portion of net sales are made to major pharmaceutical and
health care products distributors and major retail chains in the United
States. Consequently, net sales and quarterly growth comparisons may be
affected by fluctuations in the buying patterns of major distributors,
46
retail chains and other trade buyers. These fluctuations may result from
seasonality, pricing, wholesaler buying decisions or other factors.
- - Competitive factors, including technological advances attained by
competitors, patents granted to competitors, new products of competitors
coming to the market, new indications for competitive products, and
generic, prescription and/or OTC products that compete with products of
Schering-Plough or the Merck/Schering-Plough Pharmaceuticals joint venture
(such as competition from OTC statins, like the one approved for use in
the U.K. for which impact in the cholesterol reduction market is not yet
known).
- - Increased pricing pressure both in the United States and abroad from
managed care organizations, institutions and government agencies and
programs. In the United States, among other developments, consolidation
among customers may increase pricing pressures and may result in various
customers having greater influence over prescription decisions through
formulary decisions and other policies.
- - The potential impact of the Medicare Prescription Drug, Improvement and
Modernization Act of 2003; possible other U.S. legislation or regulatory
action affecting, among other things, pharmaceutical pricing and
reimbursement, including Medicaid and Medicare, involuntary approval of
prescription medicines for over-the-counter use; and other health care
reform initiatives and drug importation legislation. Legislation or
regulations in markets outside the U.S. affecting product pricing,
reimbursement or access. Laws and regulations relating to trade,
antitrust, monetary and fiscal policies, taxes, price controls and
possible nationalization.
- - Patent positions can be highly uncertain and patent disputes are not
unusual. An adverse result in a patent dispute can preclude
commercialization of products or negatively impact sales of existing
products or result in injunctive relief and payment of financial remedies.
- - Uncertainties of the FDA approval process and the regulatory approval and
review processes in other countries, including, without limitation, delays
in approval of new products.
- - Failure to meet Good Manufacturing Practices established by the FDA and
other governmental authorities can result in delays in the approval of
products, release of products, seizure or recall of products, suspension
or revocation of the authority necessary for the production and sale of
products, fines and other civil or criminal sanctions. The resolution of
manufacturing issues with the FDA discussed in Schering-Plough's 10-Ks,
10-Qs and 8-Ks are subject to substantial risks and uncertainties. These
risks and uncertainties, including the timing, scope and duration of a
resolution of the manufacturing issues, will depend on the ability of
Schering-Plough to assure the FDA of the quality and reliability of its
manufacturing systems and controls, and the extent of remedial and
prospective obligations undertaken by Schering-Plough.
- - Difficulties in product development. Pharmaceutical product development is
highly uncertain. Products that appear promising in development may fail
to reach market for numerous reasons. They may be found to be ineffective
or to have harmful side effects in clinical or pre-clinical testing, they
may fail to receive the necessary regulatory approvals, they may turn out
not to be economically feasible because of manufacturing costs or other
factors or they may be precluded from commercialization by the proprietary
rights of others.
- - Efficacy or safety concerns with respect to marketed products, whether or
not scientifically justified, leading to recalls, withdrawals or declining
sales.
- - Major products such as CLARITIN, CLARINEX, INTRON A, PEG-INTRON, REBETOL
Capsules, REMICADE and NASONEX accounted for a material portion of
Schering-Plough's 2003 revenues. If any major product were to become
subject to a problem such as loss of patent protection, OTC availability
of the Company's product or a competitive product (as has been disclosed
for CLARITIN and its current and potential OTC competition), previously
unknown side effects; if a new, more effective treatment should be
introduced; generic availability of
47
competitive products; or if the product is discontinued for any reason,
the impact on revenues could be significant. Also, such information about
important new products, such as ZETIA and VYTORIN, or important products
in our pipeline, may impact future revenues. Further, the launch of
VYTORIN may negatively impact sales of ZETIA.
