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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 SEPTEMBER 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 incorporation) (I.R.S. Employer
2000 Galloping Hill Road Identification No.)
Kenilworth, NJ (908) 298-4000
(Address of principal executive offices) (Registrant's telephone
07033 number,
(Zip Code) including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months, 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 September 30, 2004: 1,472,762,054
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
STATEMENTS OF CONDENSED CONSOLIDATED OPERATIONS
(UNAUDITED)
(Amounts in millions, except per share figures)
Three Months Nine Months
Ended Ended
September 30, September 30,
---------------------- ----------------------
2004 2003 2004 2003
------- ------- ------- -------
Net sales $ 1,978 $ 1,998 $ 6,088 $ 6,386
------- ------- ------- -------
Cost of sales 711 652 2,241 2,094
Selling, general and administrative 892 873 2,785 2,653
Research and development 378 382 1,201 1,074
Other expense (income), net 34 41 112 49
Special charges 26 350 138 370
Equity (income) from cholesterol joint venture (95) (24) (249) (21)
------- ------- ------- -------
Income/(loss) before income taxes 32 (276) (140) 167
Income taxes (expense)/benefit (6) 11 28 (77)
------- ------- ------- -------
Net income/(loss) $ 26 $ (265) $ (112) $ 90
------- ------- ------- -------
Preferred stock dividends 12 - 12 -
------- ------- ------- -------
Net income/(loss) available to common shareholders $ 14 $ (265) $ (124) $ 90
======= ======= ======= =======
Diluted earnings/(loss) per common share $ .01 $ (.18) $ (.08) $ .06
======= ======= ======= =======
Basic earnings/(loss) per common share $ .01 $ (.18) $ (.08) $ .06
======= ======= ======= =======
Dividends per common share $ .055 $ .17 $ .165 $ .51
======= ======= ======= =======
See notes to condensed consolidated financial statements.
2
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(Dollars in millions, except per share figures)
September 30, December 31,
2004 2003
------------- ------------
Assets
Cash and cash equivalents $ 4,685 $ 4,218
Short-term investments 881 587
Accounts receivable, net 1,342 1,329
Inventories 1,516 1,651
Deferred income taxes 460 472
Prepaid expenses
and other current assets 550 890
--------------- --------
Total current assets 9,434 9,147
Property, plant and equipment 6,843 6,817
Less accumulated depreciation 2,391 2,290
--------------- --------
Property, net 4,452 4,527
Goodwill 214 218
Other intangible assets, net 241 401
Other assets 762 809
--------------- --------
Total assets $ 15,103 $ 15,102
=============== ========
Liabilities and Shareholders' Equity
Accounts payable $ 926 $ 1,030
Short-term borrowings and current
portion of long-term debt 866 1,023
Other accrued liabilities 1,942 2,556
--------------- --------
Total current liabilities 3,734 4,609
Long-term debt 2,392 2,410
Other long-term liabilities 729 746
--------------- --------
Total long-term liabilities 3,121 3,156
Shareholders' Equity:
Mandatory convertible preferred shares - $1 par
value; issued - 28,750,000;
$50 per share face value 1,438 -
Common shares - $.50 par value;
issued:2,029,686,377 1,015 1,015
Paid-in capital 1,251 1,272
Retained earnings 10,452 10,918
Accumulated other comprehensive loss (469) (426)
--------------- --------
Total 13,687 12,779
Less treasury shares: 2004 - 556,924,323 shares;
2003 - 558,666,318 shares, at cost 5,439 5,442
--------------- --------
Total shareholders' equity 8,248 7,337
--------------- --------
Total liabilities and shareholders' equity $ 15,103 $ 15,102
=============== ========
See notes to condensed consolidated financial statements.
3
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
STATEMENTS OF CONDENSED CONSOLIDATED CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30,
(UNAUDITED)
(Amounts in millions)
2004 2003
------- -------
Operating Activities:
Net (loss)/income $ (112) $ 90
Adjustments to reconcile net (loss)/income to net cash
provided by operating activities:
Tax refund from loss carryback 404 -
Tax matters (473) -
Special charges (124) 370
Depreciation and amortization 325 297
Changes in assets and liabilities:
Accounts receivable (36) 594
Inventories 103 (207)
Prepaid expenses and other assets 17 27
Accounts payable and other liabilities (95) (796)
------- -------
Net cash provided by operating activities 9 375
------- -------
Investing Activities:
Capital expenditures (299) (462)
Proceeds from transfer of license 118 35
Purchases of investments (294) (212)
Other, net (3) 5
------- -------
Net cash used for investing activities (478) (634)
------- -------
Financing Activities:
Cash dividends paid to common shareholders (243) (750)
Net change in short-term borrowings (173) 1,136
Proceeds from preferred stock issuance, net 1,394 -
Other, net (42) 10
------- -------
Net cash provided by financing activities 936 396
------- -------
Effect of exchange rates on cash and
cash equivalents - 1
------- -------
Net increase in cash and
cash equivalents 467 138
Cash and cash equivalents, beginning
of period 4,218 3,521
------- -------
Cash and cash equivalents, end of period $ 4,685 $ 3,659
======= =======
See notes to condensed consolidated financial statements.
4
SCHERING-PLOUGH CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Basis of Presentation
These unaudited condensed consolidated 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. These 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 and financial position for the
interim periods presented.
Revenue Recognition
The Company's pharmaceutical products are sold to direct purchasers (e.g.,
wholesalers, retailers and certain health maintenance organizations). Price
discounts and rebates on such sales are paid to federal and state agencies as
well as to indirect purchasers and other market participants (e.g., managed care
organizations that indemnify beneficiaries of health plans for their
pharmaceutical costs and pharmacy benefit managers).
The Company recognizes revenue when title and risk of loss passes to the
purchaser and when reliable estimates of the following can be determined:
i. commercial discount and rebate arrangements;
ii. rebate obligations under certain Federal and state governmental
programs and;
iii. sales returns in the normal course of business.
When recognizing revenue the Company estimates and records the applicable
commercial and governmental discounts and rebates as well as sales returns that
have been or are expected to be granted or made for products sold during the
period. These amounts are deducted from sales for that period. Estimates
recorded in prior periods are re-evaluated as part of this process. If reliable
estimates of these items can not be made, the Company defers the recognition of
revenue.
Special Charges
Special charges for the three months ended September 30, 2004 totaled $26
million, primarily relating to employee termination costs. Special charges for
the nine months ended September 30, 2004 totaled $138 million, comprised of $111
million in employee termination costs and $27 million in asset impairment
charges. For the nine month period ended September 30, 2003, special charges
totaled $370 million, comprised of $20 million of asset impairment charges and
$350 million in increased litigation reserves.
5
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 are being recognized as a special
charge over the employees' remaining service periods. This delayed expense
recognition follows the guidance in Statement of Financial Accounting Standards
(SFAS) No. 146, "Accounting for Costs Associated with Exit or Disposal
Activities." Amounts recognized, relating to this program, during the three and
nine months ended September 30, 2004 were $2 million and $19 million,
respectively, with cumulative costs recognized of $183 million through
September 30, 2004. Amounts expected to be recognized during the remainder of
2004 and 2005 are $1 million and $7 million, respectively.
In addition to the Voluntary Early Retirement Program in the United States, the
Company recognized $23 million and $92 million, respectively, of other employee
severance costs for the three and nine months ended September 30, 2004.