- - Unfavorable outcomes of government (local and federal, domestic and
international) investigations, litigation about product pricing, product
liability claims, other litigation and environmental concerns could
preclude commercialization of products, negatively affect the
profitability of existing products, materially and adversely impact
Schering-Plough's financial condition and results of operations, or
contain conditions that impact business operations, such as exclusion from
government reimbursement programs.
- - Economic factors over which Schering-Plough has no control, including
changes in inflation, interest rates and foreign currency exchange rates.
- - Instability, disruption or destruction in a significant geographic region
- due to the location of manufacturing facilities, distribution facilities
or customers - regardless of cause, including war, terrorism, riot, civil
insurrection or social unrest; and natural or man-made disasters,
including famine, flood, fire, earthquake, storm or disease.
- - Changes in tax laws including changes related to taxation of foreign
earnings.
- - Changes in accounting standards promulgated by the American Institute of
Certified Public Accountants, the Financial Accounting Standards Board or
the SEC, or the Public Company Accounting Oversight Board that would
require a significant change to Schering-Plough's accounting practices.
For further details and a discussion of these and other risks and uncertainties
that may impact Schering-Plough's forward looking statements, see
Schering-Plough's past and future SEC filings.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
The Company is exposed to market risk primarily from changes in foreign currency
exchange rates and, to a lesser extent, from interest rates and equity prices.
Refer to "Management's Discussion and Analysis of Operations and Financial
Condition" in the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 2003 for additional information.
Item 4. Controls and Procedures
Management, including the chief executive officer and the chief financial
officer, has evaluated the Company's disclosure controls and procedures as of
the end of the quarterly period covered by this Form 10-Q and has concluded that
the Company's disclosure controls and procedures are effective. They also
concluded that there were no changes in the Company's internal control over
financial reporting that occurred during the Company's most recent fiscal
quarter that have materially affected, or are reasonably likely to materially
affect, the Company's internal control over financial reporting.
48
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Legal proceedings involving the Company are described in the 2003 10-K and the
2004 first quarter 10-Q, together referred to as the "Reports" in this Legal
Proceedings Item. Unless specifically indicated below, matters described in the
Reports are still pending. The following description should be read together
with the Reports. It covers material developments to previously reported
proceedings and new legal proceedings involving the Company that arose since the
April 28, 2004 filing date of the 2004 first quarter 10-Q.
Patent Matters. PRIME PAC PRRS Patent. In January 2000, a jury found that the
Company's PRIME PAC PRRS (Porcine Respiratory and Reproductive Syndrome) vaccine
infringed a patent owned by Boehringer Ingelheim Vetmedica, Inc ("Boehringer
Ingelheim"). An injunction was issued in August 2000 barring further sales of
the Company's vaccine. On June 3, 2004, a jury in the United States District
Court for the district of New Jersey awarded Boehringer Ingelheim $6.9 million
plus interest in this matter.
DR. SCHOLL'S FREEZE AWAY Patent. On July 26, 2004, OraSure Technologies filed an
action in the U.S. District Court for the Eastern District of Pennsylvania
alleging patent infringement by Schering-Plough Healthcare Products by its sale
of DR. SCHOLL'S FREEZE AWAY wart removal product. The FREEZE AWAY product was
launched in March 2004. As of June 30, 2004, net sales of this product totaled
$8.4 million.
Investigations. Pennsylvania Investigation. On July 30, 2004, Schering-Plough
Corporation, the U.S. Department of Justice and the U.S. Attorney's Office for
the Eastern District of Pennsylvania announced settlement of the previously
disclosed investigation by that Office.
Under the settlement, Schering Sales Corporation, an indirect wholly owned
subsidiary of Schering-Plough Corporation, will plead guilty to a single federal
criminal charge concerning a payment to a managed care customer. As a result,
Schering Sales Corporation will be excluded from participating in federal
healthcare programs. The settlement will not affect the ability of
Schering-Plough Corporation to participate in those programs.
The aggregate settlement amount is $345.5 million in fines and damages,
comprised of a $52.5 million fine to be paid by Schering Sales Corporation, and
$293 million in civil damages to be paid by Schering-Plough Corporation.
Schering-Plough Corporation will be credited with $53.6 million that was
previously paid in additional Medicaid rebates against the civil damages amount,
leaving a net settlement amount of $291.9 million. Of that amount, $177.5
million of the total settlement will be paid in 2004, and the remaining portion
will be paid by March 4, 2005. Interest will accrue on the unpaid balance at the
rate of 4 percent.
The payments will be funded by cash from operations, borrowings and/or proceeds
from the issuance of securities. There will be no impact on 2004 full year
results related to the Pennsylvania settlement.
Under the settlement, Schering-Plough Corporation also entered into a five year
corporate integrity agreement with the Office of the Inspector General of the
Department of Health and Human Services, under which Schering-Plough Corporation
agreed to implement specific measures to promote
49
compliance with regulations on issues such as marketing. Failure to comply can
result in financial penalties.
Details of the initiation and progress of the investigation can be found in the
Company's prior 10-K and 10-Q reports beginning with the 10-K for 1999.
The Company cannot predict the impact of this settlement, if any, on other
outstanding investigations.
Pricing Matters. During 2000, Warrick Pharmaceuticals (Warrick), the Company's
generics subsidiary, was sued by the state of Texas. In 2002, the Company and
its subsidiary, Schering Corporation, were added as defendants. The lawsuit
alleges that Warrick supplied the state with false reports of wholesale prices,
which caused the state to pay Medicaid claims on prescriptions of Warrick's
albuterol sulfate solution and inhaler at a higher-than-justified level. On May
3, 2004, the Company announced that it has reached an agreement with the
attorney general's office of the State of Texas to settle the matter for a total
of $27 million.
Securities and Class Action Litigation. On March 31, 2003, the Company was
served with a putative class action complaint filed in the U.S. District Court
in New Jersey alleging that the Company, Richard Jay Kogan (who resigned as
Chairman of the Board November 13, 2002, and retired as Chief Executive Officer,
President and Director of the Company April 20, 2003) and the Company's Employee
Savings Plan (Plan) administrator breached their fiduciary obligations to
certain participants in the Plan. In May 2003, the Company was served with a
second putative class action complaint filed in the same court with allegations
nearly identical to the complaint filed March 31, 2003. On October 6, 2003, a
consolidated amended complaint was filed, which names as additional defendants
seven current and former directors and other corporate officers. The Court
dismissed this complaint on June 29, 2004. On July 16, 2004, the plaintiffs
filed a Notice of Appeal.
SEC Inquiries and Related Litigation. On June 9, 2004, the SEC and the Company
announced settlement of the SEC's enforcement proceeding regarding the books and
records and internal controls provisions of the Foreign Corrupt Practices Act
relating to payments of approximately $76,000 made between February 1999 and
March 2002 by one of the Company's foreign subsidiaries, Schering-Plough Poland,
to a charitable organization called the Chudow Castle Foundation. Without
admitting or denying the allegations in the complaint, the Company paid a
$500,000 civil penalty; consented to the issuance of a Commission Order
requiring the Company to cease and desist from committing or causing violations
of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934;
and agreed to retain an independent consultant to review the Company's policies
and procedures regarding compliance with the Foreign Corrupt Practices Act and
to implement any changes recommended by the consultant.
On September 9, 2003, the SEC and the Company announced settlement of the SEC
enforcement proceeding against the Company and Richard Jay Kogan, former
Chairman and Chief Executive Officer, regarding meetings held with investors the
week of September 30, 2002, and other communications. Without admitting or
denying the allegations, the Company agreed not to commit future violations of
Regulation FD and related securities laws and paid a civil penalty of $1
million. Mr. Kogan paid a civil penalty of $50 thousand.
The federal putative class actions filed against the Company and Mr. Kogan
regarding the meetings held with investors the week of September 30, 2002, and
other communications were consolidated and, pursuant to that consolidation, an
amended complaint dated March 13, 2003, was filed, alleging violations of
Sections 10(b), 20(a) and 20(A) of the Securities Exchange Act of 1934 relating
to the
50
alleged disclosures made during the meetings mentioned in the paragraph above.