Asset Impairment Charges
Asset impairment charges have been recognized in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets." For the nine
months ended September 30, 2004, the Company recognized asset impairment
charges of $27 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 nine month period ended September
30, 2003, the Company recognized asset impairment charges of $20 million
related to manufacturing facility assets.
Litigation Charges
During the three and nine months ended September 30, 2003, the Company
recognized $350 million of litigation charges primarily as a result of the
investigations into the Company's sales and marketing practices (see "Legal,
Environmental and Regulatory Matters" footnote for additional information).
6
Summary of Selected Special Charges
The following summarizes the activity in the accounts related to employee
termination costs and asset impairment charges ($ in millions):
Employee Asset
Termination Impairment
Costs Charges
----------- ----------
Special charges accrual balance at December 31, 2003 $ 29 $ -
Special charges incurred during nine months ended
September 30, 2004 111 27
Write-offs - (27)
Credit to retirement benefit plan liability (19) -
Cash disbursements (78) -
----- ------
Special charges accrual balance at September 30, 2004 $ 43 $ -
===== ======
The balance at September 30, 2004 for employee termination costs represents the
value of stock grants ($22 million) not yet distributed and severance payments
remaining to be paid ($21 million) as of September 30, 2004.
Strategic Agreement
In September 2004, the Company announced that it entered into a strategic
agreement with Bayer Pharmaceuticals Corporation ("Bayer") intended to enhance
the companies' pharmaceutical resources.
Commencing in October 2004, in the United States and Puerto Rico, the Company
will market, sell and distribute Bayer's primary care products including Avelox
(moxifloxacin HCl) and Cipro (ciprofloxacin HCl) under an exclusive license
agreement. The Company will pay Bayer substantial royalties on these products
based on sales.
Also commencing in October 2004, the Company will assume Bayer's
responsibilities for U.S. commercialization activities related to the erectile
dysfunction medicine Levitra (vardenafil HCl) under Bayer's co-promotion
agreement with GlaxoSmithKline PLC. The Company will report its share of
Levitra's results as alliance revenue.
Additionally, under the terms of the agreement, Bayer will support the promotion
of certain of the Company's oncology products in the United States and key
European markets for a defined period of time.
In Japan, upon regulatory approval, Bayer will co-market the Company's
cholesterol absorption inhibitor ZETIA (ezetimibe). This arrangement does not
include the rights to any future cholesterol combination product.
This agreement with Bayer potentially restricts the Company from marketing
products in the United States that would compete with any of the products under
the strategic alliance. As a result, the Company expects that it may need to
sublicense rights to garenoxacin, the quinolone antibacterial agent that the
Company licensed from Toyama Chemical Co. Ltd. ("Toyama"). The Company is
exploring its options with regard to garenoxacin and
7
will continue to fulfill its commitments to Toyama under its arrangement,
including taking the product through regulatory approval. The Toyama arrangement
is discussed in further detail in the "Product License" footnote below.
Product License
On June 21, 2004, the Company entered into a collaboration and license agreement
with 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 in the second quarter of 2004 for an up-front fee of $80
million to Toyama. This amount has been expensed and reported in "Research and
development" for the nine months ended September 30, 2004 in the Statements of
Condensed Consolidated Operations.
Inventories
Inventories consisted of ($ in millions):
September 30, December 31,
2004 2003
------------- ------------
Finished products $ 551 $ 664
Goods in process 659 648
Raw materials and supplies 306 339
------ ------
Total inventories $1,516 $1,651
====== ======
Other Intangible Assets
The components of the balance sheet caption "Other intangible assets, net" are
as follows ($ in millions):
September 30, 2004 December 31, 2003
---------------------------------- ----------------------------------
Gross Gross
Carrying Accumulated Carrying Accumulated
Amount Amortization Net Amount Amortization Net
-------- ------------ --- -------- ------------ ---
Patents and
licenses $418 $277 $141 $614 $318 $296
Trademarks and
other 143 43 100 143 38 105
---- ---- ---- ---- ---- ----
Total other
intangible
assets $561 $320 $241 $757 $356 $401
==== ==== ==== ==== ==== ====
These intangible assets are amortized on the straight-line method over their
respective useful lives. In the nine months ended September 30, 2004, the
Company did not make any payments that were capitalized for patent and licensing
rights. For the three months ended September 30, 2004 the net carrying amount of
patents and
8
licenses was reduced by approximately $118 million as a result of Bristol-Myers
Squibb's reacquisition of co- promotion rights of TEQUIN in the U.S. In the nine
months ended September 30, 2003, the Company paid $11 million for patent and
licensing rights. These amounts are being amortized over approximately 9 years.
The residual value of intangible assets is estimated to be zero. Amortization
expense related to other intangible assets for the nine months ended September
30, 2004 and 2003 was $30 million and $41 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 $40 million per
year based on the intangible assets recorded as of September 30, 2004.
Accounting for Stock-Based Compensation
The following table reconciles net income/(loss) and earnings/(loss) per common
share (EPS), as reported, for the three and nine months ended September 30, 2004
and 2003 to pro forma net income/(loss) and EPS, as if the Company had expensed
the grant date fair value of both stock options and deferred stock units as
permitted by SFAS No. 123, "Accounting for Stock-Based Compensation." These pro
forma amounts may not be representative of the initial impact of adopting SFAS
No. 123 since, as amended, it permits alternative methods of adoption.
($ in millions, except per share figures):
Three months Nine months
ended ended
-------------------------- -------------------------
Sept 30, Sept 30, Sept 30, Sept 30,
2004 2003 2004 2003
------- -------- -------- -------
Net income/(loss), as reported $ 26 $ (265) $ (112) $ 90
Add back: Expense included in reported net
income/(loss) for deferred stock units, net of tax 8 14 28 38
Deduct: Pro forma expense as if both stock options and
deferred stock units were charged against net
income/(loss), net of tax (24) (33) (77) (95)
------ ------- ------- ------
Pro forma net income/(loss) using the fair value method $ 10 $ (284) $ (161) $ 33
====== ======= ======= ======
Diluted earnings/(loss) per common share:
Diluted earnings/(loss) per common share, as reported $ .01 $ (.18) $ (.08) $ .06
Pro forma diluted earnings/(loss) per common share using the fair
value method .00 (.19) (.12) .02
Basic earnings/(loss) per common share:
Basic earnings/(loss) per common share, as reported $ .01 $ (.18) $ (.08) $ .06
Pro forma basic earnings/(loss) per common share using the fair
value method .00 (.19) (.12) .02
Basic and diluted earnings/(loss) per common share are calculated based on net
income/(loss) available to common shareholders.
9
Other expense (income), net
The components of other expense (income), net are as follows ($ in millions):
Three Months Nine Months
Ended Ended
September 30, September 30,
2004 2003 2004 2003
---- ---- ----- ----
Interest cost incurred $ 44 $ 26 $ 144 $ 56
Less: amount capitalized on construction (5) (2) (14) (7)
---- ---- ----- ----
Interest expense 39 24 130 49
Interest income (20) (9) (50) (37)
Foreign exchange (gains) losses - (1) 5 1
Other, net 15 27 27 36
---- ---- ----- ----
Total $ 34 $ 41 $ 112 $ 49
==== ==== ===== ====
Cash paid for interest, net of amounts capitalized, was $85 million for the nine
months ended September 30, 2004. Cash paid for interest, net of amounts
capitalized, was $27 million for the nine months ended September 30, 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 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 $15,000 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 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
10
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 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.
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.
11
Equity Income from Cholesterol Joint Venture
The Company and 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 with
Merck exists (see "Strategic Agreement" footnote above for information regarding
the Company's agreement with Bayer to co-market ZETIA in Japan). 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 agreements provide 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, general and administrative costs, that are
not reflected in "Equity (income) from cholesterol joint venture" and are borne
by the overall cost structure of the Company. The agreements do not provide for
any jointly owned facilities and, as 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.
The Company utilizes the equity method of accounting for the cholesterol joint
venture. Under that method, the Company records its share of the operating
profits less its share of the research and development costs in "Equity (income)
from cholesterol joint venture" in the Statements of Condensed Consolidated
Operations.
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) from cholesterol
joint venture" represents the contribution 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" totaled $95 million for the
three months ended September 30, 2004. "Equity (income) from cholesterol joint
venture" totaled $249 million for the nine months ended September 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
12
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.
As discussed above, the Company accounts for the Merck/Schering-Plough
Cholesterol Partnership under the equity method of accounting. As such the
Company's net sales do not include the sales of this joint venture. The joint
venture launched VYTORIN in the U.S. market during the third quarter of 2004. In
order to ensure immediate product availability at the pharmacy level, purchasers
were offered limited, one-time distribution allowances, as well as, extended
payment terms on their first orders. Substantially all of the approximately $42
million of VYTORIN net sales made by the joint venture in the third quarter were
made under these initial terms. Subsequent sales of product were made under
customary terms, which do not have such allowances or extended payment terms.
The level of trade inventories for VYTORIN in the U.S. distribution channel is
expected to be at normal levels by year-end 2004.
Revenue from the sales of VYTORIN is recognized by the joint venture when title
and risk of loss has passed to the customer. To date, management of the joint
venture has been able to make reliable estimates of product returns, rebates and
other discounts for VYTORIN by using the historical experiences of comparable
product launches in the U.S. marketplace.
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%
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" and,
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
13
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 or (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 September 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 registered for issuance up to $2 billion in
various debt and equity securities. Subsequently, the Company issued $1.438
billion face amount of mandatory convertible preferred stock on August 10, 2004
under the shelf. As of September 30, 2004, $563 million principal amount of
securities remain registered and unissued. See below for additional information
on the preferred stock issuance.
Mandatory Convertible Preferred Stock
On August 10, 2004, the Company issued 28,750,000 shares of 6% mandatory
convertible preferred stock with a face value of $1.438 billion. Net proceeds to
the Company were $1.39 billion after deducting commissions, discounts and other
underwriting expenses. The proceeds are being used for general corporate
purposes, including the reduction of commercial paper borrowings.
The mandatory conversion date of the shares is September 14, 2007. On this date,
each share will automatically convert into between 2.2451 and 2.7840 common
shares of the Company depending on the average closing price of the Company's
common shares over a period immediately preceding the mandatory conversion date,
as defined in the prospectus. The preferred shareholders may elect to convert at
anytime prior to September 14, 2007 at the minimum conversion ratio of 2.2451
common shares per share of the preferred stock. Additionally, if at anytime
prior to the mandatory conversion date, the closing price of the Company's
common shares exceeds $33.41 (for at least 20 trading days within a period of 30
consecutive trading days) the Company may elect to cause the conversion of all,
but not less than all, of the preferred shares then outstanding at the same
minimum conversion ratio of 2.2451 common shares for each preferred share.
The preferred stock accrues dividends at an annual rate of 6% on shares
outstanding. The dividends are cumulative from the date of issuance and, to the
extent the Company is legally permitted to pay dividends and the Board of
Directors declares a dividend payable, the Company will pay dividends on each
dividend payment
14
date. The dividend payment dates are March 15, June 15, September 15 and
December 15, with the first dividend to be paid on December 15, 2004, if so
declared by the Board of Directors. A dividend was declared by the Board of
Directors on September 28, 2004, payable on December 15, 2004.
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.
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 September 30,
2004, $563 million remains registered and unissued under the shelf registration.
On April 29, 2004, Moody's placed the Company's senior unsecured credit rating
of "A3" 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 "A3" 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 "F-2" from "F-1." 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. On
August 4, 2004, Fitch affirmed the Company's "A-" senior unsecured and bank loan
rating and the "F-2" commercial paper rating, and reiterated the negative
outlook.
Comprehensive Income (Loss)
Total comprehensive income (loss) for the three months ended September 30, 2004
and 2003 was $45 million and $(267) million, respectively. Total comprehensive
income (loss) for the nine months ended September 30, 2004 and 2003 was $(155)
million and $206 million, respectively.
15
Earnings Per Common Share
The following table reconciles the components of the basic and diluted EPS
computations (amounts in millions):
Three Months Nine Months
Ended Ended
September 30, September 30,
EPS Numerator: 2004 2003 2004 2003
----- ------- ------ ------
Net income/(loss) $ 26 $ (265) $ (112) $ 90
Less: Preferred stock dividends 12 - 12 -
----- ------- ------ ------
Net income/(loss) available to common shareholders $ 14 $ (265) $ (124) $ 90
----- ------- ------ ------
EPS Denominator:
Average shares outstanding 1,472 1,469 1,472 1,469
for basic EPS
Dilutive effect of options
and deferred stock units 3 - - 1
----- ------- ------ ------
Average shares outstanding
for diluted EPS 1,475 1,469 1,472 1,470
----- ------- ------ ------
For the nine months ended September 30, 2004, the equivalent of 88 million
common shares issuable under the Company's stock incentive plans were excluded
from the computation of diluted EPS because their effect would have been
antidilutive. Also, 42 million of common shares obtainable upon conversion of
the Company's mandatory convertible preferred stock were excluded from the
computation of diluted EPS because their effect would have been antidilutive.
See "Mandatory Convertible Preferred Stock" footnote above for additional
information.
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 Nine months ended
September 30, September 30,
------------------ ---------------
2004 2003 2004 2003
----- ----- ----- -----
Service cost $ 25 $ 24 $ 74 $ 69
Interest cost 33 29 99 85
Expected return on plan assets (37) (40) (113) (117)
Amortization, net 9 - 25 -
Termination benefits (1) 1 - 12 -
Settlement (1) 1 - 5 -
----- ----- ----- -----
Net pension expense $ 32 $ 13 $ 102 $ 37
===== ===== ===== =====
16
The components of other post-retirement benefits expense were as follows ($ in
millions):
Three months ended Nine months ended
September 30, September 30,
-------------------- --------------------
2004 2003 2004 2003
-------- -------- ------- --------
Service cost $ 1 $ 2 $ 8 $ 7
Interest cost 2 4 15 12
Expected return on plan assets (1) (4) (9) (12)
Amortization, net - - 2 -
Termination benefits (1) - - 2 -
-------- -------- -------- --------
Net other post-retirement benefits
expense $ 2 $ 2 $ 18 $ 7
======== ======== ======== ========
(1) Termination benefits and Settlement costs primarily relate to the
matters discussed in the "Special Charges" footnote.