The Company filed a motion to dismiss these class actions May 6, 2003, and the
plaintiffs have sought leave of the court, and thereafter filed a second amended
complaint. On June 29, 2004, the Court dismissed the second amended complaint.
On September 25, 2003, a lawsuit was filed in New Jersey Superior Court, Union
County, against Richard Jay Kogan and the Company's outside Directors alleging
breach of fiduciary duty, fraud and deceit and negligent misrepresentation, all
relating to the alleged disclosures made during the meetings mentioned above.
The Company removed this case to federal court. A motion to remand to state
court and the Company's motion to dismiss are pending.
Environmental Matters. On November 20, 2003, we received a General Notice of
Potential Liability from EPA addressed to Arno/Scholl's Adhesive Tapes, Inc., a
former subsidiary of the Company, relating to the Lake Culmet Cluster Site in
Chicago, Illinois. There are several hundred other potentially responsible
parties for the site. The Company believes it was named erroneously and that
another unrelated company should be responsible for any clean-up obligations at
this site. The Company is working with the government to have the matter
resolved.
The New Jersey Department of Environmental Protection sent Schering-Plough a
letter, received September 24, 2003, stating that the Company "may be legally
responsible for damages to natural resources" in the state. The Department has
not adopted regulations covering how such liability is to be calculated, making
it difficult to accurately predict the ultimate extent of the Company's
exposure.
Tax Matters. In October of 2001, the IRS auditors asserted, in reports, that the
Company is liable for additional tax for the 1990 through 1992 tax years. The
reports allege that two interest rate swaps that the Company entered into with
an unrelated party should be recharacterized as loans from affiliated companies,
resulting in approximately $195 million of tax, plus interest. The Company
estimates the interest to be approximately $280 million. In April of 2004, the
Company received a formal Notice of Deficiency (Statutory Notice) from the IRS
asserting additional federal income tax due of $195 million. The statutory
ninety-day notice period expired on July 7, 2004, and the Company expects to
receive a bill from the IRS for additional tax of $195 million plus interest of
$280 million. The Company believes it has complied with all applicable rules
and regulations related to the tax treatment of interest rate swaps. Thus, the
Company intends to pay the tax and the interest and file suit for refund. It is
likely that this payment will be made in the third quarter of this year. The
Company's tax reserves are adequate to cover the payment of these amounts.
51
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities
ISSUER PURCHASES OF EQUITY SECURITIES
Total Number of Maximum Number
Shares Purchased as of Shares that May
Part of Publicly Yet Be Purchased
Total Number of Average Price Paid Announced Plans or Under the Plans or
PERIOD Shares Purchased per Share Programs Programs
- ------------------------------------------------------------------------------------------------------------------------------
January 1, 2004 through March 31, 2004 54,862(1) $ 17.97 N/A N/A
- ------------------------------------------------------------------------------------------------------------------------------
April 1, 2004 through June 30, 2004 0 0 N/A N/A
- ------------------------------------------------------------------------------------------------------------------------------
TOTAL 2004 54,862 $ 17.97
- ------------------------------------------------------------------------------------------------------------------------------
(1) All of the shares included in the table above were repurchased pursuant to
the Company's stock incentive program and represent shares delivered to the
Company by option holders for payment of the exercise price and tax
withholding obligations in connection with stock options.
Item 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of Shareholders was held on April 27, 2004. At the meeting:
1. Four nominees for director were elected for a three-year term by a vote of
shares as follows:
Fred Hassan received 1,270,798,792 votes for his election (97.49% of
shares voted; 86.36% of shares outstanding) and 32,882,222 votes were withheld
(2.53% of shares voted; 2.24% of outstanding shares).
Philip Leder, M.D. received 1,273,473,248 votes for his election (97.69%
of shares voted; 86.54% of shares outstanding) and 30,207,766 votes were
withheld (2.32% of shares voted; 2.06% of outstanding shares).