In accordance with FASB Staff Position No. 106-2, "Accounting and Disclosure
Requirements Related to the Medicare Prescription Drug, Improvement and
Modernization Act of 2003" (the "Medicare Act"), the Company began accounting
for the effect of the federal subsidy under the Medicare Act in the third
quarter of 2004. As a result, the Company's accumulated benefit obligation for
other post-retirement benefits was reduced by $51 million, and the Company's net
other post-retirement benefits expense was reduced by $5 million for the nine
months ended September 30, 2004. The reduction in the other post-retirement
benefits expense consists of reductions in service cost, interest cost and net
amortization of $1 million, $2 million and $2 million, respectively.
Segment Data ($ 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 Nine months ended
September 30, September 30,
--------------------------- ---------------------------
2004 2003 2004 2003
------------ ------------ ------------ ------------
Prescription Pharmaceuticals $ 1,556 $ 1,585 $ 4,681 $ 5,101
Consumer Health Care 239 243 868 802
Animal Health 183 170 539 483
------------ ------------ ------------ ------------
Consolidated net sales $ 1,978 $ 1,998 $ 6,088 $ 6,386
============ ============ ============ ============
17
Profit by segment:
Three months ended Nine months ended
September 30, September 30,
-------------------- --------------------
2004 2003 2004 2003
-------- -------- -------- --------
Prescription Pharmaceuticals $ 83 $ 80 $ 43 $ 496
Consumer Health
Care 35 48 180 156
Animal Health 20 19 41 56
Corporate and other (1) (106) (423) (404) (541)
-------- -------- -------- --------
Consolidated profit/(loss)
before tax $ 32 $ (276) $ (140) $ 167
======== ======== ======== ========
(1) For the three and nine months ended September 30, 2004, Corporate and other
included special charges of $26 million and $138 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 September 30, 2004
relate to the reportable segments as follows: Prescription Pharmaceuticals - $23
million, Consumer Health Care - $1 million and Corporate and other - $2 million.
Special charges for the nine months ended September 30, 2004 relate to the
reportable segments as follows: Prescription Pharmaceuticals - $119 million,
Consumer Health Care - $3 million, Animal Health - $2 million and Corporate and
other - $14 million.
For the three and nine months ended September 30, 2003, Corporate and other
included special charges of $350 million and $370 million, respectively, related
to increased litigation reserves of $350 million and asset impairment charges of
$20 million (see "Special Charges" footnote for additional information).
Corporate and other also includes interest income and expense, foreign exchange
gains and losses, headquarters expenses and other miscellaneous items. The
accounting policies used for segment reporting are the same as those described
in the "Summary of Significant Accounting Policies" in the Company's 2003 Annual
Report.
Sales of products comprising 10% or more of the Company's U.S. or international
sales in the nine months ended September 30, 2004 were as follows ($ in
millions):
U.S. International
---- -------------
CLARINEX $ 313 $ 218
NASONEX 271 178
OTC CLARITIN 344 -
REMICADE - 535
The Company does not disaggregate assets on a segment basis for internal
management reporting and, therefore, such information is not presented.
18
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 September 30, 2004, and the
related expenses incurred during the nine months ended September 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.
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. For the nine months ended September 30, 2004, net sales
of this product totaled approximately $16 million.
United Kingdom Patent Infringement Action. On August 6, 2004, the Company
brought a patent infringement action in the United Kingdom against Cipla Ltd.
and Neolabs Ltd. following the defendants advising of their intent to pursue
marketing of desloratadine in the United Kingdom. In 2003, the Company's sales
of desloratadine in the United Kingdom were approximately $24.2 million.
19
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, has pleaded 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 was paid in the third quarter of 2004. The
remaining portion will be paid by March 4, 2005. Interest accrues on the unpaid
balance at the rate of 4 percent.
The payments have been and will be funded by cash from operations, borrowings
and 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 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 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.
20
Massachusetts Investigation. The U.S. Attorney's Office for the District of
Massachusetts is 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 relating to dealings with 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
Pharmaceuticals ("Warrick"), the Company's generic subsidiary. The Company has
received other subpoenas and informal document requests in this investigation.
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 Generally Accepted Accounting Principles ("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 September 30, 2004
continue to reflect a minimum liability for the Massachusetts investigation. As
noted above, the Pennsylvania investigation has been settled, and therefore,
the remaining reserves reflect the agreed upon settlement amounts yet to be
paid. 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
21
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 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.
22
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, the Company's generic subsidiary. The U.S. Attorney's
investigation and the FTC proceeding are described herein. The Texas litigation
is described in previously filed Reports on Form 10-K and 10-Q. 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 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 deny class certification in New Jersey, the only
remaining statewide class action suit involving the Company, was granted on
September 30, 2004. Approximately 96 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
23
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. On September
20, 2004, this case was dismissed by the Court upon consent of the parties.
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 alleged
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 Abbreviated New Drug
Applications (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 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. On
September 30, 2004, the federal court overseeing many of these cases denied the
Company's motion to dismiss. Discovery is ongoing.
Pricing Matters
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 Pharmaceuticals, the Company's generic subsidiary, 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 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
24
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 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.
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. The case was remanded to state
court. The Company has filed a motion to dismiss.
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.
The New Jersey Department of Environmental Protection sent the Company 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.
On September 24, 2004, the Company, along with approximately 80 other parties,
were named as third-party defendants in a complaint, alleging that it (and other
parties) generated waste that was sent to the Burlington Environmental
Management Services, Inc. Landfill ("BEMS Site"), located in Southampton
Township, Burlington County, New Jersey. The complaint also indicates that the
Company and the other 80 parties are
25
liable for costs expended to clean up the BEMS Site under New Jersey's Spill
Compensation and Control Act (New Jersey's "Superfund" statute). The Company is
currently investigating the allegations.
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, 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. In
April of 2004, the Company received a formal Notice of Deficiency (Statutory
Notice) from the IRS asserting additional federal income tax due. The Company
received bills related to this matter from the IRS on September 7, 2004. Payment
in the amount of $194 million for income tax and $279 million for interest was
made on September 13, 2004. The Company believes it has complied with all
applicable rules and regulations and intends to file a suit for refund for the
full amount of the tax and interest. The Company's tax reserves were adequate to
cover the above-mentioned payments.
26
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and Board of Directors of
Schering-Plough Corporation:
We have reviewed the accompanying condensed consolidated balance sheet of
Schering-Plough Corporation and subsidiaries (the "Corporation") as of September
30, 2004, and the related statements of condensed consolidated operations for
the three-month and nine-month periods ended September 30, 2004 and 2003, and
the statements of condensed consolidated cash flows for the nine-month periods
ended September 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 condensed 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 condensed 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
October 27, 2004
27
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 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 marketing and research efforts at historical
levels.
Throughout this period of time, the Company has held to its core strategy and
continued to invest in sales and marketing and scientific research at historical
levels. However, this level of investment is not sustainable without a
significant increase in cash flow from operations. 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 that will
have a positive material impact on operating cash flows.
28
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 and commercial launch 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.
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 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 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
29
million was previously paid in 2003 as additional Medicaid rebates
against the damages amount, leaving net payments of $291.9 million.
During the third quarter of 2004, $177.5 million was paid related to
this settlement. 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. Prior to 2003, 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.
- Market shares and sales levels for PEG-INTRON (pegylated interferon)
and REBETOL (ribavirin) have fallen significantly, in a market that
continues to contract. 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. As a result of the introduction of this competitor, earnings
and cash flow from PEG-INTRON have been and may continue to be
materially and negatively impacted. In addition, generic forms of
REBETOL have been approved in the important U.S. market, also
resulting in a material and negative impact on earnings and cash
flow.
- 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. During the third quarter of 2004,
market share trends of certain products have begun to show early signs of
sequential stabilization. However, overall markets for many of these products
continue to contract. No assurance can be given that such stabilization will
continue. The Company's ability to generate profits is dependent upon growing
sales of existing products, successfully commercializing VYTORIN and controlling
expenses. Through the first nine months of 2004, the Company has incurred a net
loss of $112 million, which included pre-tax special charges of $138 million and
pre-tax research and development charges of $80 million for product licensing
fees related to the agreement with Toyama Chemical Co. Ltd. ("Toyama").
Management cannot give assurance that operations will generate profits in the
near term, especially if VYTORIN is not a commercial success.
30
Net Sales
Consolidated net sales for the third quarter totaled $2.0 billion, a decrease of
$20 million or 1 percent compared with the same period in 2003. Consolidated net
sales for the third quarter reflected a volume decline of 4 percent and a
favorable foreign exchange rate impact of 3 percent. For the nine months,
consolidated net sales decreased $298 million or 5 percent versus 2003.
Consolidated net sales for the first nine months reflected a volume decline of 9
percent and a favorable foreign exchange rate impact of 4 percent. Net sales in
the United States decreased 4 percent versus the third quarter of 2003 and 17
percent for the nine-month period. International sales advanced 1 percent for
the third quarter and 5 percent year-to-date compared with the same periods in
2003. International sales included a favorable foreign exchange rate impact of 5
percent for the quarter and 8 percent for the first nine months.
The Company accounts for the Merck/Schering-Plough cholesterol joint venture
under the equity method of accounting. As such, the Company's net sales do not
include the sales of this joint venture.
Net sales for the third quarter and nine months ended September 30, were as
follows:
(Dollars in millions)
Third Quarter Nine Months
------------- -----------
2004 2003 % 2004 2003 %
---- ---- - ---- ---- -
GLOBAL PHARMACEUTICALS $1,556 $ 1,585 (2) $4,681 $ 5,101 (8)
Remicade 188 142 33 535 382 40
Clarinex / Aerius 175 169 3 530 561 (6)
Nasonex 153 114 34 449 368 22
PEG-Intron 132 172 (23) 425 641 (34)
Temodar 121 90 35 309 237 31
Integrilin 94 79 18 245 260 (6)
Intron A 81 103 (21) 239 302 (21)
Claritin Rx * 67 68 (1) 240 247 (3)
Rebetol 52 125 (58) 239 540 (56)
Subutex 45 37 22 136 103 32
Elocon 42 41 2 127 121 5
Caelyx 39 30 32 109 78 39
CONSUMER HEALTH CARE 239 243 (1) 868 802 8
OTC 150 149 1 456 441 3
OTC Claritin 110 111 (1) 344 336 2
Foot Care 86 80 9 252 224 12
Sun Care 3 14 (79) 160 137 17
ANIMAL HEALTH 183 170 8 539 483 12
------ ------- ---- ------ ------- ----
CONSOLIDATED NET SALES $1,978 $ 1,998 (1) $6,088 $ 6,386 (5)
------ ------- ---- ------ ------- ----
* 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 $175 million in the third quarter of 2004, an increase of 3
percent versus the third quarter of 2003. Sales outside the U.S. climbed 39
percent to $57 million in the third quarter due to market share gains and
continued conversion from prescription CLARITIN. U.S.
31
sales decreased 8 percent to $118 million in the third quarter 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 6 percent to $530 million for the nine-month period.
International net sales of REMICADE, for the treatment of rheumatoid arthritis,
Crohn's disease and ankylosing spondylitis, were up $46 million or 33 percent to
$188 million in the third quarter and were up $153 million or 40 percent to $535
million for the first nine months. The increase was primarily due to greater
medical use and expanded indications in European markets.
Global net sales of NASONEX Nasal Spray, a once-daily corticosteroid nasal spray
for allergies, rose 34 percent to $153 million in the third quarter primarily
due to favorable trade inventory comparisons in the U.S. Global net sales
increased 22 percent to $449 million for the first nine months primarily due to
favorable trade inventory comparisons in the U.S. coupled with international
sales growth, tempered by a decline in U.S. market share. International sales of
NASONEX grew 23 percent to $48 million for the quarter and 23 percent to $178
million for the nine-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 23 percent to $132 million in the
third quarter and decreased 34 percent to $425 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 35 percent to $121 million for the third quarter and increased
31 percent to $309 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 21 percent to $81 million for
the third quarter and 21 percent to $239 million year-to-date due primarily to
lower demand.
In the third quarter and first nine months of 2004, global net sales of REBETOL
Capsules for use in combination with INTRON or PEG-INTRON for treating hepatitis
C, decreased 58 percent to $52 million and 56 percent to $239 million,
respectively, due to ongoing competition including the launch of generic
versions of REBETOL in the United States in April 2004 and increased price
competition outside the U.S.
International net sales of prescription CLARITIN decreased 1 percent to $67
million in the third quarter and decreased 3 percent to $240 million for the
nine month period of 2004 due to the continued conversion to CLARINEX.
Global net sales of INTEGRILIN Injection, a glycoprotein platelet aggregation
inhibitor for the treatment of patients with acute coronary syndromes which is
sold primarily in the U.S., increased 18 percent to $94 million for the third
quarter due to increased patient utilization coupled with favorable U.S. trade
inventory comparisons. Global net sales decreased 6 percent to $245 million for
the first nine months of 2004 due to unfavorable changes in U.S. trade inventory
levels.
Millennium Pharmaceuticals, Inc. ("Millennium") and the Company have a co-
promotion agreement for INTEGRILIN. Millennium notified the Company that it
intends to exercise its right under the agreement to assume responsibilities for
consumer service, managed care contracting, government reporting and physical
distribution of INTEGRILIN. As a result, as early as the fourth quarter of 2005,
the Company expects to cease recording sales of INTEGRILIN and would begin to
record its share of the co-promotion profits as alliance revenue. This change in
reporting would have no impact on earnings.
32
International sales of SUBUTEX, for the treatment of opiate addiction, increased
22 percent to $45 million in the third quarter and 32 percent to $136 million
for the nine-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 32 percent to $39
million for the third quarter and 39 percent to $109 million for the first nine
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 third quarter and first nine
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
$52 million in the third quarter of 2003 and $130 million for the first nine
months of 2003.
Net sales of consumer health care products, which include OTC, foot care and sun
care products, decreased $4 million or 1 percent in the third quarter. Sales of
OTC CLARITIN for the third quarter of 2004 were $110 million, down 1 percent
from $111 million in 2003. The decrease in sales was due to competition from
branded and private label loratadine. For the year-to-date period of 2004, net
sales of consumer health care products increased $66 million or 8 percent. Sales
of foot care products increased 9 percent to $86 million in the third quarter
and 12 percent to $252 million year-to-date due primarily to the successful
launch of FREEZE AWAY, a wart-remover product. Net sales of sun care products
increased $23 million or 17 percent year-to-date due to the timing of orders and
shipments coupled with favorable weather conditions.