Eugene R. McGrath received 1,270,744,681 votes for his election (97.48% of
shares voted; 86.35% of shares outstanding) and 32,936,333 votes were withheld
(2.53% of shares voted; 2.24% of outstanding shares).
Richard de J. Osborne received 1,257,304,598 votes for his election
(96.45% of shares voted; 85.44% of shares outstanding) and 46,376,416 votes were
withheld (3.56% of shares voted; 3.16% of outstanding shares).
52
2. The designation by the Audit Committee of Deloitte & Touche LLP to audit
the books and accounts of the Company for the year ending December 31,
2004 was ratified by a vote of 98.22% of shares voted (or 87.01% of
outstanding shares):
For Against Abstain
--- ------- -------
1,280,389,552 15,370,618 7,920,844
3. The Operations Management Team Incentive Plan was approved by a vote of
94.7% of shares voted (or 83.9% of outstanding shares):
For Against Abstain
--- ------- -------
1,234,591,283 57,879,831 11,209,900
Item 5. Other Information
Regulatory Affairs Development:
The Company sells numerous upper respiratory products which contain
pseudoephedrine (PSE), an FDA approved ingredient for the relief of nasal
congestion. The Company's annual sales of upper respiratory products which
contain PSE totaled approximately $160 million in 2003 and approximately
$95 million through June 2004. These products include all CLARITIN D
products as well as some DRIXORAL, CORICIDIN and CHLOR-TRIMETON products.
The Company understands that PSE has been used in the illicit manufacture
of methamphetamine, a dangerous and addictive drug. To date, we believe
that nine states and Canada have enacted regulations concerning the sale
of PSE, including limiting the amount of these products that can be
purchased at one time, or requiring that these products be located behind
the counter, with the stated goal of deterring the illicit/illegal
manufacture of methamphetamine. To date, the regulations have had no
material impact on the Company's operations or financial results. Were
such regulations to be adopted throughout the United States and in other
countries that are key markets for the products, the impact of such
regulations on the Company's sales of these specific products cannot be
predicted. At this time, the Company has no information indicating that,
based on these regulations, a material adverse impact on the Company's
operations or financial condition is likely based on these regulations in
the next several years.
53
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits - The following Exhibits are filed with this document:
Exhibit Number Description
- -------------- -----------
3(i) Certificate of Correction of Certificate of Incorporation
12 Computation of Ratio of Earnings to Fixed Charges
15 Awareness letter
31.1 Sarbanes-Oxley Act of 2002, Section 302 Certification for
Chairman of the Board, Chief Executive Officer and President
31.2 Sarbanes-Oxley Act of 2002, Section 302 Certification for
Executive Vice President and Chief Financial Officer
32.1 Sarbanes-Oxley Act of 2002, Section 906 Certification for
Chairman of the Board, Chief Executive Officer and President
32.2 Sarbanes-Oxley Act of 2002, Section 906 Certification for
Executive Vice President and Chief Financial Officer
(b) Reports on Form 8-K:
During the three-month period ended June 30, 2004, the Company filed (or
furnished) three current reports on Form 8-K:
1. Report on Form 8-K, filed April 22, 2004, under Item 5 - Other
Events and Regulation FD Disclosure, Item 7 - Financial Statements
and Exhibits and Item 12 - Results of Operations and Financial
Condition.
2. Report on Form 8-K, filed May 6, 2004, under Item 7 - Financial
Statements and Exhibits and Item 9 - Regulation FD Disclosure.
3. Report on Form 8-K, filed May 26, 2004, under Item 5 - Other Events
and Regulation FD Disclosure.
54
SIGNATURE(S)
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Schering-Plough Corporation
---------------------------
(Registrant)
Date August 3, 2004 /s/Douglas J. Gingerella
--------------------------------
Douglas J. Gingerella
Vice President and Controller
(Duly Authorized Officer and
Chief Accounting Officer)
55