Global net sales of animal health products increased 8 percent in the third
quarter of 2004 to $183 million and 12 percent to $539 million for the
nine-month period. Sales were favorably impacted by foreign exchange of 4
percent and 7 percent for the quarter and nine-month period, respectively.
Costs and Expenses
Cost of sales as a percentage of net sales increased to 35.9 and 36.8 percent
for the third quarter and first nine months of 2004, respectively, versus 32.6
and 32.8 percent in the third quarter and nine-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. The absence of European LOSEC revenues in both the third
quarter and nine months of 2004 contributed to the unfavorable comparison as
well.
Selling, general and administrative expenses increased $19 million or 2 percent
to $892 million for the third quarter and increased $132 million or 5 percent to
$2.8 billion for the first nine months of 2004. The increase was primarily due
to higher sales force costs associated with the previously reported field force
expansion coupled with the unfavorable impact of foreign exchange, tempered by
lower promotional spending. The third quarter and year-to-date ratios to net
sales of 45.1 and 45.7 percent, respectively, are higher than the 43.7 and 41.5
percent ratios in the respective prior year periods, primarily due to these
increased costs coupled with the lower overall sales reported in the 2004
periods.
33
Research and development spending decreased 1 percent to $378 million in the
third quarter and increased 12 percent to $1.2 billion year-to-date,
representing 19.1 and 19.7 percent of net sales, respectively. The decrease in
research and development spending for the third quarter is primarily due to the
timing of spending on research programs. Research and development spending for
the nine-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.
Other expense (income), net for the third quarter of 2004 decreased versus the
third quarter of 2003 due primarily to provisions for asset write-offs in the
prior year, offset by higher net interest expense. Other expense (income), net
for the first nine months of 2004 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.
Partially offsetting the higher interest expense is an increase in interest
income due to higher investment balances as well as the interest income from the
investment of the proceeds from the August 2004 issuance of the mandatory
convertible preferred shares.
Special Charges
Special charges for the three months ended September 30, 2004 totaled $26
million, primarily relating to employee termination costs. Special charges for
the nine months ended September 30, 2004 were comprised of $111 million of
employee termination costs and $27 million of asset impairment charges. For the
nine month period ended September 30, 2003 special charges totaled $370 million,
comprised of $350 million to increase litigation reserves and $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 third quarter and first
nine months of 2004 were $2 million and $19 million, respectively, with
cumulative costs of $183 million recognized through September 30, 2004. Amounts
expected to be recognized during the remainder of 2004 and 2005 are $1 million
and $7 million, respectively.
In addition to the VERP, the Company recognized $23 million and $92 million of
other employee severance costs in the third quarter and nine-month period of
2004, respectively, primarily outside the United States.
Asset Impairment Charges
The Company recognized $27 million of asset impairment charges in the first nine
months of 2004, primarily 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 nine months of 2003 related to manufacturing
facility assets.
34
Litigation Charges
During the three and nine months ended September 30, 2003, the Company
recognized $350 million of litigation charges, primarily as a result of the
investigations into the Company's sales and marketing practices (see "Legal,
Environmental and Regulatory Matters" footnote for additional information).
Equity Income from Cholesterol Joint Venture
Global cholesterol franchise sales, which include ZETIA and VYTORIN, totaled
$344 million in the 2004 third quarter and $780 million year-to-date compared
with sales of $137 million and $306 million in the third quarter and first nine
months of 2003, respectively. VYTORIN has now been approved in 11 countries and
has completed the European Mutual Recognition Process (MRP) as of October 1,
2004. ZETIA has been approved in 71 countries. In the United States, more than
12 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) 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) from
cholesterol joint venture" represents the contribution 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 $95 million in the third quarter of 2004 versus $24 million in the third
quarter of 2003. For 2004 year-to-date, equity income from cholesterol joint
venture totaled $249 million including a $7 million milestone earned as a result
of the approval in Mexico of the ezetimibe/simvastatin product, versus $21
million for the first nine months of 2003.
Net income/(loss)
Net income/(loss) was income of $26 million for the 2004 third quarter versus a
loss of ($265) million in 2003. Net income in the third quarter of 2004 includes
pre-tax special charges of $26 million, as described above. Net loss in the
third quarter of 2003 includes a non-tax deductible special charge of $350
million, as described above.
Net income/(loss) was a loss of ($112) million for the first nine months of 2004
versus income of $90 million in 2003. Net loss for year-to-date 2004 includes a
pre-tax research and development charge of $80 million for the license of
garenoxacin from Toyama Chemical Company Ltd. as well as pre-tax special charges
of $138 million, as described above. Net income for the first nine months of
2003 includes special charges of $370 million, as described above.
Effective Tax Rate
The effective tax rate was 20.0 percent in the third quarter and first nine
months of 2004. The effective tax rate was 15.0 percent for the first nine
months of 2003 excluding the $350 million non-tax deductible special charge in
2003 to increase litigation reserves.
35
Liquidity and Financial Resources - nine months ended September 30, 2004
Background
The following background information presents the current state of the Company's
liquidity and financial resources.
At September 30, 2004, the majority of 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
September 30, 2004 by $2.3 billion. However, as discussed above, the majority of
cash is held by foreign-based subsidiaries, and the U.S. operations have cash
needs and carry substantially all the debt. Generally, using the funds held by
the foreign-based subsidiaries for the cash needs of the U.S.-based subsidiaries
results in U.S. income tax payments. The amount of any U.S. income tax payments
would depend upon a number of factors, including the amount of the funds used,
whether the U.S. operations were generating taxable profits or losses and
changes in U.S. tax laws (see discussion of the "American Jobs Creation Act of
2004" below).
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 Company's U.S. 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 additional U.S.
income tax payments. See discussion of the "American Jobs Creation Act of 2004"
below.
36
On October 22, 2004, the President signed the "American Jobs Creation Act of
2004" (the "Act"). A provision of this Act allows companies to repatriate funds
held by foreign-based subsidiaries at a reduced tax rate under certain
circumstances. The Company is currently evaluating the provisions of the Act and
is investigating the repatriation of foreign-based subsidiaries' funds under its
provisions.
In 2005, and possibly beyond, the Company expects to finance a portion of its
U.S. cash needs by accessing the funds held by foreign based subsidiaries. The
Company expects to access these funds either by repatriating some of these
amounts and utilizing some or all of its current U.S. operating losses or by
repatriating funds under the provisions of the Act. If funds were to be
repatriated under the Act, a tax payment would be due, albeit at a reduced rate.
Any such tax payment will be accrued in future periods. Also, repatriation of
funds under the Act will not reduce the Company's operating losses. These losses
can be carried forward to offset future taxable income.
Based on the provisions of the Act, a maximum of $9.2 billion of undistributed
foreign earnings may be eligible for repatriation under the Act. As indicated
above, the Company is considering the details of the Act. If a decision is made
that some or all of the unremitted foreign earnings are no longer considered
permanently reinvested, additional tax will be payable which could be recognized
as early as the fourth quarter of 2004.
Discussion of Cash Flow
Cash provided by operating activities totaled $9 million for the first nine
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, the payment of
$473 million to the U.S. government for a tax deficiency related to certain
transactions entered into in 1991 and 1992 and the payment of $177.5 million
under the settlement agreement with the U.S. Attorney's Office for the Eastern
District of Pennsylvania. The final payment under the settlement agreement is
$114.4 million, plus interest which accrues on the unpaid balance at 4 percent
per year, due by March 4, 2005. (See the "Legal, Environmental and Regulatory
Matters" footnote included in the financial statements to this report.)
For the first nine months of 2004 operating activities provided minimal cash. As
a result, capital expenditures and dividends were funded through the existing
cash balances, borrowings and the mandatory convertible preferred stock
issuance.
As discussed above, this overall net use of cash occurred entirely in the U.S.
operations. Foreign operations generated net cash of approximately $795 million
through the first nine months, but the net use of cash in the U.S. totaled
approximately $1.3 billion during this same period of time. Through the first
nine months of 2004, the cash shortfall in the U.S. was funded with cash that
was available in the U.S. at the beginning of the year, as well as with the
proceeds received from the issuance of $1.438 billion of mandatory convertible
preferred shares, discussed below, and U.S. commercial paper borrowings.
In August 2004, the Company issued 6% mandatory convertible preferred stock (see
"Mandatory Convertible Preferred Stock" footnote included in the financial
statements to this report) and received net proceeds of $1.39 billion after
deducting commissions, discounts and other underwriting expenses. The proceeds
were used to reduce short-term commercial paper borrowings, for the payment of
settlement amounts and litigation costs (as described above), funding of
operating expenses, shareholder dividends and capital expenditures. The
preferred
37
stock was issued under the Company's $2.0 billion shelf registration. As of
September 30, 2004, $563 million remains registered and unissued under the shelf
registration.
For the remainder of 2004 and for 2005, the net use of cash in the U.S.
operations is expected to continue. The Company expects to use commercial paper
borrowings to fund the U.S. operations through the end of 2004. Beginning in
early 2005, however, the Company expects to have to access the funds held by its
foreign-based subsidiaries to fund its U.S. operations. The tax implications of
accessing these funds is discussed above.
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 September 30, 2004, no funds were drawn under
either of these facilities.
At September 30, 2004, short-term borrowings totaled $866 million. Approximately
91 percent of this was outstanding commercial paper. The commercial paper
ratings discussed below have not significantly affected the Company's ability to
issue or rollover 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 rollover
outstanding commercial paper can, at times, be less than that of companies with
higher short-term
38
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.
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 allowed 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 September 30, 2004, $563 million
remains registered and unissued under the shelf registration.
On April 29, 2004, Moody's placed the Company's senior unsecured credit rating
of "A3" 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 "A3" 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 payable 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 "F-2" from
"F-1." 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. On August 4, 2004, Fitch
affirmed the Company's "A-" senior unsecured rating and bank loan rating and the
"F-2" commercial paper rating, and reitereated the negative outlook.
Financial Arrangements Containing Credit Rating Downgrade Triggers
The Company has an interest rate swap arrangement that contains a credit rating
downgrade trigger. This arrangement requires 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
counterparty to the interest rate swap can elect early termination following a
specified period, as described below.
This arrangement utilizes two long-term interest rate swap contracts (each
contract consisting of twenty individual confirmations). One contract is between
a foreign-based subsidiary and a bank, and the other contract is 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
39
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 parties at market rates. Prepayments totaling $1.9 billion
have been made under both contracts as of September 30, 2004 and December 31,
2003. The prepaid amounts have been netted in the preparation of the condensed
consolidated balance sheet in accordance with Financial Accounting Standards
Board (FASB) Interpretation No. 39, "Offsetting of Amounts Related to Certain
Contracts."
The 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. Both S&P's and Moody's current credit
ratings are below the specified minimum. 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. Under the "American
Jobs Creation Act of 2004" previously discussed in this "Liquidity and
Financial Resources" section, 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.
40
The Company had a second, unrelated interest rate swap arrangement that was
terminated earlier in 2004 due to the Company's recent credit rating downgrade.
The impact of the termination 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.
41
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 products of competitors, new
information from clinical trials of marketed products or post-marketing
surveillance 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.
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 and private-label competition was introduced. 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. In October 2004, a third generic ribavirin was
approved by the FDA. The generic forms of ribavirin compete with the Company's
REBETOL (ribavirin) Capsules in the United States. The REBETOL patents are
material to the Company's business. U.S. sales of REBETOL in 2003 were $306
million. For the nine months ended September 30, 2004, U.S. sales of REBETOL
were $54 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.
42
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 severely diminished and earnings and cash
flow have been 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 (INEGY, marketed as VYTORIN in the United
States) completed the MRP in Europe on October 1, 2004. 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.
In September 2004, the Company announced that it entered into an agreement with
Bayer Pharmaceuticals Corporation ("Bayer") intended to enhance the companies'
pharmaceutical resources. The agreement was entered into by the Company
primarily for strategic purposes.
Commencing in October 2004, in the United States and Puerto Rico, the Company
will market, sell and distribute Bayer's primary care products including Avelox
(moxifloxacin HCl) and Cipro (ciprofloxacin HCl) under an exclusive license
agreement. The Company will pay Bayer royalties in excess of 50% on these
products based on sales, which will have an unfavorable impact on the Company's
gross margin percentage. In addition, the Company expects to add 800-900
existing Bayer sales representatives to support these products.
Also commencing in October 2004, the Company will assume Bayer's
responsibilities for U.S. commercialization activities related to the erectile
dysfunction medicine Levitra (vardenafil HCl) under Bayer's co-promotion
agreement with GlaxoSmithKline PLC. The Company will report its share of
Levitra's results as alliance revenue.
Additionally, under the terms of the agreement, Bayer will support the promotion
of certain of the Company's oncology products in the United States and key
European markets for a defined period of time.
In Japan, upon regulatory approval Bayer will co-market the Company's
cholesterol absorption inhibitor ZETIA (ezetimibe). This arrangement does not
include the rights to any future cholesterol combination product. ZETIA was
filed with regulatory authorities in Japan during the fourth quarter of 2003.
This agreement with Bayer potentially restricts the Company from marketing
products in the United States that would compete with any of the products under
the strategic alliance. As a result, the Company expects that it may need to
sublicense rights to garenoxacin, the quinolone antibacterial agent that the
Company licensed from
43
Toyama Chemical Co. Ltd. ("Toyama"). The Company is exploring its options with
regard to garenoxacin and will continue to fulfill its commitments to Toyama
under its arrangement, including taking the product through regulatory approval.
Under the Bayer agreement, there will be a business integration and transition
period during the remainder of 2004. The transaction is expected to be mildly
dilutive in 2004 in terms of its impact on earnings per share.
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.
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
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 $15,000 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.
44
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 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
45
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 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
Revenue Recognition
The Company's pharmaceutical products are sold to direct purchasers (e.g.,
wholesalers, retailers and certain health maintenance organizations). Price
discounts and rebates on such sales are paid to federal and state agencies as
well as to indirect purchasers and other market participants (e.g., managed care
organizations that indemnify beneficiaries of health plans for their
pharmaceutical costs and pharmacy benefit managers).
The Company recognizes revenue when title and risk of loss passes to the
purchaser and when reliable estimates of the following can be determined:
i. commercial discount and rebate arrangements;
ii. rebate obligations under certain Federal and state governmental
programs and;
iii. sales returns in the normal course of business.
When recognizing revenue the Company estimates and records the applicable
commercial and governmental discounts and rebates as well as sales returns that
have been or are expected to be granted or made for products sold during the
period. These amounts are deducted from sales for that period. Estimates
recorded in prior
46
periods are re-evaluated as part of this process. If reliable
estimates of these items can not be made, the Company defers the recognition of
revenue.
Revenue recognition for new products is based on specific facts and
circumstances including estimated acceptance rates from established products
with similar marketing characteristics. Absent the ability to make reliable
estimates of rebates, discounts and returns, the Company would defer revenue
recognition.
Product discounts granted are based on the terms of arrangements with direct,
indirect and other market participants as well as market conditions, including
prices charged by competitors. Rebates are estimated based on sales terms,
historical experience, trend analysis and projected market conditions in the
various markets served. The Company evaluates market conditions for products or
groups of products primarily through the analysis of wholesaler and other third
party sell-through and market research data as well as internally generated
information. Data and information provided by purchasers and obtained from third
parties are subject to inherent limitations as to their accuracy and validity.
Sales returns are generally estimated and recorded based on historical sales and
returns information, analysis of recent wholesale purchase information,
consideration of stocking levels at wholesalers and forecasted demand amounts.
Products that exhibit unusual sales or return patterns due to dating,
competition or other marketing matters are specifically investigated and
analyzed as part of the formulation of accruals.
During 2004, the Company entered into agreements with the major U.S.
pharmaceutical wholesalers. These agreements deal with a number of commercial
issues, such as product returns, timing of payment, processing of chargebacks
and the quantity of inventory held by these wholesalers. With respect to the
quantity of inventory held by these wholesalers, these agreements provide a
financial disincentive for these wholesalers to acquire quantities of product in
excess of what is necessary to meet current patient demand. Through the use of
this monitoring and the above noted agreements, the Company expects to avoid
situations where the Company's shipments of product are not reflective of
current demand.
Rebates, Discounts and Returns
Rebate accruals for Federal and state governmental programs were $131 million at
September 30, 2004 and $127 million at December 31, 2003. Commercial discounts
and other rebate accruals were $144 million at September 30, 2004 and $211
million at December 31, 2003, respectively. These and other rebate accruals are
established in the period the related revenue was recognized resulting in a
reduction to sales and the establishment of a liability, which is included in
other accrued liabilities.
In the case of the governmental rebate programs, the Company's payments involve
interpretations of relevant statutes and regulations. These interpretations are
subject to challenges and changes in interpretive guidance by governmental
authorities. The result of such a challenge or change could affect whether the
estimated governmental rebate amounts are ultimately sufficient to satisfy the
Company's obligations. Additional information on governmental inquiries focused
in part on the calculation of rebates is contained in the "Legal, Environmental
and Regulatory Matters" footnote included in the financial statements to this
report. In addition, it is possible that, as a result of governmental challenges
or changes in interpretive guidance, actual rebates could materially exceed
amounts accrued.
47
The following summarizes the activity in the accounts related to accrued
rebates, sales returns and discounts:
Three Months Nine Months
Ended Ended
September 30, 2004 September 30, 2004
Accrued Rebates / Returns / Discounts, Beginning of Period $ 452 $ 487
----- -----
Provision for Rebates 100 309
Payments (123) (372)
----- -----
(23) (63)
----- -----
Provision for Returns 14 39
Returns (1) (24)
----- -----
13 15
----- -----
Provision for Discounts 21 143
Discounts granted (38) (157)
----- -----
(17) (14)
----- -----
Accrued Rebates / Returns / Discounts, End of Period $ 425 $ 425
===== =====
Management makes estimates and uses assumptions in recording the above accruals.
Actual amounts may differ from these estimates. Adjustments to estimated amounts
during the above periods were not significant.
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 other critical
accounting policies.
48
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, estimates of rebates, discounts
and returns, 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,
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.
49
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 or new information from clinical trials of
marketed products or post-marketing surveillance, 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 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.
50
- - Changes in accounting standards promulgated by the American Institute of
Certified Public Accountants, the Financial Accounting Standards Board,
the SEC, or the Public Company Accounting Oversight Board that would
require a significant change to Schering-Plough's accounting practices.
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.
51
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Legal proceedings involving the Company are described in the 2003 10-K and the
2004 first and second quarter 10-Qs, 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 August 3, 2004 filing date of the 2004 second quarter 10-Q.
Patent Matters. United Kingdom Patent Infringement Action. On August 6, 2004,
the Company brought a patent infringement action in the United Kingdom against
Cipla Ltd. and Neolabs Ltd. following the defendants advising of their intent to
pursue marketing of desloratadine in the United Kingdom. In 2003, the Company's
sales of desloratadine in the United Kingdom were approximately $24.2 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, has pleaded 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 was paid in the third quarter of 2004. The
remaining portion will be paid by March 4, 2005. Interest accrues on the unpaid
balance at the rate of 4 percent.
The payments have been and will be funded by cash from operations, borrowings
and 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.
Securities and Class Action Litigation. 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
52
manufacturers are co-defendants in some of these lawsuits. In general,
plaintiffs claim that they would not have purchased or would have 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 deny class certification in New Jersey, the only remaining
statewide class action suit involving the Company, was granted on September 30,
2004. Approximately 96 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.
SEC Inquiries and Related Litigation. 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.
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. The case was remanded to state
court. The Company has filed a motion to dismiss.
Environmental Matters. On September 24, 2004, the Company, along with
approximately 80 other parties, were named as third-party defendants in a
complaint, alleging that it (and other parties) generated waste that was sent to
the Burlington Environmental Management Services, Inc. Landfill ("BEMS Site"),
located in Southampton Township, Burlington County, New Jersey. The complaint
also indicates that the Company and the other 80 parties are liable for costs
expended to clean up the BEMS Site under New Jersey's Spill Compensation and
Control Act (New Jersey's "Superfund" statute). The Company is currently
investigating the allegations.
Tax Matters. In October of 2001, 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.
In April of 2004, the Company received a formal Notice of Deficiency (Statutory
Notice) from the IRS asserting additional federal income tax due. The Company
received bills from the IRS related to this matter on September 7, 2004. Payment
in the amount of $194 million for income tax and $279 million of interest was
made on September 13, 2004. The Company believes it has complied with all
applicable rules and regulations and intends to file a suit for refund for the
full amount of the tax and interest. The Company's tax reserves were adequate to
cover the above-mentioned payments.
53
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
ISSUER PURCHASES OF EQUITY SECURITIES
Total Number of Maximum Number of
Shares Purchased as Shares that May Yet Be
Part of Publicly Purchased Under the
Total Number of Average Price Paid Announced Plans or 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
July 1, 2004 through
September 30, 2004 23,928 (1) $18.88 N/A N/A
TOTAL 2004 78,790 $18.24
(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 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 $152 million through September 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 twelve 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.
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Item 6. Exhibits
Exhibits - The following Exhibits are filed with this document:
Exhibit Number Description
- ------------- ------------
3(i) Restated 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
55
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: October 28, 2004 /s/Douglas J. Gingerella
-------------------------
Douglas J. Gingerella
Vice President and Controller
(Duly Authorized Officer and
Chief Accounting Officer)
56